Pricing Bonds in a Negotiated Sale

Note: This Best Practice (BP) is one of a group of seven documents relating to the sale of bonds. These seven documents should be read and considered in conjunction with each other because of the interaction of the processes to which they apply. The documents are:

• Bank Loans and Direct Placements
• Debt 101: Issuing Bonds and Your Continuing Obligations
• Selecting and Managing the Method of Sale of Bonds
• Selecting and Managing Municipal Advisors
• Selecting Bond Counsel
• Selecting Underwriters for Negotiated Bond Sales
• Pricing Bonds in a Negotiated Sale

Cost of borrowing, one of the most important outcomes of the sale of bonds, is established through the pricing process. Unlike a competitive sale, bond pricing in a negotiated sale requires a much greater degree of issuer involvement. An issuer negotiates both the yield on the bonds and the underwriters’ compensation (also called underwriter discount or gross spread), which includes the takedown (or sales commission), management fee, underwriting risk, and expenses. Success by an issuer in negotiating the price of its bonds depends on the issuer’s ability and willingness to devote sufficient time to understanding the market and the historical performance of its bonds.

1. Communicate to the underwriter specific goals to be achieved in the pricing of bonds and expectations regarding the roles of each member of the financing team, including the issuer and an independent Municipal Advisor employed to assist in the planning, structuring and pricing processes. Identify the issuer representative who has authority to make key decisions and be available throughout the pricing process.Take steps during the underwriter selection process and prior to final pricing to manage the compensation to underwriters by:
   • including a provision in the request for proposal that requires respondents to indicate the range of costs for each component of compensation and specify an expected maximum for each,
   • setting a cap on fees and expenses, and
   • obtaining and reviewing information on each component of underwriters compensation for other recent similar sales.
2. Develop an understanding of prevailing market conditions, evaluate key economic and financial indicators, and assess how these indicators likely will affect the timing and outcome of the pricing. Obtain a pricing book from the underwriter and/or the Municipal Advisor which would include the following information:
   • supply and expected demand for municipal bonds;
   • release of key economic indicators, actual or anticipated actions by regulatory or political bodies, and other factors that might affect capital markets;
   • interest rates and current market yields of recently priced and outstanding bonds with similar characteristics, preferably from nearby issuers;
   • interest rates and interest rate indices for bonds with similar characteristics provided by independent services that track pricing performance; and,
   • historic benchmark index data for the bond issue being sold and for other bond issues being sold.
3. Issuers should be aware they have an important role in determining how bonds will be allocated among syndicate members, if any. Issuers should consider order priority and the designation policies in reviewing the preliminary pricing wire and the Agreement Among Underwriters prior to the sale. To a large extent the designation policy controls the distribution of underwriter compensation among the syndicate members.
4. Work with the underwriter to develop an appropriate premarketing effort to gauge and build investor interest. In consultation with outside professionals (e.g., Municipal Advisor, underwriter, pricing consultant), consider providing for retail orders either through a separate retail order period or by identifying certain maturities as retail priorities. If doing a retail order period, issuers should take measures to establish the legitimacy of the retail orders such as limiting order size and disclosure of zip code designation.
5. Request that the senior managing underwriter propose a consensus pricing scale on the day prior to the pricing that represents the individual views of the members of the underwriting syndicate and obtain multiple interest rate scales from syndicate members.
6. Evaluate carefully whether structural features, such as call features and original issue discount, that impact the true interest cost (TIC) of a bond offering, but limit future flexibility in managing the debt portfolio, will result in greater overall borrowing costs.
7. During the pricing of the bonds, the issuer should have sufficient current market information, have real-time access to the order book (through themselves or their Municipal Advisor), and be in close contact with the lead underwriter. Consider repricing at lower interest rates at the end of the order period, with consideration to order flow and order volumes.
8. Issuers should be aware they also have an important role in determining how bonds will be allocated among investors. Discuss with the underwriter and municipal advisor accounts that are buy-and-hold investors versus short-term investors “flippers” and the impact these accounts will have on the bond pricing. The issuer should review the proposed allotments of the bonds to ensure achievement of the issuer’s objectives.
9. Evaluate the bond sale after its completion to assess the level of up-front costs of issuance, including whether the underwriters’ compensation was fair given the level of effort and market conditions, as well as pricing of the bonds, both in terms of the overall TIC and on a maturity-by-maturity basis.
10. Develop a database with information on each issue sold in regard to pricing performance, including the types of bonds sold (general obligation or revenue bonds), credit rating, maturities, yield and takedown by maturity, and the TIC.