Bond underwriters are like a box of chocolates (forgive me, Forrest). Unless you know what to look for, it’s difficult to know what you are going to get. And, as with chocolates, once you have selected and committed to the underwriter, the experience just might leave you, well, unsatisfied. This article illustrates some of the differences among underwriters, and may just help you pick the best one for you.
Underwriting bonds is a lot like an auction. I realized this years ago while attending an estate auction with my wife. We had an interest in a beautiful 1950’s art-deco dining room set (ok, she had an interest). An important part of the auctioneer’s job was to aggressively pre-market the auction and attract as many buyers as possible. The auction house did a real good job of that – crowds of buyers were gathered around, pre-sale, like treasure hunters. It was the perfect setup for the robust sale that followed. Likewise, the most successful bond sales I’ve seen over the years carry the same high level of energy and investor anticipation. I have found that, given different situations, underwriters can be better or worse at achieving that type of environment.
Once the bond auction is underway and your initial bond prices have been released to investors, it is the underwriter’s job to push investors into bidding the prices higher. This is all done by phone and online today, of course, but it always feels to me the same as watching investors physically throwing their hands up in the air and aggressively bidding to win. It’s fun and exciting being part of the action. And remember this: higher bond prices = lower bond interest rates. Bottom line: as with any auctioneer, the ability of your underwriter to use a high energy selling process to push prices up and rates down is critical to the success of your bond sale.
Finally, your underwriter should be prepared to buy your bonds if, for whatever reason, too few eager investors show up that day; like an auction house that doesn’t fill up. Underwriters that buy bonds in these situations are “supporting the sale,” or “underwriting” in order to hold your bond prices up and interest rates down. But will they do it? Underwriting can be very risky – underwriters might find themselves buying your bonds at a certain price then selling them later at a lower price, which creates a loss to them. Rather than risk a loss, an underwriter may find it less nerve-racking, and less risky for them, to lower your prices and increase the interest rates on your bonds. Anecdotal evidence suggests that firms that underwrite more often than others typically have comparatively larger excess capital positions. But capital alone isn’t good enough, they must be willing to risk it. Depending on the situation, some underwriters are more willing than others.
So, how do you decide which underwriter is right for you? Most fiscal officers start with existing relationships. Like most things in life, that approach has its good and bad sides. The good comes from continuity and comfort level. The bad comes from less pricing control and the possibility of bad matches. For example, you wouldn’t hire a well-known farm implement company to auction your collection of rare art. Likewise, you may not want to work with a smaller, regionally limited underwriter to market your large, nationally attractive bond sale. Or, for example, perhaps your underwriter is very good at selling general obligation bonds, but you are selling lease purchase certificates of participation (COPs). Some underwriters do a better job with COPs than others and therefore are more likely to achieve the lowest rates. In short, underwriters have unique strengths suited to particular types and sizes of bonds being sold.
Does your underwriter have the qualities necessary to sell your bonds at the lowest rates? I encourage you to explore this question in detail well before auction time.
By the way, my wife and I did eventually win the bidding. We just happened to be the perfect buyer – strong demand with money set aside for this exact item. I hope your bond issues always find buyers just like us.
John Payne is Partner at Bradley Payne Advisors, LLC
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