Module 6 Part 2
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SELLING SYNDICATE — FINANCIALLY COMMITTED
The SELLING SYNDICATE is composed of one or more broker/dealers who are willing to commit themselves and large sums of money to bringing the securities issue to market. These broker/dealers commit themselves financially, and they assist in the pricing of the issue. The selling syndicate uses information gathered from their sales forces on the salability of the issue to help determine marketability and a good price for the issue.
The syndicate arranges to purchase shares or bonds from the issuer. The amount the lead underwriter allows the selling syndicate to sell is based upon the amount of financial commitment the selling syndicate makes. The lead underwriter takes the largest percentage of the issue to sell and the other members of the syndicate are allotted varying amounts, depending on their financial commitment.
The SYNDICATE LETTER
Outlines the terms under which the account will be managed, including
- •The AMOUNT of the issue each member is ALLOTTED
- •The amount of MONEY each member must CONTRIBUTE
- •The basis for which the issue will be distributed in the case of being oversold
- •The OBLIGATIONS of each syndicate member
- •The type of participation under which the underwriting account will be based:
- -An "EASTERN" account
- -A "WESTERN" account
The members of the syndicate sign the syndicate letter, which binds them to underwriting the issue. The syndicate letter is signed prior to the release of the issue.
•With respect to corporate issues, the syndicate letter is signed at the due diligence meeting the night before (OR the morning of) the sale. This is the last opportunity for syndicate members to pull out of the commitment.
•With respect to municipal issues, the syndicate letter is usually signed about two weeks before the actual issue of the bonds.
The syndicate letter is also known as the AGREEMENT AMONG UNDERWRITERS, the ACCOUNT LETTER, the SYNDICATE CONTRACT, or the SYNDICATE AGREEMENT.
When the underwriting is over
, the syndicate manager analyzes
the issue’s sales
— the amount of securities sold by each
, the amount of securities left over
, and the amount of group net orders (and thus credit to all members).
- •The manager then sends the final syndicate agreement with final numbers to each member — how much each member sold and how much sales charge they will receive.
- •The final syndicate agreement that lists how much each syndicate member sold AND how much sales charge each will receive is SENT in the SYNDICATE SETTLEMENT LETTER.
SELLING GROUP — NO FINANCIAL COMMITMENT
The SELLING GROUP is made up of all of the other broker/dealers who are NOT financially committed to the underwriting, yet are able to sell parts of the issue. The selling group is formed as a separate group from the syndicate. Syndicate members receive verbal commitments from these other broker/dealers to help sell the issue; HOWEVER, the SELLING GROUP participants do not have to make a commitment to sell a specific number of shares.
Because the broker/dealers in the selling group DO NOT make a financial commitment to the underwriting, they ONLY participate in the selling of the issue and DO NOT have a minimum amount to sell. They DO NOT participate in the setting the issue’s selling price, NOR DO THEY benefit as much with the sales of the issue. The SELLING GROUP reaps the smallest amount of profit from the sale of the issue.
Which of the following is part of an underwriting syndicate that has a financial responsibility to the underwriting but has no other commitments other than pricing and selling?
(C) Syndicate member
(D) Selling group member
(C) Syndicate member. The syndicate member has a financial commitment and does the selling, but the manager, or underwriter, does all the other work. The selling group sells, but has no financial commitment.
EASTERN & WESTERN ACCOUNTS
When an underwriting syndicate is formed, the syndicate members participate in the offering based on an EASTERN ACCOUNT or a WESTERN ACCOUNT regarding the sales and accounting of the underwriting.
EASTERN ACCOUNT — UNDIVIDED ACCOUNT
If the syndicate is formed under an EASTERN account method (also known as an UNDIVIDED ACCOUNT), all the members have undivided selling responsibility and UNDIVIDED LIABILITY in the issue. Test-taking tip: "E" for EASTERN and "U" for UNDIVIDED account are both vowels.
UNDIVIDED selling responsibility MEANS ALL members of the syndicate must attempt to sell the whole issue (stock or bonds) UNTIL the ENTIRE issue is sold, REGARDLESS of each syndicate member’s commitment.
•The underwriters POOL the whole issue, and each can sell as much as they want as long as part of the issue is available to sell.
•Each syndicate member gets CREDIT and COMISSION on what each sells; HOWEVER, EXCESS profits from these sales are divided based on each syndicate member’s participation as outlined in the syndicate letter.
•In essence, each syndicate member MAY end up selling more (or less) than agreed to as outlined in the syndicate letter, based on what is available to sell.
Means that IF there is any unsold part of the issue at the close of the underwriting period, syndicate members are EACH LIABLE for their proportionate share of the unsold issue.
•This means that at the close of the selling period, syndicate members are required to buy a percentage of the unsold amount of the issue based on each syndicate member’s percentage of participation as agreed to in the syndicate letter.
•EVEN IF a syndicate member sells as much as it committed to sell, or sells more than the firm committed to sell, the firm may still have to purchase additional stock or bonds if other syndicate members were unable to sell their allocation. - Damn, that sucks! Why would anyone do this?
UNDIVIDED LIABILITY Example:
If a syndicate member is a 15% participant, but sells only 10% of the issue, this member is entitled to 10% for the sales, but receives the full 15% of the excess profits over the sales, as long as the entire issue is sold
- Conversely, if a syndicate member is a 15% participant and sells 20% of the issue, this member receives a commission for the full 20%; however, he will only receive excess profits (if any) on 15% of the issue.
- If the entire issue is not sold (therefore no excess profits), this same syndicate member is liable for, and has to buy, 15% of the unsold portion of the issue, regardless of whether that syndicate member sold more or less than the agreed to amount.
A syndicate member in an undivided $12 million municipal offering agreed to sell $1.2 million of the offering. Initially, the firm only sold $900,000 of the bonds. After four weeks, $1.5 million of the offering remains to be sold. The syndicate manager decides to close and settle the account. The syndicate member firm has liability for what amount of the bonds?
(C) $1.2 million
(D) $1.5 million
Answer (A) $150,000. Although selling responsibility is 100% of the commitment, when the offering closes down, the liability associated with the syndicate letter takes precedence. In this case, the $1.5 million left in the account means that the syndicate member must take the firm’s percentage from the leftover bonds. Since the member is a 10% member (1.2 million divided by 12 million), the syndicate member would only have to sell $150,000 (10% of $1.5 million). The firm has a reduced liability, because the syndicate letter only commits the firm to the same percentage of the unsold issue. The firm is not obligated to sell $300,000. Rather, it is only obligated to sell $150,000 of the unsold issues
WESTERN ACCOUNT — DIVIDED ACCOUNT
If the syndicate is formed under a "WESTERN" ACCOUNT METHOD (also known as a DIVIDED ACCOUNT), each syndicate member has UNDIVIDED selling responsibility BUT DIVIDED LIABILITY. Test-taking tip: "W" for western and "d" for divided are both consonants. With divided liability, each syndicate member firm has undivided sales responsibility (just as in an eastern account method), meaning that the firm has to sell until the WHOLE offering is sold.
HOWEVER, in the event that the whole issue is NOT SOLD, each syndicate member that sold all of the issue it had committed to is NOT LIABLE for the unsold part of the issue. THIS IS HOW THE THE WESTERN ACCOUNT METHOD DIFFERS FROM THE EASTERN ACCOUNT METHOD. Only the syndicate members that do not sell the amount they committed to sell must purchase their unsold portions for their own account.
WESTERN ACCOUNT - DIVIDED ACCOUNT
If the entire issue is sold, a 15% participant who sells his entire 15% only receives 15% of the profits.
If only a part of the issue is sold, a 15% participant who sells his entire 15% receives 15% of the profits; however, a 15% participant who sells only 10% of the issue is liable for the remaining 5% that did not sell.
A syndicate member in a divided $6 million municipal offering agrees to sell $600,000 of the offering. Initially the firm only sold $400,000 of the bonds. After one week, $1 million of the offering remains to be sold. The syndicate manager calls all of the members to tell them to sell and reminds them of their commitment. This syndicate member firm has selling responsibility for what amount of the bonds?
(D) $1 million
Answer (D) $1 million. The selling responsibility is 100%. When the offering closes down, the liability would then take precedence. But in this case, the question asks for selling responsibility, which is the $1 million in the account. Selling responsibility is ALWAYS 100%. If the question had asked for liability, as above, the answer would have been $200,000.
Didn't get this one right, go through this one a few times.
Any NEW CORPORATE issue that is sold to the public MUST be registered with the Securities and Exchange Commission (SEC) and sold through either an UNDERWRITING OR a PRIVATE PLACEMENT. (We are not concerned with private placements here since they are not on the TEST.)
Many times, when a company sells shares in an underwriting, a CORPORATE OFFICER or other INVESTORS who own stock in the company may wish to sell some of their stock. These investors can add their shares to the underwriting, and then the underwriting is both a PRIMARY and a SECONDARY underwriting. The PRIMARY part of the underwriting is the stock from the company; the SECONDARY part of the underwriting is the stock from the selling stockholders.
Corporations may issue any of the following three types of securities: bonds, preferred stock, and common stock. These securities can be sold through an underwriting that is led by a lead underwriter. The lead underwriter, with the assistance of a selling syndicate, sells the securities. In some instances an informal arrangement is made that resembles a selling group. Broker/dealers who are not members of the syndicate contact the syndicate to see if they can get some of the issue.
Corporations NEGOTIATE with an underwriter to sell their securities to investors at the least cost to the corporation. Many times, corporations negotiate with a known underwriter who may have managed previous underwritings for that company.
WORK OF THE MANAGER
The underwriter helps the issuer decide on the best method to sell the securities.
•Once this underwriter is selected and an underwriting agreement is signed, the issuer’s responsibilities are reduced to providing information for the prospectus and supplying the issue certificates.
•The underwriters perform all the work associated with registering the issue, selling the issue, and informing the public about the issue.
•While the underwriters are negotiating with the issuer, they will simultaneously begin forming a selling syndicate.
- The underwriter also registers the issue with the SEC AND with ANY STATES where the issue will be sold.
- •Registering the issue with the states in which it will be sold is called BLUE-SKYING the issue
- The underwriter writes the PROSPECTUS with help from the issuer’s attorneys. The purpose of the prospectus is TWOFOLD:
- •To satisfy the SEC disclosure requirement
- •To provide information for the selling broker/dealers to distribute to client
The underwriter also helps the issuer make important decisions regarding when, and in what quantity, securities should be issued. For corporate securities, such as stocks or corporate bonds, the underwriter handles all the work regarding registration of the issue, including:
- •Registering the issue with the SEC.
- •Making sure that the issue satisfies all the requirements of each state in which the issue will be sold. When an underwriter does this, it is said that the underwriter is blue-skying the issue, because the various state requirements are called blue-sky requirements.
- •Determining which other broker/dealers will be part of the syndicate.
The syndicate manager is responsible for which of the following?
I. Blue-skying the issue
II. Sending the registration statement to the SEC
III. Putting the prospectus together
IV. Determining allocations for syndicate members
V. Stabilizing the issue
VI. Allocating securities for the syndicate
(A) I and II only
(B) IV, V, and VI only
(C) I, II, IV, V, and VI only
(D) I, II, III, IV, V, and VI
Answer (D) I, II, III, IV, V, and VI. These are all responsibilities of the manager or co-managers, which is why they receive a manager’s fee. The issuer turns over all registration to the syndicate manager, but provides the firm with all necessary information. The managers direct the step-by-step process of the underwriting. Stabilizing the issue is done during the initial offering and is related to maintaining a public offering price.
REGISTERING THE CORPORATE ISSUE
The SEC reviews the registration statement that the underwriter files. Providing the registration statement is complete, the SEC releases the issue to be sold. The date the issue is released to be sold is CALLED the EFFECTIVE DATE.
The period of time between the filing of the registration statement and the EFFECTIVE DATE of the offering is known as a QUIET PERIOD OR a COOLING OFF PERIOD. The quiet or cooling off period lasts at least 20 days and is required to allow:
- •Time for the issuer to perform a final review of the issue
- •The issuer to register with the respective states in which it will be offered (blue-skying), performed by the underwriter
- •The public to digest the news of the upcoming issue
- •The SEC to review the prospectus for required information
- •The underwriter to prepare for the sale of the issue
During the cooling off period, nothing other than a PRELIMINARY PROSPECTUS, which is more often called a RED HERRING, may be sent to the public to induce that person to buy the issue.
- •NO PRICE will be shown in the preliminary prospectus.
- •Anyone within the industry (i.e., anyone other than the general public) may receive any information about the issue without the same restrictions.
- •The issue cannot be promoted or sold during the quiet period. Until the registration statement has been viewed and an effective date declared by the SEC, the underwriter’s communication with the public about the issue is limited.
- •Until the effective date, NO solicitations are permitted. Thus, NO ADVERTISING information may be sent with a preliminary prospectus.
The underwriter and the syndicate members determine the price at which the issue will be offered to the public.
- •The selling syndicate determines the price of the offering based on the current performance of the company and the value of the company in relation to the market at the time of the offering.
- •To determine this, the selling syndicate reviews the corporate dividends and earnings, products offered by the company, other companies in the industry, and any other factors that may affect the price that the public will be willing to pay for the securities.
- •Selling group participants have NO input on the offering price of the securities. These firms do not have a financial commitment to the sale of the securities.
Which of the following can be sent with the preliminary prospectus?
(A) The registered rep’s card with a note indicating the important pages
(B) A history of the trading of the company’s stock in the OTC market
(C) A summary of the prospectus
(D) Nothing. The preliminary prospectus indicates that the issue is still in registration. Nothing can be sent during the registration process, except the preliminary prospectus, or what is commonly referred to as the red herring. Once the issue becomes effective, other advertising and soliciting is permitted.
The Securities Act of 1933 states that all new issues of stock and corporate bonds must be accompanied by a PROSPECTUS.
The prospectus accompanies the registration statement and the SEC reviews the prospectus before it can be released. The SEC does not approve or disapprove the prospectus; the SEC only reviews it to assure that all necessary information has been disclosed and that the information is complete.
A TOMBSTONE ADVERTISEMENT, usually displayed in a newspaper, states that the underwriting broker/dealers are bringing a new issue to market.
- •TOMBSTONE ads are generic and only state the issuer, the price of the issue, the syndicate underwriting the issue, and where an investor can obtain more information.
- •Tombstone ads for corporate issues state who is selling the issue, for example, the corporation, a selling stockholder, or both.
- •If the corporation is selling the securities to investors, the offering is defined as a primary issue.
- •If a large stockholder is selling the securities to other investors, these transactions are considered a secondary distribtution.
- •If both the corporation and a large stockholder are selling securities simultaneously, the offering is considered a split offering, OR a primary AND a secondary issue.
PENALTY BID/STABILIZING BID
The syndicate letter includes other terms associated with the underwriting beyond the commitment on the part of the syndicate members and whether the underwriting account is either eastern or western. The syndicate letter also includes the following stipulations associated with the initial offering:
- •The amount of the STABILIZING BID and when it will be used
- •The order of settlement in the account for a sold-out issue
- •The names of all the syndicate members and their participation amount
- •The agreement among the underwriters, including whether the manager has full control over the syndicate and what entities are allowed into the syndicate
- •The duties of the manager
- •Any other pertinent information about the members of the syndicate
- •The spread, which includes the manager’s fee, the concession, and the re-allowance in the corporate offering
Stabilizing the issue is required when the market price of the outstanding shares or bonds starts to fall below the offering price of the new issue.
If a new issue is not able to sell all of the offered shares, a secondary market may develop prior to the completed initial offering of the new issue.
If the price of the issue in the secondary market falls below the price of the new issue, the syndicate will have a difficult time finding investors to partake in the new issue.
- If the price of the issue becomes unstable, the syndicate manager may support the price of the issue in the secondary market by offering a STABILIZING BID, OR price, to anyone who wishes to sell the issue in the secondary market. The syndicate manager thus offers to repurchase the issue.
- •The STABILIZING BID PRICE (which is an offer to buy the stock or the bonds) is at either the same price as the new issue OR just BELOW it.
If a new issue is selling for $15, a stabilizing bid may be at $15 or as low as $14.75 to maintain a price close to the public offering price. If the public offering price is not supported, any additional shares issued in the primary offering are priced lower than the initial offering price.
Accordingly, anyone who buys the stock in the secondary market pays MORE for the stock than if they purchased the stock at the initial offering price.
The stabilizing bid is also called the PENALTY BID.
This is so named because a selling group member loses the commission on the sale of any issue that is repurchased by a syndicate manager; in this way, the selling group is penalized.
The purpose of the stabilizing or penalty bid is to PREVENT selling group members from generating excess commissions by selling the issue to individuals who then simply sell the issue back to the syndicate manager without losing any money. - Makes sense!
PRIORITY ALLOCATION OF ORDERS
Terms and conditions for an underwriting are established in a PURCHASE CONTRACT and the AGREEMENT AMONG UNDERWRITERS. The terms and conditions include specified levels of participation. The priority for allocation of orders allows representatives to indicate their customer’s interests for an underwriting. The syndicate manager determines which firms receive securities, but the agreement specifies the level of participation for each underwriter.
IF an issue is oversold (i.e., there are more buy orders than there are stocks or bonds), the syndicate manager determines the ORDER OF SETTLEMENT, or priority in which the orders are filled. For corporate offerings that are oversold, the syndicate manager allots issues in the following order:
- 1. GROUP NET ORDERS — these orders are sold at the PUBLIC OFFERING PRICE. Issues are first allotted to group net orders because these are orders where everyone in the selling syndicate receives part of the concession. Each member of the syndicate shares in the concession on the sale according to its participation, LESS any expenses charged to the underwriting. A GROUP NET ORDER is a large order to buy the new issue that is placed by one of the selling syndicate members, BUT all of the syndicate members get credit for the sale. Since all members of the syndicate receive part of the concession, these orders take precedence over designated orders.
- 2. DESIGNATED ORDERS — issues are allotted to DESIGNATED ORDERS after group net orders are filled. A designated order is an order to buy the new issue that is placed by one of the syndicate members; only THAT SYNDICATE member, plus any other syndicate member WHO HAS BEEN DESIGNATED, is credited for the sale. Not ALL syndicate members receive credit for the sale. Securities are allotted based on the size of each order being considered. Usually, large blocks take priority. (A mutual fund or other institution usually places large orders.)
The syndicate manager has the authority as specified in the agreement. If a member of the syndicate places an order on behalf of a mutual fund, the order must be a designated order.
DESIGNATED ORDERS Example:
- In a syndicate with three members including the manager, one member of the syndicate places three group net orders. The three orders are placed as group net orders, and all the syndicate members each receive credit as a percentage of these total sales and all share in the commission for the sales.
- Any individual syndicate orders that come in are filled as designated orders.
Issues allotted next are based on the size of each order being considered; USUALLY, large blocks take priority.
Issues are also allotted based on criteria established by the lead manager, who may play favorites OR fill orders on a first-come, first-served basis. Politics play a big part here.
If a corporate offering is OVERSOLD, the manager tries to find a way to fill all the orders. Many times the manager negotiates different clauses in the contract with the issuer. One such clause is the Greenshoe clause, named after an offering in 1924 with the Green Shoe Manufacturing Company. At that time the offering was oversubscribed because of a rush for shares. The underwriter went to the issuer requesting an additional amount of shares. The issuer agreed to an additional 10% in shares, and thus the name "Greenshoe clause."
The GREENSHOE CLAUSE is a statement in the underwriting papers between the issuer and the lead underwriter allowing for a predetermined amount of extra shares to be offered IF the whole issue is oversold.
•The number of extra shares can vary, but the issuer has agreed to allow for the extra shares.
Not every offering has a Greenshoe clause in the underwriting papers, but it is a benefit for the underwriter if the issue is oversold.
A corporate issue that is being underwritten has been effective for over a week. The price starts to drop, so the manager enters a stabilizing bid. The public offering price on the issue is $31. At what price will the manager enter the stabilizing bid?
Answer (C) 31. The stabilizing bid must be AT or BELOW the public offering price. It is always AT the public offering price for no other reason than to keep the price the same as the initial offering price. ALWAYS pick the public offering price in a question on stabilizing bids.
The two types of municipal issues are:
- The two types of municipal issues are:
- •General obligation bonds
- •Revenue bonds
GENERAL OBLIGATION BONDS
A GENERAL OBLIGATION BOND (also known as a GO bond) is issued by a municipality and backed by the taxing power of the municipality. Therefore, by law, selecting an underwriter to issue general obligation bonds must ALWAYS be done through a competitive bid process. In this way, the issue is underwritten for the LEAST cost to the municipality.
•The municipality most often places an advertisement in the BOND BUYER, an online newspaper well known by underwriters, asking for underwriting bids.
In its Bond Buyer advertisement, the municipality asks investment bankers to submit bids on their proposed issue. This advertisement requesting bids is called a NOTICE OF SALE. If the issue is small, the municipality may only advertise in the local paper, hoping for a local bank to underwrite it.
The Notice of Sale provides all the information that the underwriters need to make a bid, including:
- •The maturity date(s) of the bond
- •The range of acceptable interest rates
- •The call features
- •The method by which the interest cost is to be computed, EITHER under the NET INTEREST COST METHOD or the TRUE INTEREST COST METHOD•Good faith deposit as outlined by the issuer
- •Other items of importance
COMPETITIVE BID PROCESS
When a competitive bid is issued, the process is as follows:
•Each prospective underwriter submits a sealed bid to the issuer, stating:
- -The amount of money to be offered to the issuer as payment for the bonds
- -The interest cost per year
- -The total interest cost to the issuer, EITHER as a NET INTEREST COST or a TRUE INTEREST COST
NEW ISSUE WORKSHEET
Each underwriter obtains a bid sheet from the Bond Buyer, called the NEW ISSUE WORKSHEET, which outlines the bidding procedures.
Each sealed bid MUST be delivered by a certain time on a certain date (and usually arrives just minutes before the deadline).
•The issuer then opens the bids and chooses the underwriter that is offering the issue to the public for the LEAST amount of interest cost to the issuer, AND the GREATEST AMOUNT of MONEY paid to the issuer.
•The underwriter must also be able to sell the MINIMUM amount of bonds that the issuer requires.
The City of San Francisco has issued an advertisement stating that it is accepting bids for a $40 million general obligation bond with maturities from 2001 through 2020. The advertisement is called a:
(B) Public offering
(C) Notice of sale
(D) Public notice
Answer (C) Notice of sale. The notice of sale is an advertisement by the issuer, soliciting bids for a municipal bond. A tombstone is an announcement about an underwriting that has been published by an underwriting syndicate. The other two answer choices are meaningless here.
DETERMINING THE BID
When an underwriter bids on a municipal offering, the following factors must be considered:
1. The current market interest rates as compared to the range of interest rates allowed by the issuer — the issuer always give a 2% to 3% window in which the underwriters must keep the interest. For this reason, the first item determined when making the bid is the SCALE, which is the interest rate COMBINED with the price to determine the yield to the investor.
2. The interest rates, as found in one of the appropriate indexes for long-term bonds found in the Bond Buyer.
•For REVENUE BONDS, the syndicate looks to the REVENUE BOND INDEX (also known as the REV 30 INDEX).
• The REV 30 INDEX is an index of the average interest rate on 25 revenue bonds with 30 years to maturity — very important in determining the interest rates for a new issue of revenue bonds. Revenue bonds are not rated since there is no way to determine if the revenue bond project will be able to make all interest and principal payments.
• For GENERAL OBLIGATION bonds, the syndicate looks to the GENERAL OBLIGATION 20 YEAR BOND INDEX that closely mimics the ratings of the bond they will be underwriting.
• The GO 20 Index is an index of the average of the interest rates on 20 general obligation bonds — very important in determining the interest rates for a new issue of general obligation bonds. It is equivalent to an A+ (A1) rating.
• A 40 municipal GO Bond Index that is EQUIVALENT to BBB ratings and an 11 GO Bond Index that is EQUIVALENT to AA ratings are also available.
• All these indexes are determined every week, on Thursday, and published in the Bond Buyer on Friday.
• REMEMBER, ratings are the determination of the ABILITY of the issuer to make timely PAYMENTS of principal and interest.
3. The 30-DAY VISIBLE SUPPLY — a weekly list of municipal bonds that will be offered through an underwriting during the next 30 days, published on Mondays in the Bond Buyer
4. Calculate the net interest cost or the true interest cost, depending on the requirement by the issuer
NET INTEREST COST is the amount of money the issuer actually pays over the life of the bond. Multiplying the face value of each bond by the interest paid over the life of the bond and adding that together determines the net interest cost
. (You will not have to calculate this
TRUE INTEREST COST is more involved; in essence, it is the interest cost, taking into consideration the time value of money
- -If the bonds are bid at a premium, the net interest cost is calculated by subtracting the premium from the total interest cost.
- -If the bonds are bid at a discount, the net interest cost is calculated by adding the discount to the total interest cost.
5. Any information on the tax-exempt status of the bonds, the financial condition of the issuer, OR any other factors that may affect the interest rate and price of the bonds. The underwriter obtains this information by consulting with the issuer’s bond counsel.
•The BOND COUNSEL is hired by the issuer to assess the tax-exempt status of the bonds and to check existing laws regarding the issuance of the bond.
6. The underwriter also checks the placement ratio, which is found in the Bond Buyer every week on Mondays.
•This ratio is the number of bonds sold in a given week divided by the number of bonds offered during that week, thereby providing an estimate of the performance of new municipal bond issue sales. The PLACEMENT RATIO is very important for underwriters because it shows whether people are buying bonds and whether higher rates are needed to sell the bonds.
SUBMITTING THE BID
When a Notice of Sale has been placed by an issuer, the underwriters who want to enter a bid will download the New Issue Worksheet from the advertisement in the Bond Buyer.
This worksheet makes it EASIER for the lead underwriter and syndicate to determine a bid.
The underwriters fill in and complete the Bond Buyer New Issue Worksheet based on the information in the Notice of Sale.
After determining its bid, the underwriter submits it accompanied by a GOOD FAITH DEPOSIT, which is a check for the specified amount of money in the Notice of Sale.
•The good faith deposit is required by the issuer to ensure that the underwriter intends to fulfill its obligations as underwriter. All good faith deposits are returned to the losing bidders.
•The issuer keeps the deposit of the winning bid and, if all goes well, uses this money to offset payment for the bonds by the underwriter.
•All competitive bid underwritings ARE firm commitment underwritings, since the underwriter buys the issue outright from the issuer and then sells it to investors.
Financial advisers who work with the municipality cannot bid on competitive issues unless they get permission from the issuer. The Municipal Securities Rulemaking Board (MSRB) Rules forbid financial advisers from also acting as underwriters without permission. A potential conflict of interest may occur IF financial advisers have information that could give them an advantage in the bidding process. The financial adviser, working on behalf of the issuer, is trying to set the lowest possible interest rates for the bonds, WHILE underwriters are trying to set an interest rate that is higher to make the bonds attractive for investors.
SCALE IN A NEW MUNICIPAL BOND
When municipal bonds are issued with serial maturities, the pricing of new bonds is offered on a YIELD SCALE, NOT a dollar amount. The YIELD SCALE represents the yield to maturity for the serial bonds as they mature. In competitive bidding for municipal bonds, the yield scale is one of the first things to be determined by the underwriting syndicate. If necessary, review the previous module on Municipal Securities for a detailed discussion on serial bonds.
Remember that serial bonds have a certain amount of principal maturing each year, and the interest rates for each of these years can be, and usually are, DIFFERENT. There are three types of OFFERING SCALES of new bonds. The OFFERING SCALE depends on the interest rate of each maturity date and the price at which the bond is offered. The offering yield is also highly influenced by the present Treasury-bill yield curve. The yield scale follows the yield curve of other outstanding bonds very closely. Yield scales are graphically represented similarly to yield curves and are described as follows:
- •A NORMAL YIELD SCALE occurs when bonds with early maturities have lower interest yields than bonds with later maturities. This is the most commonly occurring yield scale, especially with steady rates in the market.
- •An INVERTED YIELD SCALE occurs when bonds with early maturities have higher interest yields than bonds with later maturities. This occurs very rarely, when rates are falling and are expected to stay low over a period of years.
- •A FLAT YIELD SCALE occurs when bonds with early maturities have the same yield as bonds with later maturities. This is also a “rare occurrence.”
A municipality issues a REVENUE BOND to fund a project or facility that eventually generates revenues to repay the bond issuance and ongoing maintenance
Because revenue bonds are not backed by the taxing power of the municipality, there is no requirement for competitive bidding by underwriters. Therefore, revenue bonds are most often underwritten on a negotiated basis, much like corporate bonds.
Which of the following best describes a normal yield scale?
(A) Early-maturing bonds have higher yields; then yields decrease for later-maturing bonds.
(B) Early-maturing bonds have lower yields; then yields increase for later-maturing bonds.
(C) All maturities are the same.
(D) There is no such thing as a normal yield scale; they are all the same.
Answer (B) Early-maturing bonds have lower yields; then yields increase for later-maturing bonds. This means that the early maturities have lower yields, and as the bond maturities become longer, the yields go up. An inverted yield curve, which happened with some short bonds in early 2000, has early maturities with higher yields than later maturities.
A municipality enters into a negotiated underwriting when the issuer is NOT required to seek out a competitive bid. The issuer usually negotiates with the investment banker or underwriter of its choice to determine the cost of the issue, which may be even lower than if it went to bid.
Negotiated underwritings are usually managed by an investment banker with whom the municipality has dealt with in the past. The cost to the issuer is NEGOTIATED with that investment banker. The underwriter NEGOTIATES the best price with the issuer, taking into account the expected market for the bonds once they are issued.
Negotiated underwritings of municipal and state issues are usually underwritten on a FIRM BASIS, although they can be underwritten on a best effort basis. If underwritten on a best effort basis, the municipality usually executes it as an All or None underwriting (AON).
Prior to a bond being issued, a municipality must obtain a LEGAL OPINION from a BOND COUNSEL, who is a lawyer knowledgeable in the laws of municipal bonds. The legal opinion by the bond counsel, in effect, states that:
- •The bond is a municipal bond as set forth by the laws in the area where the bond is being issued.
- •The bond interest is EXEMPT from taxes.
- •No other legal matters will affect the value of the bond. (The bond counsel first determines if the bond interest is exempt from federal taxes and then if it is exempt from state taxes.)
In forming an opinion, bond counsels research the state and local laws to check into the requirements for a bond to have tax-exempt status. They may assist in getting favorable legislation passed in the locality if need be, and supply information to the underwriters for the official statement.
The opinions that bond counsels offer regarding the tax status of the bond can be one of the following:
•QUALIFIED LEGAL OPINION — the bond counsel gives a qualified legal opinion if some aspect of the issue may make the bond interest taxable OR if it has a legal matter that may affect its value.
•NONQUALIFIED LEGAL OPINION — the bond counsel gives a nonqualified legal opinion if NO aspect of the issue could possibly prevent it from being tax-exempt.
You must also know:
The last act of bond counsels prior to the bonds being issued is to review one of the certificates to determine that all of its WORDING and LEGAL INFORMATION is correct
- •The bond counsel ATTESTS to the tax-exempt status of the bond.
- •The IRS determines the tax-exempt status of the bond through the laws that have been passed.
The OFFICIAL STATEMENT is the EQUIVALENT for a MUNICIPAL BOND as a PROSPECTUS is for a CORPORATE ISSUE. The underwriter prepares the official statement prior to the bonds being sold to the public. It is distributed to all purchasers and to other dealers upon request. Prior to the official statement, a preliminary official statement may be issued, but it does not include pricing information.
The official statement provides the most detailed financial analysis of the municipality. The official statement also sets forth:
- •The purpose or use of the bonds
- •How the funds will be used
- •Call provisions
- •Other information pertinent to the bond and desired by potential investors
Which of the following statements is a description of a qualified legal opinion?
(A) The bond is qualified for issue.
(B) The legal opinion on the bond’s tax-exempt status is less than 100% certain.
(C) The bond counsel is qualified to give the legal opinion.
(D) The issuer is qualified to issue the bond with tax-exempt status.
Answer (B) The legal opinion on the bond’s tax-exempt status is less than 100% certain. If a legal opinion is qualified, the opinion may express uncertainty regarding either the tax-exempt status or some legal matter affecting the bond. A nonqualified legal opinion is for a municipal bond with no uncertainties regarding its tax-exempt status.
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