Chapter 4 Study Notes Flashcards
Issuing General Obligation (GO) Bonds
A general obligation issue typically requires approval by the voters since it’s their taxes that will repay the debt. For a GO bond, the indenture (bond resolution) will state the statutes which permit the issuer to levy taxes. A GO issue is generally subject to debt limitations that are placed on the municipality by a voter referendum or by statutes. The municipality is not permitted to issue bonds in excess of its debt limitation, since doing so will exceed its debt ceiling.
Issuing Revenue Bonds
Feasibility Study
The municipality must hire a consulting engineer to study the project and present a report to determine if the project can bring in the needed revenues. This is referred to as conducting a feasibility study.
An accounting firm is typically retained to help determine whether the revenues will be sufficient to cover expenses and debt service.
Role of the Underwriter
A municipal underwriter plays an important role in the offering of securities. The underwriter acts as a vital link between the issuer and the public by assisting the issuer in pricing the securities and, in some cases, helping to structure the financing and preparing the official statement.
Selecting an Underwriter
There are typically two ways that a municipal issue will select its underwriter—through a negotiated sale or a competitive sale
Negotiated Sale
negotiated sale involves an issuer that brings its issue to market by selecting the lead underwriter or senior manager that will sell the issue to the public. The underwriter will work with the issuer on a one-to-one basis. The underwriter may either offer the bonds through a public offering or sell them directly to a select group of institutional investors through a private placement. If necessary, the underwriter may solicit other broker-dealers to form a syndicate and assist in the offering.
Competitive Sale
Rather than selecting an underwriter, an issuer may invite all interested underwriters to submit bids for the issue. Essentially, the underwriters will be in competition with each other. The best bid that’s submitted will be awarded the bonds. Normally, the best bid is the one that costs the issuer the least amount of interest dollars over the life of the issue. The winning underwriter is committed to the issuer at the specific level submitted. At this point, the interest cost to the issuer is set and any changes that are made by the underwriter are at its liability.
Internet Bidding
With the increasing use of the internet as a tool in the securities industry, municipal bonds can now be bid for online.
Advantages of a Negotiated Sale
A negotiated sale enables an issuer to exercise greater influence over both the selection of the underwriter and distribution. In addition, negotiated sales allow for far greater flexibility in the timing and structure of an offering. Issuers can more easily respond to changes in the market by adjusting the issue’s structure up until the time of sale.
Disadvantage of a Negotiated Sale
Due to a lack of competition, an underwriter involved in a negotiated sale may structure the offering to maximize its own profits. In addition, issuers may be seen as showing favoritism to the underwriter and must stand ready to defend the qualitative and quantitative factors that were used in its selection.
Advantages of a Competitive Sale
By choosing a competitive sale, the issuer is protecting the public by taking advantage of market competition in order to achieve an effective interest cost that’s as low as possible.
Disadvantage of a Competitive Sales
One disadvantage of competitive sales is that the issuer is limited in its ability to adjust the timing and structure of the issue. In addition, the issuer has little influence over which firm will be awarded the underwriting, which other firms will be involved in the underwriting team (syndicate), and how the bonds will be distributed.
Underwriters may also be uncertain of the market demand for the new issue. To compensate, bids will often include an additional risk premium. This is especially true if the issuer is not well-known among underwriting firms. A competitive sale also offers the underwriter the least amount of structuring flexibility since the issuer determines most of the offering’s terms.
Procedures for Competitive Bids
Notice of Sale
Structure of the Issue
Bond Counsel and the Legal Opinion
Financial Advisor
Notice of Sale
When an issuer wants to sell bonds through a competitive bid, it will advertise by means of a Notice of Sale. The notice is published in major financial newspapers, as well as publications which are specific to the municipal securities industry, such as The Bond Buyer. The issuer may also send a notice to underwriters that have placed bid on previous issues
Structure of the Issue
The Notice of Sale specifies whether the issue will be structured as a serial or term maturity. For a serial issue, maturities are scheduled over several years. This allows the issuer to pay down the principal over an extended period. Serial bonds are normally quoted on a yield-to-maturity basis.
Bond Counsel and the Legal Opinion
he Notice of Sale will also discuss the status of the legal opinion. Every municipal issue must be issued with a legal opinion which is written by a recognized bond counsel and reflects on the validity of the bond issue. Bonds are usually issued with the legal opinion printed on the bond. However, it may also be printed on a separate sheet of paper and attached to the bond.
Financial Advisor
The financial advisor, also referred to as the fiscal consultant or fiscal agent, consults with the issuer and advises it on matters such as the price, timing, structure, and marketing of the issue (similar to an underwriter). The financial advisor may also assist the municipality in choosing an underwriter and analyzing the financing needs of the community
Official Statement
The disclosure document that’s used in a municipal offering is referred to as the official statement. Municipal securities issuers are not subject to the disclosure requirements that pertain to corporate offerings. However, the SEC requires firms that are selling municipal securities to follow high standards in assuring that the information being disseminated is complete and accurate. The official statement contains the most detailed information about a new municipal offering as well as financial information about the issuer. The underwriter will often assist in the preparation of an official statement.
EMMA
The Electronic Municipal Market Access (EMMA) system is the MSRB’s dataport through which municipal bond underwriters and issuers submit official statements and continuing disclosures.
New Issue Information Dissemination Service (NIIDS) – Rule G-34
depository application requirement
SRB Rule G-34 requires an underwriter to apply to a securities depository to ensure that a new issue is depository-eligible.
The underwriter is required to file an application by no later than one business day from the award by the issuer for a competitive sale, and by no later than one business day after the execution of the contract to purchase the securities from the issuer for a negotiated sale.
depository-eligible
The term depository-eligible refers to a security being able to be held by a registered clearing agency (e.g., the Depository Trust Company, or DTC) in book-entry form.
(NIIDS)
Broker communication
the managing underwriter communicates information about the new issue to other dealers and data vendors within two business hours using the New Issue Identification System (NIIDS). This is done so they can clear, confirm, and settle transactions in these securities through the National Securities Clearing Corporation (NSCC).
The managing underwriter is required to make submissions to the NIIDS for municipal securities, with the following exceptions:
An issue that’s not depository-eligible
Any issue that’s maturing in 60 days or less
Commercial paper
Time of Formal Award
Any information submitted through NIIDS must be done by no later than two business hours after Time of Formal Award, which is:
For competitive issues – the later of the time that the issuer announces the award or the time that the issuer notifies the underwriter of the award
For negotiated issues – the later of the time that the contract to purchase the securities from the issuer is executed or the time that the issuer notifies the underwriter of its execution
The Time of First Execution
is the time the underwriter plans on executing its first transaction in a new issue. Although there are exceptions, this typically occurs no less than (at least) two business hours after all of the information that’s required by NIIDS has been transmitted.
Responsibilities of Syndicate Manager
Some of the responsibilities of the syndicate manager include taking the largest underwriting commitment and keeping track of sales and how many bonds are available. The manager presides over the preliminary pricing meeting at which the manager requests for each member to submit their pricing scale.
Syndicate Letter
he syndicate letter specifies the obligations and participation level of the members.
how long the syndicate lasts
an acknowledgment that the bid and offering terms will be set by the majority of the members, and the priority of orders.
The syndicate letter also establishes that the syndicate isn’t a partnership, but rather a joint venture in which the liability of each member is detailed.
For a negotiated issue, the syndicate is formed using an agreement among underwriters, rather than a syndicate letter.
Syndicate
Divided Account
In a divided or Western account, each member is responsible for a specific percentage of the issue. If the member has sold its portion of the issue, it will not be responsible for any part of the unsold balance
Syndicate
Undivided Account
In an undivided or Eastern account, each member is responsible for a specific percentage of the unsold balance, regardless of how much the member sold.
Determining the Bid
After the syndicate is formed, it will determine the bid that it intends to submit to the issuer. The dollar amount of the bid being offered to the issuer is referred to as the bid price.
After the preliminary scale or pricing is set, syndicate members will distribute the scale to their traders and sales personnel to gauge investor interest. Orders are solicited and some orders for bonds are lined up before the actual bid is submitted.
Final Pricing Meeting
At the final pricing meeting (held before the bid is due), the syndicate manager announces the proposed pricing scale, the size of the underwriting spread, and the interest rates that the members believe will make the issue attractive to potential investors. During this meeting, the manager receives the opinions of the syndicate members regarding the pricing scale and spread.
Reoffering Scale
Next, the syndicate manager will determine the amount of profit that it intends to make. Using the bid limitations that are set for coupon rates and bid price, the syndicate will establish the complete reoffering scale (i.e., the yields that future bondholders will receive). The reoffering scale will list each maturity and the corresponding coupon and yield, along with the amount of selling profit.
Submitting Reoffering Scale to issuer
Once the scale has been established, it’s used to calculate the bid which must be submitted to the issuer on either a net interest cost (NIC) or true interest cost (TIC) basis.
swing coupon
In order to produce the desired spread on an issue, a swing coupon may be utilized. The swing coupon is the maturity year in which the coupon will be adjusted to produce the desired spread.
Net Interest Cost
syndicate must submit a bid to the issuer in the form of either net interest cost or true interest cost. The NIC shows the total interest cost to the issuer over the life of the offering, plus any discount or less any premium. The actual computation requires the number of bonds, years to maturity, and coupon rates.
True interest cost
also called the Canadian Method) takes into account the time value of money. The TIC calculation starts with NIC, but then uses present value tables to arrive at the NIC. Computers can calculate these bids almost instantaneously.
Submission of the Bid
The bid along with the good faith deposit (similar to a security deposit) is submitted at the designated time and place that’s listed in the notice of sale. The bid must be presented on the bid form that’s provided by the issuer. The bid form typically requires the bidding syndicate to enter its proposed interest rate(s) and the price that it’s willing to pay. The bid that the syndicate submits is the end point in the process of pricing the issue.
Winning the Bid
After the bids are opened, the syndicate with the lowest bid (lowest NIC or TIC) is awarded the issue. The winning bid is typically the one that costs the issuer the least amount of interest over the life of the bond. Good faith checks are returned to losing syndicates.
Order Period
Once the municipality awards the bid to the winning syndicate, the syndicate will immediately call its customers to inform them of the details of the new offering. Some customers will accept the terms and agree to buy the issue, while others will think that the cost is too high and will pass on the issue. The period after the awarding of the bid is referred to as the order period. During this time, non-priority orders that are submitted by account members are allocated without consideration of time of submission.
Spread
The syndicate and its members make a profit by selling the bonds at a higher price than it paid to the issuer. The difference between the price that’s paid to the issuer (the bid) and the price at which the bonds are sold to the public (the reoffering yields) is referred to as the underwriting spread or production.
takedown or total takedown.
The total takedown is divided into two parts—the additional takedown and concession. A firm that’s not a syndicate member (i.e., a firm that’s part of the selling group) is able to purchase bonds at a small discount or concession from the public offering price.
Selling Group
A selling group is a group of municipal securities brokers and dealers that help the underwriting syndicate distribute the new issue. The members of the selling group don’t share in the underwriting syndicate’s net profit and are not liable for any of the bonds that remain unsold. Selling group members purchase bonds from the syndicate at a price less the concession and then sell the bonds to the public at the offering price.
retention bonds
If syndicate members choose to retain some of the issue for their own purposes, these bonds are referred to as
Priority of Orders
Allocation is done according to the priority of orders which is disclosed in the syndicate letter.
- Presale Orders - placed prior to awarding of the issue, highest priority
- Group Net Orders - These are orders in which all members of the syndicate share the profit (the total takedown).
- Designated orders - With these orders the total takedown is directed to the dealers that are designated by the customer.
- Member Orders - Since these orders are entered by member firms for their own clients, they receive the lowest priority. Only the firm that enters the order will receive the total takedown.
Settlement of Issues
When Issued
ntil the issue’s settlement date is established, the bonds will trade on a when issued basis (commonly abbreviated W.I.). This means that the trade will take place when, as, and if the bonds are issued and will be canceled only if the bonds are not issued as originally represented.
A purchaser of the new issue will receive a when issued confirmation. The buyer will not owe any funds to the dealer at that time since the amount of accrued interest cannot be calculated without a settlement date.
Tombstone Advertisement
If the winning syndicate intends to advertise the issue, it will publish a tombstone. The tombstone ad will show the amount of the issue and its purpose.
Interest payment dates will be given along with the dated date.
The name of the bond counsel that will write the legal opinion will also be given, and it’s likely that the general counsel and underwriter’s counsel will be included as well.
There will be a list of maturities along with the coupon rate and yields-to-maturity. However, if the settlement date isn’t available, the information given in the tombstone will not be sufficient to calculate the dollar price or any accrued interest.
Secondary Market Trading of municipals
The OTC market is a negotiated market in which negotiation occurs at the best bid and offer prices. Since there’s no central exchange for the trading of municipal securities, broker-dealers have established a number of outlets that may be used to market their inventories of municipal bonds. Brokers’ brokers are primarily used by dealers to obtain pricing information while still remaining anonymous.
Brokers’ Broker Communication Systems
In some cases, a broker-dealer may ask another firm to assist it in selling bonds in the secondary market. This firm, referred to as a broker’s broker, deals exclusively with other brokerage firms and banks.
Each firm provides a wire service which shows the bonds that are out for bid (for sale). A firm that subscribes to the service can contact the brokers’ broker and enter a bid for a block of bonds or put a block of bonds out for a bid.
broker’s broker,
broker’s broker doesn’t underwrite new issues, carry inventory positions, or deal with public customers. Instead, they act as agents by purchasing and selling for brokers and dealers as well as receiving a commission for the service they provide
The Bond Buyer
The Bond Buyer is the online newspaper of the municipal industry and contains news that pertains to both the municipal market and the financial community in general. The Bond Buyer also contains announcements such as notices of sale, call notices, a new issue calendar, and other pertinent announcements.
The Bond Buyer compiles a variety of statistics that relate to the municipal bond market, some of which are listed below.
Visible Supply
The 30-Day Visible Supply is compiled each day from the Bond Buyer’s columns, “Sealed Bids Invited” (competitive offerings) and “Proposed Negotiated Offerings.” The Visible Supply reflects the total dollar volume of bonds expected to reach the market over the next 30 days and gives an indication of the supply side of the market.
The Bond Buyer Placement Ratio
is compiled weekly at the close of business on Friday. The ratio represents the dollar amount of bonds that were sold by underwriting syndicates each week as a percentage of the amount that were issued that week by issuer’s selling $1 million or more par value of securities. The placement ratio gives an indication of the demand side of the market.
Bond Buyer Indexes
The Bond Buyer compiles indexes that are widely watched in the municipal bond industry. These indexes give an indication of the average weekly yields for general obligation and revenue bonds.
The 20 Bond Index
is the average yield on 20 general obligation bonds with 20-year maturities. This index has an average rating equivalent to Moody’s Aa2 and S&P’s AA.
calculated/published weekly
The 11 Bond Index
is the average yield on 11 of the 20 bonds in the 20 Bond Index. The average rating for the 11 bonds is Aa1 and AA+. calculated/published weekly
The Revenue Bond Index
is the average yield on 25 revenue bonds with 30-year maturities rated A1 or A+.
calculated/published weekly
Bond Buyer Municipal Bond Index
which represents an average of the prices of 40 recently issued, actively traded municipal bonds. The prices are calculated based on quotations obtained from municipal brokers’ brokers. The index is published daily and the components of the index are adjusted twice per month.
The SIFMA Index
The SIFMA Index is a seven-day market index of Variable Rate Demand Obligations (VRDOs) issues with outstanding amounts of at least $10 million.
Municipal Market Data (MMD) Curve
The Municipal Market Data (MMD) Curve is published by Thompson Financial and is the yield curve of the highest rated (AAA) municipal bonds.
municipal bond traders
The main market makers for municipal bond trading are municipal bond traders who work for dealer firms and dealer banks. These traders are connected by phone and computer so that they are able to buy and sell for other dealers and for their own inventories.
principal trade.
If the trader buys or sells for its firm’s account, the trade is a principal trade.
Agency Trade
if the trade is executed by the trader on behalf of another party, the trade is referred to as an agency trade. The trader receives a commission for executing agency trades.
joint account
Two or more municipal securities dealers may form a joint account in order to purchase and distribute a large block of securities and therefore spread the risk.
Municipal Bond Trader
appraise or evaluate
A municipal bond trader may also be asked to appraise or evaluate an issue in order to determine the marketability of the bonds in an investor’s portfolio. Evaluations are used to determine the individual price for a given municipal bond in a portfolio if the bond is to be sold that day. For instance, a trader may be asked to give an idea of what a particular bond(s) is worth for estate valuation purposes.
Using Treasury Futures
Treasury futures contracts are a form of derivative whose prices will fluctuate based on the value of Treasury securities.
If rates increase, the futures contract’s value will decrease. Therefore, a trader who sells these futures contracts will be able to repurchase them at a lower price, thereby profiting from the difference. This profit will help offset the loss of capital on the bonds that the investor currently owns.
A firm bid or firm offer
is a quote for a municipal security that will not change for a specific period for the prospective party to whom the quote is given.
Down bid
means the most recent bid for a security is lower than the previous bid.
List
List is the price at which a security is offered. If a security is “traded at list,” it’s trading at its list price.
Workable
is a (bid) price at which a dealer indicates it’s willing to buy bonds. Dealers often obtain workable indications from other municipal firms to give clients an indication of the prices at which they could sell their bonds.
Out firm
is a quotation that a dealer is committed to honor, usually for a set period.
The following order qualifiers may be used by investors when they purchase municipal bonds:
- All or None
- Fill or Kill
- Multiples of offering -occur when a seller offers bonds in lots of 25, 50, 100, or 200 bonds of $1,000 each.
locked market
A locked market occurs when the prices being shown by a dealer that’s bidding for a security and a dealer that’s offering the same security are identical.
Cover bid
is the difference between the bid in which a transaction was executed (the winning bid) and the next best bid. The cover bid is usually expressed in basis points or in dollars per bond
Municipal Bond Quotation
Summary
Municipal bonds are typically quoted (bid or offered) on a yield basis. As stated earlier, some term issues are referred to as dollar bonds since they are quoted at a dollar price (percentage of par), rather than on a yield-to-maturity basis.
Municipal Bond Quotation
Example
For example, a quote for New York State bond may be:
100M New York State 4.00 7-1-40 @ 6.25 - 1/2 C30 @ 100
The offering is for $100,000 face value of 4.00% New York State general obligation bonds which mature July 1, 2040 and are callable beginning July 1, 2030 @ 100. The bonds are assumed to be GOs since no description beyond the name is indicated. If a bond is a revenue issue, it must be designated as such and the type of project (e.g., water or sewer) must be indicated.
Yield Disclosure Pricing
The Municipal Securities Rulemaking Board requires using the lower value of the price or yield that’s calculated to maturity, as compared to the price or yield that’s calculated to the call. The general rules relating to pricing of bonds are:
- A bond that’s selling at a discount is always be priced to maturity
- A bond that’s selling at a premium, but callable at par, is always be priced to the call
- A bond that’s selling at a premium, but callable at a premium, may be priced to maturity or to the call, whichever gives the lower price or yield
yield-to-worst
This concept of pricing to the lowest yield is often referred to as the yield-to-worst.
