The Fallacy of Comparable Bond Sales

 

In a negotiated sale, when bonds are priced, underwriters often justify interest rates with "comparable sales." A truly comparable sale is difficult to find. To be comparable, there must be at least two issues with the following features:

The sale must occur on the same date and possibly at the same time. In today’s volatile rate environment, rate changes of as much as .05% in one day are not uncommon.
   

The sales must occur in the same state. For example, Missouri issues are tax exempt from both Federal and State income taxes while most Illinois issues are exempt from Federal taxation only. Accordingly, Missouri issues almost always carry lower rates than similar Illinois issues.
   

The sales must have the same Internal Revenue Code treatment. In order for two issues to be comparable, both must be bank qualified or both must be non-bank qualified.
   

The issues must have the same bond rating.

   

The issues must be the same type. For example, general obligation bonds and lease obligations are not comparable. Lease obligations and utility revenue bonds are not comparable.
   

The comparison must reflect yields and not rates since discount bonds compared to par or premium bonds would have very different interest rates even if the yields were the same. Furthermore, yield comparisons must be based on the yield to maturity, regardless of how the bonds were reoffered, since callable premium bonds understate the true interest cost. (See the article "The Problem With Premium Pricing")

A competitive bond sale (or a negotiated sale in which the underwriter is selected through a competitive process with rate indexing) provides the only true comparable results. With competitive bidding, the bids themselves demonstrate the difference in each firm’s perceptions and appetite for a particular security at a given time. When multiple bids are received, further justification of interest rates is not required.

Except as noted above, any other comparison is likely to give an inaccurate picture of bond pricing.  Furthermore, while many underwriters will attempt to select issues that are similar, the choice of issues
selected by the underwriter, for purposes of comparison, can be manipulated to demonstrate that their pricing was excellent (yields were lower than the prevailing market) when in fact pricing may have been inferior. 

The following is an example demonstrating the fallacy of comparables. The issues are not comparable!
 

Comparison of Your City's Bond Issue to Other Issuers

 

 

 

 

 

 

 

 

 

Your City

City B

City C

City D

City E

 

Missouri

Missouri

Illinois

Missouri

Missouri

 

 

$5,000,000

$11,000,000

$5,000,000

$5,000,000

$5,000,000

 

 

Bank Qualified

Non-Bank Qualified

Bank Qualified

Bank Qualified

Bank Qualified

 

 

General Obligation
 Bonds

General Obligation
 Bonds

General Obligation
 Bonds

General Obligation
 Bonds

Lease Revenue
Bonds

 

 

Aa3

Aa3

Aa3

Aa3

Aaa Insured

 

 

2/8/2007*

2/8/2007*

2/8/2007*

2/1/2007*

2/8/2007*

 

2007

3.600%

3.600%

3.600%

3.600%

3.600%

 

2008

3.600%

3.600%

3.600%

3.600%

3.600%

 

2009

3.650%

3.650%

3.650%

3.650%

3.650%

 

2010

3.650%

3.650%

3.650%

3.650%

3.650%

 

2011

3.700%

3.700%

3.700%

3.700%

3.700%

 

2012

3.750%

3.750%

3.750%

3.750%

3.750%

 

2013

3.750%

3.750%

3.750%

3.750%

3.750%

 

2014

3.800%

3.800%

3.800%

3.800%

3.800%

 

2015

3.800%

3.800%

3.800%

3.800%

3.800%

 

2016

3.850%

3.850%

3.850%

3.850%

3.850%

 

2017

3.875%

3.875%

3.875%

3.875%

3.875%

__________ 
*  Represents Sale Date 

The following is a description of the above issues and why they are not comparable.

Example 1 – Comparison of Your City to City B

In the following example, the two issues are not comparable because “Your City” issued Bank Qualified Bonds and is compared to a Non-Bank Qualified bond issue. 

Comparison of Your City's Bond Issue To City B

 

 

 

 

 

 

 

Your City

 

City B

 

 

Missouri

 

Missouri

 

 

$5,000,000

 

$11,000,000

 

 

Bank Qualified

 

Non-Bank Qualified

 

 

General Obligation Bonds

 

General Obligation Bonds

 

 

Aa3

 

Aa3

 

 

2/8/2007*

 

2/8/2007*

2007

 

3.600%

 

3.600%

2008

 

3.600%

 

3.600%

2009

 

3.650%

 

3.650%

2010

 

3.650%

 

3.650%

2011

 

3.700%

 

3.700%

2012

 

3.750%

 

3.750%

2013

 

3.750%

 

3.750%

2014

 

3.800%

 

3.800%

2015

 

3.800%

 

3.800%

2016

 

3.850%

 

3.850%

2017

 

3.875%

 

3.875%

__________ 
*  Represents Sale Date 

Under the Internal Revenue Code, banks may not deduct the carrying cost of tax-exempt municipal bonds. For banks, this provision has the effect of eliminating the tax-exempt benefit of municipal bonds. An exception is included in the Code that allows banks to deduct 80% of the carrying cost of a “qualified tax-exempt obligation.”  In order for bond issue to be a qualified tax-exempt obligation the bonds must be (i) issued by a “qualified small issuer,” (ii) issued for public purposes, and (iii) designated as qualified tax-exempt obligations.  A “qualified small issuer” is (with respect to bonds issued during any calendar year) an issuer that issues no more than $10 million of tax-exempt bonds during the calendar year.  Qualified tax-exempt obligations are commonly referred to as “bank qualified bonds” and generally carry rates between 15 to 25 basis points (.15% to .25%) lower than other issues on maturities purchased by banks (generally ten years or shorter).  Accordingly, your City should have received rates (yields) at least .15% lower than City B.

Example 2 – Comparison of Your City to City C

In the following example, the two issues are not comparable because “Your City” is located in Missouri and City C is located in Illinois. 

 

Comparison of Your City's Bond Issue To City C

 

 

 

 

 

 

 

Your City

 

City C

 

 

Missouri

 

Illinois

 

 

$5,000,000

 

$5,000,000

 

 

Bank Qualified

 

Bank Qualified

 

 

General Obligation Bonds

 

General Obligation Bonds

 

 

Aa3

 

Aa3

 

 

2/8/2007*

 

2/8/2007*

2007

 

3.600%

 

3.600%

2008

 

3.600%

 

3.600%

2009

 

3.650%

 

3.650%

2010

 

3.650%

 

3.650%

2011

 

3.700%

 

3.700%

2012

 

3.750%

 

3.750%

2013

 

3.750%

 

3.750%

2014

 

3.800%

 

3.800%

2015

 

3.800%

 

3.800%

2016

 

3.850%

 

3.850%

2017

 

3.875%

 

3.875%

__________ 
*  Represents Sale Date 

As previously noted, Missouri issues are exempt from both Federal and State income taxes while most Illinois issues are exempt only from Federal income taxation. Accordingly, Missouri issues almost always carry lower rates than similar Illinois issues.  Furthermore, if the comparison involves issues from states where the interest is exempt from state income taxation the comparison is relevant only if the different states have similar tax rates.  In this example, Your City should have had rates approximately 5 to 10 basis points lower than City C.

Example 3 – Comparison of Your City to City D

In the following example, the two issues are not comparable because rates for “Your City” were set on
February 8, 2007 and rates for City D were set on February 1, 2007.  Interest rates (yields) declined by approximately .10% from February 1 to February 8.  Accordingly, your City should have received rates approximately .10% lower than those shown below. 

 

Comparison of Your City's Bond Issue To City D

 

 

 

 

 

 

 

Your City

 

City D

 

 

Missouri

 

Missouri

 

 

$5,000,000

 

$5,000,000

 

 

Bank Qualified

 

Bank Qualified

 

 

General Obligation Bonds

 

General Obligation Bonds

 

 

Aa3

 

Aa3

 

 

2/8/2007*

 

2/1/2007*

2007

 

3.600%

 

3.600%

2008

 

3.600%

 

3.600%

2009

 

3.650%

 

3.650%

2010

 

3.650%

 

3.650%

2011

 

3.700%

 

3.700%

2012

 

3.750%

 

3.750%

2013

 

3.750%

 

3.750%

2014

 

3.800%

 

3.800%

2015

 

3.800%

 

3.800%

2016

 

3.850%

 

3.850%

2017

 

3.875%

 

3.875%

__________ 
*  Represents Sale Date 

Example 4 – Comparison of Your City to City E

In the following example, the two issues are not comparable because “Your City” sold General Obligation Bonds and City E sold Leasehold Revenue Bonds. 

Comparison of Your City's Bond Issue To City E

 

 

 

 

 

 

 

Your City

 

City E

 

 

Missouri

 

Missouri

 

 

$5,000,000

 

$5,000,000

 

 

Bank Qualified

 

Bank Qualified

 

 

General Obligation Bonds

 

Lease Revenue Bonds

 

 

Aa3

 

Aaa Insured

 

 

2/8/2007*

 

2/8/2007*

2007

 

3.600%

 

3.600%

2008

 

3.600%

 

3.600%

2009

 

3.650%

 

3.650%

2010

 

3.650%

 

3.650%

2011

 

3.700%

 

3.700%

2012

 

3.750%

 

3.750%

2013

 

3.750%

 

3.750%

2014

 

3.800%

 

3.800%

2015

 

3.800%

 

3.800%

2016

 

3.850%

 

3.850%

2017

 

3.875%

 

3.875%

__________ 
*  Represents Sale Date 

You may have expected City E’s issue to have lower rates than Your City since this issue was insured; however, revenue bonds or lease obligations almost always have higher interest rates than general obligation bonds with comparable ratings.  Accordingly, the yields on your issue should have been approximately 5 basis points lower than those shown above.

Summary

While many underwriters attempt to select issues that are similar, the choice of issues selected can be manipulated to demonstrate that pricing for your issue was fair or excellent (yields were lower than the prevailing market) when in fact pricing may have been inferior.   

How likely is it that an underwriter would select "comparable issues" that had lower yields than those assigned to your issue? When selecting your financing team, to assist you in obtaining the best possible pricing, consider that financial advisors serve in a fiduciary capacity while underwriters serve in an arms length commercial transaction.

 

WM Financial Strategies
11710 Administration Drive
Suite 7
St. Louis, Missouri 63146

Phone (314) 423-2122
Fax (314) 432-2393
JHoward@munibondadvisor.com