Municipal Bond Underwriting Spreads.

The Underwriting Spread

In a new offering of municipal bonds, underwriters make money from the "underwriting spread." The underwriting spread (underwriter spread or underwriting fee) is the difference between the price at which a bond issue is bought (the purchase paid) and the price at which the bonds are sold to investors.

An underwriting spread can be obtained using a discount, par or premium pricing approach (or a combination of the three pricing methods). Generally, the pricing approach does not affect the underwriter's compensation.⁽¹⁾The underwriter will establish a purchase price for the bonds and interest rates that result in the desired level of compensation.

Without knowing how bonds are priced, it is not possible to know what compensation the underwriter is receiving. For example, an underwriter that purchases a bond issue at a discount of 1/2% (purchase price of 99.5%) does not necessarily obtain a 1/2% fee. The compensation will be more than 1/2% if the bonds are sold at a premium (a price higher than 100%). A discount of 1/2% coupled will reoffering premiums totaling 1/2% would net the underwriter a total spread of 1%. Stated differently, if the underwriter purchases the bonds 99.5% and sells the bonds at 100.5% the compensation is 1%.

Municipal Bond Yields and Rates

The underwriting spread affects the bond issue price and rates with the constant variable being the current market yield. Current market yield refers to the rate of return required to entice an investor to purchase a bond for a particular duration of time. For a new bond offering, when bonds are sold to the public at a price of 100%, the rate on the bonds and the yields are the same as indicated in the following example.

Year	Rate	Yield	Price
1	3.35%	3.35%	100.000%
2	3.40	3.40	100.000
3	3.50	3.50	100.000
4	3.60	3.60	100.000
5	3.70	3.70	100.000

When bonds are sold to the public at a price other than 100%, the rate on the bonds (and the price at which the bonds are sold) must be adjusted so that investors obtain the same rate of return (yield). In setting the rates on individual maturities of a bond issue, the underwriter takes the following into account (i) market yields, (ii) the prices required to obtain the desired underwriting spread, and (iii) prices that will be attractive to investors (not too high or too low).

Based on the same market yields as shown above, the following table indicates the price at which the bonds are sold when the rate on all of the bonds is 3.6%.

Year	Rate	Yield	Price
1	3.60%	3.35%	100.243%
2	3.60	3.40	100.383
3	3.60	3.50	100.282
4	3.60	3.60	100.000
5	3.60	3.70	99.547

Bond Pricing Examples

Four examples are set forth below to illustrate how different pricing approaches result in a 1% underwriter spread. In addition, the four examples show how different pricing approaches affect the amount of funds obtained by the issuer, interest rates and debt service. The four examples are based on the following:

The same pricing approach is applied to each maturity of bonds. (Often different pricing
approaches are applied to individual maturities of a single bond issue.)

The issuer sells $10,000,000 principal amount of bonds (regardless of pricing approach) and the
principal amounts maturing in each year remain constant.

The bonds mature over a 5 year term.

The underwriter establishes rates and purchase prices that result in compensation of 1%
(a 1% underwriting spread).

The market yields at the time of the sale are as follows:

Year	Yield
1	3.350%
2	3.400
3	3.500
4	3.600
5	3.700

Bonds Purchased at a Discount and Reoffered at Par

In this example the bonds are purchased from the issuer at a price of 99% and reoffered (sold to investors) at a price of 100% netting the underwriter a total spread of 1%.

Year	Principal	Rate	Yield	Price	Interest	Total Debt Service
1	$ 1,865,000	3.350%	3.350%	100.000%	$ 351,628	$ 2,216,628
2	1,930,000	3.400	3.400	100.000	289,150	2,219,150
3	1,995,000	3.500	3.500	100.000	223,530	2,218,530
4	2,065,000	3.600	3.600	100.000	153,705	2,218,705
5	2,145,000	3.700	3.700	100.000	79,365	2,224,365
Total	$10,000,000				$1,097,378	$11,097,378

Purchase Price = 99% or $9,900,000

Underwriter Compensation = $100,000

Total Debt Service as Shown Above = $11,097,378

Bonds Purchased at Par and Reoffered at a Premium

In this example the bonds are purchased from the issuer at a price of 100% and reoffered at an average price of 101% netting the underwriter a total spread of 1%.

Year	Principal	Rate⁽²⁾	Yield	Price	Interest	Total Debt Service
1	$ 1,865,000	3.737%	3.350%	100.377%	$ 386,861	$ 2,251,861
2	1,930,000	3.750	3.400	100.671	317,166	2,247,166
3	1,995,000	3.850	3.500	100.988	244,791	2,239,791
4	2,065,000	3.850	3.600	100.923	167,984	2,232,984
5	2,145,000	4.125	3.700	101.923	88,481	2,233,481
Total	$10,000,000				$1,205,284	$11,205,284

Underwriter Compensation = $100,000

Funds Received by Issuer = $10,000,000

Total Debt Service as Shown Above = $11,205,284

Bond Purchased at a Premium and Reoffered at a Premium

In this example the bonds are purchased from the issuer at a price of 101% and reoffered at an average price of 102% netting the underwriter a total spread of 1%.

Year	Principal	Rate	Yield	Price	Interest	Total Debt Service
1	$ 1,865,000	4.450%	3.350%	101.072%	$ 432,440	$ 2,297,440
2	1,930,000	4.450	3.400	102.013	349,448	2,279,448
3	1,995,000	4.350	3.500	102.400	263,563	2,258,563
4	2,065,000	4.250	3.600	102.401	176,780	2,241,780
5	2,145,000	4.150	3.700	102.037	89,018	2,234,018
Total	$10,000,000				$1,311,248	$11,311,248

Underwriter Compensation = $99,998

Funds Received by Issuer = $10,100,000

Total Debt Service as Shown Above = $11,311,248

Bonds Purchased at a Discount and Reoffered at a Discount
(Original Issue Discount Pricing)

Original issue discount pricing occurs when the rates on a new issue of municipal bonds are set lower than the current market yield. In this example, the bonds are purchased from the issuer at a price of 98% and reoffered at an average price of 99% netting the underwriter a total spread of 1%.

Year	Principal	Rate⁽²⁾	Yield	Price	Interest	Total Debt Service
1	$ 1,865,000	3.123%	3.350%	99.778%	$ 318,838	$ 2,183,838
2	1,930,000	3.125	3.400	99.472	260,594	2,190,594
3	1,995,000	3.125	3.500	98.940	200,281	2,195,281
4	2,065,000	3.200	3.600	98.522	137,938	2,202,938
5	2,145,000	3.350	3.700	98.415	71,857	2,216,858
Total	$10,000,000				$989,508	$10,989,508

Underwriter Compensation = $100,003

Funds Received by Issuer = $9,800,000

Total Debt Service as Shown Above = $10,989,508

Comparison of Four Pricing Alternatives

The following table summarizes the results from the examples above. Note that in each example the underwriter obtains approximately $100,000 (1% of the principal amount of the issue); however the amount of funds received by the issuer and the debt service paid over the life of the bond issue varies based on the pricing method used to obtain the underwriter's spread.

Purchase Price/Sale Price	Bought at Discount/Sold At Discount (Original Issue Discount)	Bought at Discount/Sold at Par	Bought at Par/Sold at Premium	Bought at Premium/Sold at Premium
Underwriter's Compensation	$100,003	$100,000	$100,000	$99,998
Funds Received by Issuer	$9,800,000	$9,900,000	$10,000,000	$10,100,000
Total Debt Service	$10,989,508	$11,097,378	$11,205,283	$11,311,248

Summary

Underwriters are compensated through an underwriting spread that can be obtained through a number of pricing combinations. The spread is the difference between the price at which a bond issue is purchased and the price at which the bonds are sold to investors. Without knowing the price at which bonds are sold an issuer can not know how much the underwriter was compensated. Without knowing the price at which the bonds are sold, an underwriter may be compensated more than had been intended. In addition, because the pricing approach affects the funds received by the issuer and the total debt service paid, it is important that issuers understand the mechanics of pricing or seek pricing assistance from an independent financial advisor.

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(1) An underwriter may set a higher level of compensation if the issuer selects a pricing strategy that is not consistent with the pricing approach desired by the underwriter.
(2) Municipal bond rates are generally in multiples of 1/20 or 1/8 of 1%. Some of the rates set forth above are for purposes of illustrating pricing rather than indicative of true market rates.