S5:E2 – Municipal Bond Underwriting: What’s It All About?

Speaker 1:        From Carr, Riggs & Ingram this is It Figures: The CRI Podcast, an accounting, advisory, and industry-focused podcast for business and organization leaders, entrepreneurs, and anyone who is looking to go beyond the status quo.

Dean Mead:      Hello and welcome to another episode of the CRI podcast, It Figures. Thank you for joining us today. My name is Dean Mead. This is a government and public sector-focused episode of It Figures but I believe it will be of interest to people in other industries as well. Today’s topic is an introduction to municipal bond underwriting. To provide some context, state and local governments have approximately $4 trillion in municipal debt outstanding. And borrowing via municipal debt is a vital resource for governments maintaining and investing in their infrastructure. And roughly half of the 90,000 governments in the U.S. have outstanding municipal debt. But many governments have never issued municipal debt or have done so rarely.

And consequently, CRI regularly gets questions from our clients about the process of issuing debt. This episode is intended to jumpstart the learning process for anyone wondering what bond underwriting is. We are very fortunate to have, as our guest today, one of the most experienced and knowledgeable municipal bond market veterans that I know, Anne Ross. Anne is the founder and principal consultant at Muni Credit & Compliance Advisors, LLC. Anne, thank you so much for sharing your time and expertise with us this morning.

Anne Ross:        Thank you, Dean, good morning. And thank you to Carr, Riggs & Ingram for inviting me to today’s podcast. Before we do get started I would like to say the following. I am not a registered municipal advisor and I am not providing any advice about how an entity should issue bonds, which is covered by the SEC’s Municipal Advisor Rule and in the MSRB Rule G-42. Rather, I am discussing the general process of underwriting.

Dean Mead:      Excellent. Anne, why don’t we begin by you telling us about your background and your experience in the municipal bond market?

Anne Ross:        Well, thank you. I do have experience in excess of 30 years in the municipal bond space. I started my firm in 2014 as a consulting practice to leverage my experience in the municipal bond market as a banker, and analyst, and a risk manager. Muni Credit & Compliance Advisors is focused largely on providing traditional municipal high-yield and investment-grade credit analysis across the range of US issuers and sectors, disclosure compliance, and credit metrics that identify stress credits held in portfolio. Previously, for the better part of 23 years, I was SVP and manager of the research department at broker-dealer Roosevelt & Cross who was responsible for all aspects of research relating to trading, underwriting, and public finance activities while serving as a member of the firm’s compliance committee. I’m known as a generalist with both buy and sell-side research experiences as well as high-yield investment banking. Industry leadership roles include National Federation of Municipal Analysts, the Municipal Analyst Group of New York, including representing several industry associations over the course of 20 years as a member of the advisory council to the GASB.

Dean Mead:      Which is where we met. And where I got to discover just how knowledgeable you are about the municipal bond industry and why I thought you’d be a perfect person to help our listeners understand what municipal bond underwriting is all about. You mentioned in your answer there that … Buy side and sell side. Could you briefly explain what those labels mean and which one an underwriter is?

Anne Ross:        Sure. A buy-side analyst works with the ultimate investor and the bonds. Working for insurance companies, mutual fund complexes, wealth managers making investments for SMAs. It’s literally the buyer of the bonds. I worked to analyze the risks for the end buyer. Sell side is where the broker-dealers come in, and my work at Roosevelt & Cross for all those years where we underwrite the bonds and we sell them to the investing public.

Dean Mead:      Thank you. Briefly, how would you describe the process that a government goes through to issue municipal bonds?

Anne Ross:        Well, there are a variety of steps regarding the underwriting process, and let’s just take a high-level view. The issuer will select a bond council, and a financial advisor, and an underwriter. Once the bond structure is decided, the underwriter and the issuer prepare bond documents. Bond counsel drafts the local ordinance, the resolutions for the indenture, and other necessary legal documents. Before bond closing, bond counsel distributes for review drafts of various agreements, certificates, or legal opinions. At bond closing, closing documents are then executed. The underwriter wires the purchase price for the bonds to a paying agent or a trustee. The paying agent or the trustee, as directed by the issuer, pays issuance costs and applies the balance of the bond proceeds to fund construction or project or fund … Refunding of existing debt. Bond closing considerations ensures compliance with regulations and maintain bond market access for future. There are continuing disclosure items, arbitrage, rebates, budget setting, and other debt reports that are required post-closing.

Dean Mead:      Would it be correct to say that, at least generally, the issuance of bonds in the municipal bond market is similar to an individual who is getting a mortgage in order to purchase a home?

Anne Ross:        Certainly. In terms of you’re going to pick with whom you’re going to be getting the mortgage, right? You’ve done your homework and you’ve settled on the mortgage provider that you think will provide the most beneficial mortgage rate to you. Then, obviously, the mortgage provider will have a series of inquiries for you and look for a level of documentation to ensure the fact that the risk that they’re underwriting is prudent. This process is not terribly dissimilar when one is issuing bonds and looking for an ultimate bond purchaser.

Dean Mead:      Great, thank you. I think that’ll be helpful to the listeners. This is not as foreign as they might think, although probably somewhat more complex than taking out a mortgage to purchase a home. So in that process you described, what does a bond underwriter do? And what services do they provide to the government?

Anne Ross:        And, of course, when we talk about the bond underwriter we’re now talking about what’s called a negotiated bond sale. And we can get to the difference between negotiated competitive sale certainly throughout this discussion. But the underwriter’s role in functions are … First and foremost, the underwriter acts as a financial intermediary that buys the bonds from the issuer, then resells the bonds to the ultimate bond investor in the primary marketplace. The underwriter acts also as a market maker providing liquidity and price discovery for the bonds. The underwriter will also perform due diligence, credit analysis, and legal compliance for the issuer, and will help structure the bond deal including maturity, coupon, and call features. The underwriter assumes the risks of holding the bonds until they are sold to the ultimate investor. And earns a profit from the difference between the purchase price they pay the issuer and the sales price to the market known as the underwriting spread.

Dean Mead:      What is an underwriter’s syndicate?

Anne Ross:        An underwriter’s syndicate is a grouping of either a single underwriter who feels that they can spread the risk and diversify the buying public audience. And they will, in a negotiated sale at an initial offering, put together a group of co-managers. So the senior or co-senior managers will lead the syndicate assisting in structuring the bonds, managing the marketing of those bonds, and the investor communications. The co-managers in the syndicate provide this larger network to sell the bonds and can provide additional capital to underwrite those bonds and assist with additional market color. These selling group members have a strong niche typically that are locally oriented and they possess a significant retail network. They manage the local marketing and they target that market to the retail investors.

Dean Mead:      A larger underwriter might involve under … Other firms that are specialists in a particular geographic region. Is that what you were describing?

Anne Ross:        True. I mean, quite frankly, if there is quote-unquote large, experienced underwriter on the type of bonds that are being issued with breadth and depth in its own distribution capability, they might not even put together a syndicate. When you put together a syndicate it’s perhaps because the bonds are a bit larger for your own resources, the bond structure and credit might be a bit more complex and highly nuanced that you might be tapping into a level of understanding of that type of risk in these other syndicate members. And, of course, also, they have local knowledge of the regional market to which they’re typically selling.

Dean Mead:      All tight, thank you that’s very helpful. You mentioned municipal advisors before. What do they do in a bond issuance? And how does that relate to the underwriter?

Anne Ross:        Well, a municipal advisor is typically either a bank, an investment bank, or a private consultant who represents the issuer. Municipal advisors have a fiduciary responsibility to the issuer. They advise on all matters regarding bond issuance. They will assist in the selection of underwriters, their compensation, the syndicate structure, and bond allocations. They also assist with negotiated sales including advice on retail order periods, institutional marketing, analysis of comparable bonds, and the secondary market data. The municipal advisor is typically used by an issuer in a competitive sale. And that’s what I said we’d come back to. A competitive sale is … Rather than negotiating the bond price with the underwriter who pays the issuer in net bond proceeds. So if you’re looking to raise 10 million, the underwriter will say, “Well, I’ll pay you 9.5 million because I want my compensation to take the risk of being able to now turn around and sell those bonds back out into the market. The issuer would then take the net proceeds, and as I said would then apply them towards whatever that project or refinancing need would be.

In a competitive market, the municipal advisor works exclusively with the issuer. And as I said, has a fiduciary responsibility, not a hands-off relationship with the issuer like the underwriter does. And they will go in and determine whether or not the bidding process produces the cheapest possible cost of capital to the issuer. So the competitive market is like an auction. The notice of sale is put out, the parameters for what the bidding requirements are are disclosed. There are mechanized platforms that do the bidding, there are typically two known names that do this.

And then there is an auction process where any interested underwriter in those bonds would submit a bid. In one instance the bidding process is closed. It’s always confidential, meaning bidder A doesn’t know who bidder B or bidder C is but they do see the bids. And in that instance, there is an opportunity, within a given timeframe, for each of those bidders to perhaps firm up and do better on their bid if they really want to be the first one chosen. And how you get that accomplished is you’re the lowest cost of capital to the issuer. Alternatively, there is a bidding process where it’s your best and most final bid. It’s your one bid, your one bid only, and you do not know whether you’re first, second, or third in the queue.

Dean Mead:      Are those the only ways that competitive and negotiated bond sales that bonds can be issued or is there an alternative to those?

Anne Ross:        Yes, there is an alternative and that is privately placing your bonds. That’s the alternative to the competitive or the negotiated bid process. And in that instance, you would typically place your bonds with one buyer. Many times that is a bank or someone who has a previous relationship with the issuer. This process does not require an underwriter. Ongoing disclosures might be limited compared to the negotiated process. Bond rating and credit enhancements may not be required to place those bonds, but in this instance, there’s potentially limited competition for those bonds under this circumstance. Or the issue may be of a small size or shorter amortization period compared with public sales which could result in rollover risk. Also, when you do engage in a private placement, you could wind up actually with a higher interest rate and more restrictive covenants, especially regarding the issuance of additional bonds.

Dean Mead:      Very briefly you mentioned rollover risk. What is that?

Anne Ross:        Rollover risk is related to the maturity of the bonds. A lot of times you’re going to issue your bonds for 20, 30, or 40 years. There might be an ability to call those bonds starting in the forthcoming 10th year or so, but you’re basically going to have those bonds outstanding at whatever that coupon cost is to you for typically the term of the bonds, that maturity date of 20, 30, 40 years. If you issue shorter debt, the rollover risk to you is that … Well, let’s say we issued the debt and it was in a low interest rate environment. And if you’re going to, let’s say, have to reissue your debt in a five-year timeframe, in that interim period rates might have gone up and you would be subject to having to reissue debt in a higher interest rate environment. As opposed to that interest cost which would be in sync with the 20, 30, or 40-year term.

Dean Mead:      Great, thank you. You’ve mentioned what seems like a big crowd of people and companies who are involved in this process. How does an underwriter interact with those other people who are involved in bond issuance such as other underwriters, bond council, rating agencies, and so on?

Anne Ross:        Well, it is a coordinated effort. And there are participants who are part of the financing team that do shoulder some similar tasks. In terms of the bond offering process, the various professionals are such that the underwriters, or the intermediaries, who work between the issuers and investors, they fill the void in the marketplace by purchasing whole bond issues and then reselling them ideally for a profit to investors. In a team approach, you have the issuer, the underwriter, and the bond council along with other underwriting participants including municipal advisors, the trustee, a rating agency, and a credit enhancer if any of those are necessary.

Dean Mead:      And credit enhancers, those are bond insurance companies that are providing some assurance in terms of the issuer making their payments?

Anne Ross:        Correct. Or also it could be enhancements provided by banks by way of lines or letters of credit.

Dean Mead:      Thank you. So going back to competitive versus negotiated bond issuances. Why would a government choose one over the other?

Anne Ross:        Well, one might choose the competitive route if you are a no-name in the market with reasonably frequent bond issuance. If your credit story again is known, is not terribly nuanced or storied, typically the competitive bidding process is used by credits that have a rating of at least a single A, certainly if they’re AA rated. And they also might be required by state law to issue on a competitive basis as opposed to a negotiated basis. If you go the negotiated route, perhaps you’re a lesser-known name, less frequently seen in the market, you are looking to develop a relationship with an underwriter thinking for future issuances. You might be a reasonably large-sized issuance and you have a more nuanced or story to tell about your credit which could also mean that you’re rated less than a single A rating and you’re in the BBB range or even less than that.

Dean Mead:      When you say nuanced or storied, am I correct in interpreting that as there are particular things about that government that might complicate the process of borrowing or might make them look less desirable as a seller of bonds without some additional explanation?

Anne Ross:        True. And also perhaps you might’ve had a misstep in past communications with the market. There might’ve been evidence of a material event. You might’ve even been late in bond payment, or might at some point in time had a historical default. Or as I said, you’re just a complicated story and the bond structure is complicated. It’s not necessarily 20 years worth of serial bond maturities with an option to call the bond starting in year 10. There might be structured nuances. You might also include term bonds, what we call bullet maturities, beyond the serial bonds that mature within typically the first 20 years. So there are structural reasons, and credit reasons, and perhaps state law requirements that might make you a candidate for moving towards a negotiated arrangement as opposed to the competitive one.

Dean Mead:      Great, thank you. You’ve touched upon this a little bit as we’ve been going through these questions, but what could you say about how the underwriters are compensated for the services that they provide?

Anne Ross:        Well, underwriter compensation is comprised of several components. And again, we’re talking about a negotiated sale at this point. The underwriter wants to secure the highest reasonable interest rate for the bonds while the issuer wants to pay the lowest possible interest rate for the bonds. So it’s somewhat of a dance, it’s somewhat of a balancing act between both parties. And ultimately, as I said, the negotiated process results in the underwriter paying the issuance X dollars for their bonds. Meaning, as I said, they want to net 10 million but the negotiated fee comes out of the front end so you might net less than 10 million, and then the difference is the fee that is paid directly to the underwriter. The way in which the fees are described there are some critical terms, one of which is the management fee. This is the fee paid to the managing underwriter, it’s included in a negotiated sale. It is structuring the issue and negotiating with the issuer, the way in which the management fee is disclosed, which as I just referenced.

Expenses are also built-in and those are advertising, printing costs, underwriters, council, MSRB fees, and other expenses. Excluded are the closing dinners, the closing momentums. It really has to do with the fees necessary to all of the participants in the transaction. The takedown, which is referenced, is normally the largest component of the spread, and it’s like a commission, and it represents the income derived by the selling broker-dealer from the sale of the bonds. And then ultimately what this is all about is being compensated for risk. The amount of compensation for risk incurred by the underwriter is related to the difficulty of the marketing of the issue, bond market conditions, the amount of bonds remaining to be resold after execution of the bond purchase agreement. Although there is typically a rarity here that any … That there’s a risk component associated with the spread or the ultimate payment to the negotiating underwriter.

Dean Mead:      One last question, Anne. What should a government look for in an underwriter?

Anne Ross:        Okay. Well, first we should say, the use and selection of underwriters may vary depending upon the level of municipal market knowledge, expertise, and experience of the issuer’s staff, relevant experience and analytical capability of the firm, and individuals who are assigned to the issuer. You want to take a look at a demonstration of the firm’s understanding of the issuer’s financial condition, their understanding of bond structures, credit rating strategies, and investor marketing strategies. You also want to look at the underwriting firms knowledge of the local political, economic, and legal set of circumstances, and any other issues that would affect the proposed financings. You’d want to see documentation of the firm’s participation in recent competitive sales that were your own or those of others in the state and the region. You’d want to know what the current pricing data has looked like before for similar deals and for your own in past issuances. And you’d want to see how they traded in the aftermarket or known as the secondary market.

You’d also want to investigate what the underwriters uncommit firms uncommitted capital availability is and its ability and willingness to purchase the entire offering. As we said, you can also develop a syndicate if that’s not the desirability of the underwriting entity. You’d want to look at for any disclosures of conflicts of interests. You’d want to look for if there are any pending investigations of the firm. Have there been any enforcement activities or disciplinary activities within the last several years? You’d want to actually hire an outside municipal advisor prior to any undertakings, even for negotiated debt issuance to assist in evaluating the proposals that you’re receiving from the underwriters when you select the underwriter and ultimately when you execute the bond sale.

Dean Mead:      Thank you, Anne. That wraps things up for today’s episode of CRI’s It Figures. Thank you, Anne, so much for a very informative discussion that I’m certain will give the listeners a head start on understanding municipal bond underwriting. If any of our listeners would like more information about municipal bonds or other government finance and accounting topics, I encourage you to visit CRI’s website, cricpa.com, where you can submit questions to us. And if you select government and public sector from the industry’s drop-down menu you’ll find a smorgasbord of free materials for your education and benefit including other episodes of It Figures, recorded webinars, articles, and other informative resources. And don’t forget to follow us on LinkedIn, Instagram, Facebook, and other social media. Thank you again for listening and have a great day.

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