Municipal Bond Market

The primary market is where investors get their first crack at investing in a municipal bond; after that, municipal bonds may be bought, sold, or traded on the secondary market. The issuer will have a commercial bank or another financial firm underwrites their entire offer; essentially, this bank or firm is buying the whole lot of bonds from the issuer. The underwriters then sell the bonds on the open market to individual investors and institutional investors alike. This open market where they are initially sold is known as the primary market.

Underwriting - Getting a Bond Issued

A commercial bank or an underwriting firm generally has four different ways in which they underwrite municipal bonds. Read these processes below:

  • They underwrite them through a bond department within a bank; the bank must be officially registered with the Municipal Securities Rulemaking Board (MSRB)
  • An issuer may have a broker dealer affiliate underwrite their bonds; this is allowed because of the Bank Holding Company Act
  • Underwrite through an operating subsidiary of a bank
  • Underwrite through a financial subsidiary of a bank

Banks have traditionally only been able to underwrite general obligation (GO) bonds. However, with the Financial Modernization Act, banks have now been given more flexibility in the ability to underwrite revenue bonds; a practice that had been restricted by the Banking Act of 1933, also known as the Glass-Steagall Act.

Different Types of Underwriting

There are two types of underwriting competitive and negotiated. In competitive underwriting, the underwriting firms will bid against each other by submitting a sealed bid to the issuer in which they will state the price that they are ready and willing to pay for the issue. It is fairly obvious that the firm with the lowest bid will win the contract to underwrite the entire issue. In negotiated underwriting, the underwriter is actually selected before the sale date; there is no sealed bid in this case. The firm is selected through a process known as Request for Proposal (RFP). In the case of a negotiated underwriting, both the firm and the issuer get together and discuss the best possible way that they can both benefit from the issuing. They have more flexibility in analyzing current market conditions and therefore are better able to price the new issue that will be best for the investors and for the issuer.

There are advantages and disadvantages to both competitive and negotiated underwriting. See the outlines below for the facts on both types.

Negotiated Underwriting

Advantages

  • Underwriter is able to perform all tasks related to the issuing from the start of the process; this eliminates the need for an outside financial adviser from the onset and results in a lower overall cost
  • There is more time to seek out investors that may be willing to pay a higher price when the bond is issued on the primary market
  • More flexibility to change the date of sale or to adapt to market conditions

Disadvantages

  • No competition between underwriters in setting the terms of the offering
  • Difficult to determine whether the gross underwriter spread is appropriate due to the fact that there is a wider range of services being provided to the issuer.
  • Accusations of ‘favoritism’ may be launched at the firms that are selected to underwrite

Competitive Underwriting

Advantages

  • Likely to achieve lowest possible capital cost through competition
  • Gross underwriter spreads are lower on issues sold through competitive underwriting, historical trends show
  • In going through a competitive sale, the process of selecting an underwriting firm seems much more fair

Disadvantages

  • Since the bidders do not know whether they will actually receive the bonds, competitive bids may contain a risk premium
  • Less flexibility for the issuer on the date of sale

Orders and Procedures

Net, concession, and takedown are the three types of orders in the primary market. The highest-priced order is sold to investors at the net, which is the actual price or yield of the bond. The underwriting group holds the entire spread, and it is therefore up to them how to take on the orders. They may choose to forgo a portion of their spread to be able to attract orders from other bond dealers - this is known as a concession. A concession is a bond that is discounted from the initial price offered to the public. Individuals within the underwriting group may submit orders at a takedown price, which is also a price that is discounted from the initial public offering. The takedown is the lowest price possible,the net is the highest price possible, and the concession typically falls in between those two.