Methods of Sale

A competitive sale and a negotiated sale are the two methods by which an underwriter may purchase municipal bonds from an issuer for reoffering to the public.

In a competitive sale, bonds are advertised for sale. The advertisement, by way of a notice of sale, includes both the terms of the sale and the terms of the bond issue. Any broker dealer or dealer bank may bid on the bonds at the designated date and time. The bonds are awarded to the bidder offering the lowest interest cost.

In a negotiated sale, an underwriter is selected to purchase the bonds. The underwriter, in turn, sells the bonds to its investor customers. The terms of the bonds are tailored to meet the demands of the underwriter's investor clients, as well as the needs of the issuer. Negotiated sales also involve a process known as a presale in which underwriters seek customer indications of interest in the issue before establishing final bond pricing.

The method of sale is known as a negotiated sale because the terms of the bonds and the terms of the sale are negotiated by the issuer and the bond purchaser. Negotiation suggests a two party process. To be an effective negotiation, the issuer should have sufficient knowledge of debt financing to take an active role in establishing the terms of the issue and sale. If the issuer does not have the knowledge or experience to effectively negotiate bond terms, an independent financial advisor can serve as a third party negotiator.

Which Method of Sale?

An important question to be addressed in any financing is whether the bond issue is better suited for a competitive or negotiated sale. Some states and local charters require competitive bidding. When the sale method is a matter of choice several factors should be considered.

Competitive bond sales offer several advantages over negotiated sales. The competitive sale typically assures the lowest interest rates. While underwriting firms may attempt to secure the best interest rates for the issuer, different firms have different perceptions of the market and cater to various investing clients. This is evidenced by the fact that there are seldom two identical bids submitted at a competitive sale. In addition, rate differentials in excess of 1/4% between low and high bidders are not uncommon.

Many studies have been completed which indicate conclusively that underwriting spreads (underwriting fees) are lower for competitive sales. (For additional information regarding underwriting spreads see Municipal Bond Underwriting Spreads on this site.) According to data from The Bond Buyer, with only three exceptions, the average weighted gross underwriting spread for negotiated issues exceeded the spread for competitive issues every year since 1987. The exceptions were in in 2004, 2008 and, most recently, in 2011.

As set forth in "An Elected Official's Guide to Government Finance," the Government Finance Officers Association recommends the use of competitive sales whenever feasible. In the June 1990 edition of "Government Finance Review", the manager for the Government Finance Officers Association's Research Center, suggests that the finance officer's responsibility to safeguard the public trust becomes more acute when negotiation is selected. In a negotiated sale, the inherent protection afforded by open competition is absent. The issuer must take an active role in determining the underwriter's compensation, participate in the development of a comprehensive marketing plan, and monitor market conditions to assure that the true interest cost is an accurate reflection of the existing yield curve for similar securities.

In spite of the advantages of competitive sales, some bond issue structures and certain market factors create conditions in which a negotiated sale may be the preferred sale method.

Poor Credit

Negotiated bond sales compensate for weaker security or credit features. A negotiated sale gives an underwriter's sales force the time and incentive to assess the credit features of the obligation. In addition, underwriting firms cater to different segments of the investing market. A negotiated sale provides the issuer an opportunity to identify those firms whose clients prefer higher yields in exchange for greater risk.

The issuer should have a sound understanding of credit quality before approaching a negotiated sale. Firms, whose clientele prefer higher yields, may advise against a rating or credit enhancement to make the issue more attractive to their clients rather than taking steps to obtain the lowest financing cost for the issuer.

Unusually Large Issues

An unusually large issue provides justification for a negotiated sale. The number of bids received declines for large issues. This is attributed to weakness in market absorption. Large issues compete for capital and may require more funds than any one market participant can commit to comfortably. Underwriters and investors seek to reduce risk by diversifying their portfolios. Large issues conflict with this objective. To reduce risk, underwriters join together to form bidding syndicates. When many firms join together, fewer bids are received and the intent of a competitive sale, namely competition, is eliminated.

Unfortunately, the only study regarding bond size and competitive bidding was completed in 1974 by the "Twentieth Century Fund Task Force on the Municipal Bond Market" which found that fewer than 3 bids were received for the majority of issues over $50,000,000 when competitive bidding was used. The markets have changed significantly since 1974 and the size of the issues that are now sold successfully by competitive bid are dramatically larger and well in excess of $300,000,000.⁽¹⁾

New Entity

An entity or governmental unit operating for less than three years would be classified as a new issuer. Without at least a three year credit history, it is difficult to appraise the credit of the issue. Like poor credit issues, the negotiated sale offers presale opportunities and time to stimulate interest in the new issuing entity.

Unusual Financing Terms

The objective of a competitive sale is to obtain the largest number of bids possible by appealing to a very broad segment of the buying community. If the issue has features designed to appeal to specific underwriters or buyers the issue may be better suited for a negotiated sale. For example, an issue requiring participation by minority or women owned firms restricts the number of qualifying underwriters. Requirements to distribute a certain amount of bonds locally may exclude underwriters that specialize in institutional rather than retail sales. Careful consideration should be given to special features that limit an issuer's ability to sell bonds competitively at a lower cost.

Innovative Structure or Security

An innovative structure or security generally requires a devotion of time for structuring and preselling an issue. This is made possible only through the negotiated process. Often the structure comes about as the creation of only one underwriting firm which anticipates that the issue can be sold to its clients. Furthermore, it is unlikely that a firm will spend a substantial amount of time developing a new investment product if there is no assurance that this will translate into a sale.

Issuers should be cautious that such a structure is in fact novel. An innovative structure often gains market acceptance over time and becomes an acceptable instrument for a competitive sale. A case in point is lease purchase transactions which are constantly gaining broader market acceptance and are now successfully sold competitively.

Market Volatility

Negotiated sales are also used to improve market timing. In volatile markets, underwriters may bid conservatively to avoid market losses. A negotiated sale allows the sale date to be timed more closely in accordance with market conditions.

Volatility refers to broad swings in market interest rates over a very short time frame. A highly volatile market may produce interest rate changes of 1/4% or higher during a week or two week time span.

A negotiated sale offers considerable timing flexibility. Once an underwriter is selected and the terms of the bonds are established, the actual date of sale can take place on short notice. HOWEVER, BEWARE; TIMING TO THE MARKET IS A DANGEROUS GAMBLE. Although timing is a popular argument used to convince issuers of the merits of a negotiated sale, timing to the market is gambling. When interest rates rise, there is no assurance that they won't continue to do so. Keep in mind that investment bankers would be wealthy enough to retire early if they could determine the highs and lows of the market.

Negotiated Bond Sale Management

In a negotiated sale, the most critical role of WM Financial Strategies is to lend competency to the negotiation process. In addition, the public official is removed from the pressures and influence of dealing directly with investment bankers. The first step in this process is to establish the terms of the financing in the best interest of its client. The second step is to select an underwriter through a competitive process. WM Financial Strategies introduces competition in the negotiated sale process by soliciting, evaluating, and recommending an underwriter through a request for proposal system.

WM Financial Strategies works to assure that promises made are promises delivered. WM Financial Strategies continually reviews the bond documents and proposed financing terms to insure that the nature of the proposed financing is modified only with the consent of all parties. Interest rates are monitored to insure consistency with prevailing marketing conditions.
 

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(1)     On May 15, 2007, the State of Washington sold $376,810,000 of General Obligation Bonds and received 6 bids. On August 22, 2012, Pierce County Washington sold $169,090,000 of Sewer Revenue Bonds and received 7 bids.

WM Financial Strategies
11710 Administration Drive
Suite 7
St. Louis, Missouri 63146
Phone (314) 423-2122
JHoward@munibondadvisor.com