When issuing bonds, a government usually chooses to sell the bonds through either a competitive bid or negotiated sale process.
The competitive bid is the common method for selecting underwriters for general obligation bonds, which are backed by the full faith and credit of the issuer. In a competitive bid process, the issuer, usually with the assistance of a financial advisor, structures the bond issue and publishes a notice of sale requesting bids from underwriters. After the bids are received, the bonds are awarded to the underwriting syndicate that submitted the best bid, i.e. the lowest true interest cost to the issuer.
Advantages
Disadvantages
In a negotiated sale, an issuer works with a single underwriting syndicate. The selection of a syndicate usually is based on factors such as past relationships, special expertise, and the size and nature of the underwriters' sales efforts. The senior manager of the syndicate will assist the issuer with structuring the bond issue, preparing the official statement, and obtaining a bond rating. The syndicate will engage in pre-sale marketing, and then will negotiate interest rates with the issuer. Negotiated sales are common with revenue-bond offerings, especially when they involve complex features.
Advantages
Disadvantages
Governmental entities usually issue bonds through competitive bid or a negotiated sale. The goal of an issuer undertaking a bond issue should be the proper administration of the bond issue at the least possible issuance cost and interest rate.
In a competitive bid sale, the issuer conducts all of the tasks necessary to offer bonds for sale including structuring the maturity schedule, preparing the official statement, verifying legal documents, obtaining a bond rating, securing credit enhancement, if advantageous, and timing the sale. These tasks are normally done with the assistance of outside consultants, including a financial advisor and bond counsel.
Once the issue is structured, the public sale begins with the publication of an official notice of sale that delineates the size, maturities, purpose, and structure of the proposed issue, along with instructions for submitting bids.
Underwriting syndicates submit closed bids to the issuer on the day and time designated in the official notice of sale. The bonds are awarded to the syndicate that has submitted the best bid, i.e. the lowest true interest cost. The winning underwriting syndicate then proceeds to market the bonds. No structural aspects of the bonds are changed regardless of the success or failure of the underwriting syndicate to sell the bonds. Any unsold bonds remain the responsibility of the syndicate.
In a negotiated sale, the bond issue is not structured before an underwriter is chosen, and the particulars of the issue are more flexible than in a competitive sale. An underwriting syndicate is not chosen through a bidding process but rather on the basis of other criteria such as expertise, financial resources, compatibility, and experience.
After a syndicate is selected, the process of structuring the bond issue and completing the other origination tasks are then undertaken primarily by the senior manager of the syndicate in conjunction with the issuer. The syndicate will engage in pre-sale marketing and then will negotiate interest rates with the issuer. The issuer often employs a financial advisor not associated with the underwriting firm to represent the issuer's interests in the process.
Both methods of selecting underwriters are used frequently in bringing municipal bonds to market. The overriding concern of many issuers is the minimization of interest rates and issuance costs; however, there currently is disagreement in the industry regarding which types of sale results in the lowest costs.
Proponents of competitive bid argue that this type of sale results in lower interest costs since syndicates have an incentive to offer low interest rates in order to increase their chances of being awarded the bonds. Competitive bid issues may also result in lower issuance costs. Data on Texas State bond issues indicate that the average underwriter's spread on competitively bid bonds is lower than that of negotiated sales.
In 1993 bond issues of $20 million or more sold through negotiated sales had an average underwriter's spread of $6.71 per $1,000 of bonds, whereas, bonds sold through competitive bid had an average cost of $5.92 per $1,000 of bonds.
In 1994 the difference in spreads for Texas bonds widened considerably. Bonds sold through negotiated sale had an average underwriter's spread of $11.32 per $1,000 versus $7.30 per $1,000 for competitively bid bonds.
The increased issuance cost for bonds sold through negotiated sale in 1994 was partially due to increased bond market volatility which resulted in a higher average underwriter's spread. Nationwide, the difference in the underwriter's spread for bonds sold through competitive bid versus negotiated sale has decreased over time to less than $1.00 per bond.
Proponents of negotiated sales argue that negotiated sales may result in lower interest costs and issuance costs. In a competitive bid sale, underwriters typically do not engage in much pre- marketing of the bonds due to the uncertainty regarding which syndicate will be awarded the bonds. In contrast, in a negotiated sale, the syndicate often performs significant premarketing of the bonds.
If investors can be found prior to the negotiation of interest rates with the issuer, the syndicate may be less inclined to build a risk factor into the rates. With a negotiated sale, there is also more flexibility in regards to changing the sales date or the structure of the issue in attempts to obtain lower interest rates.
Factors other than costs also may influence the type of sale. The concern for unbiased awards of bids has resulted in many governmental bodies increasing the use of competitive bid sales either voluntarily or requiring it by law.
Since a competitive bid sale is open to all underwriting firms and is awarded solely on the basis of lowest cost, allegations of preferential treatment can be avoided. Finally, since the bids submitted are final, any financial loss a syndicate incurs in marketing the bonds is solely the syndicate's responsibility.
A negotiated sale, however, allows the issuer to take into account the special strengths of underwriting firms. These special strengths may include expertise, sales force, and past performance. Negotiated sales also can be used to facilitate policy goals such as increasing the participation of historically underutilized businesses (HUBs) in municipal bond transactions.
The decision of how to market municipal bonds should be based on the characteristics of the issuer, the bond issue, and the market. Competitive bidding is appropriate when the issuer is well known, good demand for the bonds is predicted, and the market is stable.
A negotiated sale is more appropriate when the issuer is less known, the market instrument is complex and less well understood by investors, and the market is unstable.
In these cases, even if the bonds are bid competitively, the predicted difficulties in marketing the bonds may raise the bids submitted by underwriters resulting in higher cost for the issuer than if the bonds had been sold through a negotiated sale.
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