Seldom is there a condition which works to the disadvantage of all parties to a transaction. But this occurs frequently in competitive municipal new issues.
It is caused by bidding restrictions which are out of touch with the market and result in bonds which are less attractive to many investors and, therefore, more difficult for the underwriters to sell. The current solutions to the problem are slightly higher interest rates and more spread for the underwriters -- both to the disadvantage of the issuer.
Bonds priced at par or a discount are more attractive to many investors, and they frequently will accept a lower interest rate to get them. To the extent that this results in greater pre-sale interest in an issue, it often enables the underwriter to lower rates and tighten the spread -- both to the advantage of the issuer.
The goal of issuers should be to present their bonds to prospective bidders in the most attractive form possible. Onerous bidding restrictions can significantly reduce investor demand and temper underwriter enthusiasm.
The question of bidding parameters receives too little attention from issuers and their advisers perhaps because they don't understand the marketing side of the equation and its impact on interest cost.
In the days before computers, when the Friden calculator was the weapon of the underwriter, net interest cost, a relatively simple calculation, ruled to determine the best bids -- with no couponing restrictions, 20% (or higher) coupons appeared on the early maturities, off-set by fractionals (1/10%) on the long end.
While this lowered the net interest cost, it hurt the issuer because it drove up the true interest cost. To cure the problem, restrictions were placed on couponing -- high-low spread limitations, ascending rates, etc.
More recently, with the proliferation of computers to handle the complicated calculations, true interest cost has gained favor, and is now used by most issuers.
There are at least two advantages of true interest cost: it is the 'true interest cost' for the issuer (rather than the net interest cost approximation), and it virtually eliminates the need for other restrictions, particularly when a discount bid is permitted.
Bidding restrictions can be greatly simplified to the benefit of issuers, underwriters and investors. The simplest change is to allow a discount bid (99 or 98), and the rest should take care of itself.
This will allow bonds to be offered at par of a discount thereby increasing investor interest and resulting in lower rates and/or less underwriting spread.
When a par bid is required on a normally structured issue (level principal or level debt service) and is coupled with ascending rates or a single rate the result is several maturities of premium bonds which are less attractive to some institutions and individual investors and may result in slightly higher yields and more spread to compensate for the more difficult sales effort.
This problem is compounded if any of the premium bonds are callable, particularly if they must be priced to the call.
While it is simple to establish bidding restrictions which will result in the lowest interest cost to the issuer, it is puzzling why so many issuers or their advisers persist in setting restrictions that are only impediments to an optimum true interest cost bid and detrimental to the issuer.
Mr. Reeves is a managing director and manager of the municipal trading and syndication department at Ferris, Baker Watts Inc., in Annapolis, Md.
