Competitive and Negotiated Bonds Sales - Making the Right Choice

Background

In today’s financially challenging economy, public officials seek revenue enhancing and cost cutting measures to save every dollar.  To enhance revenues, governments obtain bids on their investments.  Among cost cutting policies, most public officials are required to obtain bids to purchase items costing only a few thousand dollars. In spite of these practices most governments sell bonds, that will cost millions of dollars, without competition. The growing practice of negotiating bond sales has led to criticism by public groups, financial service companies and the media.  Furthermore, based on analytical studies, needless negotiated sales are costing governments millions of extra dollars in borrowing costs.

Competitive vs. Negotiated Sales 

A negotiated sale and a competitive sale are the two methods by which an underwriter can purchase bonds from issuers for resale to the public.  For general obligation bonds and utility revenue bonds, competitive sales should be the preferred method of sale. Competitive sales provide issuers the following benefits:

  Lower underwriting fees, 

  Lower interest rates, and

  Promote favorable public policies by (i) providing a quantifiable basis for the selection of an
    underwriter, (ii) preventing the appearance of improprieties, and (iii) fostering competition.

Numerous analytical studies have been completed demonstrating that competitive bond sales result in lower total financing costs.  These studies show savings ranging from 5 basis points to as much as 77 basis points. Only one analytical study has ever been completed suggesting that the cost of negotiated sales is lower than competitive bidding.

In spite of these findings, more than 80% of all bonds are now sold through negotiation. While the number of complex transactions (tax increment financing, lease financings, variable rate financings and others) have contributed to the rise in negotiated sales, basic general obligation bonds and traditional utility revenue bonds are now also sold through negotiation.  In 2006, for example, almost 60% of general obligation bonds were sold through negotiation.  

The World Isn't Flat 

What constitutes a good public policy is a debatable topic; however debating the merits of a negotiated sale will not affect genuine results.  Privately commissioned studies by cigarette companies did not make smoking safe. The best debaters in the world could not make a round world flat.   

In a flat world there would never be a competitive sale of bonds because each firm would charge the same underwriting fees and the same interest rates. Simple observation demonstrates that this is not the case. While underwriting firms may attempt to secure the best interest rates for the issuer, different firms have different perceptions of current market conditions and each firm caters to their own investing clients (whether they are individual investors, banks or other institutional investors).  In addition, rates are affected by investors’ preferences for long maturities, short maturities, insured issues, call provisions and other features. The lack of a single homogenous bond market is evidenced by the fact that there are seldom two identical bids submitted at a competitive sale.  In addition, rate differentials in excess of 1/4% between low and high bidders are not uncommon.  Without competitive bidding, there is no assurance that the underwriter selected is the firm that was destined to be the low bidder. 

Debating the method of sale avoids dealing with a simple reality; if a negotiated sale is selected when a competitive sale is feasible it will cost more.

Making the Right Choice 

Not all issues should be sold competitively.  While over 15 studies have demonstrated the benefits of competitive bidding, several studies have also demonstrated that issues that receive only one or two bids may not benefit from competitive bidding.  Issues that are not likely to receive at least three bids have the following characteristics: 


Poor Credit

Unusually Large or Small Issues

New Entity

Unusual Financing Terms

Innovative Structure or Security
 

Issues that don’t have these characteristics should be sold competitively including, in particular, general obligation bonds and utility revenue bonds. 

What Came First -
the Negotiated Sale or the Complicated Structure?

Competitive bidding results in savings for general obligation bonds and traditional utility revenue bonds. Issuers should be cautious when these issues are structured with “unusual financing terms” that make them unsuitable for competitive bidding.   

Is a one year call provision really necessary or does it insure a negotiated sale now and future refunding?  Does an allocation of bonds to local investors benefit a few residents that invest in tax-exempt bonds at the expense of the majority of your constituents?  What about market timing?  Consider that in today’s electronic society changes to the sale date and bond terms can be made as easily for competitive bond sales as negotiated sales.

Who is Representing the Issuers' Interest? 

Effective marketing strategies by thousands of underwriters have overshadowed the scholarly reports regarding the benefits of competitive sales.  Underwriters are broker-dealers whose primary business is the sale of securities.  An underwriter has no incentive to recommend competitive sales. Underwriters benefit from having an exclusive right to structure an issue in the fashion that reflects the preferences of their own investor customers. 

In contrast, independent financial advisors, are not broker dealers, never underwrite bonds and represent only the interests of the issuer.  With the ultimate goal of saving money, among the services offered by independent financial advisors is recommending the best method of sale.  A financial advisor first structures the issue in the fashion that best reflects the issuer’s needs and then determines the method of sale. The underwriter willing to offer the lowest cost for the predetermined bond structure is then awarded the bonds. 

Not surprising, in a 2003 study, by Dr. Robbins and Dr. Simonsen, professors of public policy at the University of Connecticut, it was determined that issuers were far more likely to select competitive bond sales when independent financial advisors were engaged prior to a determination of the sale method. (“Financial advisor independence and the choice of municipal bond sale type”, Municipal Finance Journal, Publication Date: 03/22/2003)

Making the Right Choice 

No debate will change the outcome of a bond sale.  If the wrong method of sale is selected, it will cost more.  However, because bond issues are rarely truly comparable (different sale dates, different ratings, different call dates and other structural features, different states with varying tax rates, etc.) without an analytical study the outcome may never be known.  Accordingly, the decision whether or not to sell an issue competitively may require an appraisal of policy rather than mathematical results.  Consider the following:

1)    The normal mode of government is to foster competition not to avoid it.

2)    Perception is reality – governments are criticized for negotiated sales but not competitive bidding.

3)   A competitive sale is totally objective. 

4)    Aren’t the prices of commodities almost always higher when competition is missing? 

5)    Issuers are often unable to demonstrate the benefit of selecting one particular underwriter over
      another and competition provides the best public perception of openness in the conduct of public
      business.  Wouldn’t it make sense to sell bonds by a competitive bid in most cases?

__________
Prepared by Joy A. Howard, principal of WM Financial Strategies, and presented at the 2007 North Central Municipal Finance Forum, sponsored by The Bond Buyer and Wells Fargo.


 

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