The average gross underwriting spread earned on long-term negotiated bond offerings edged up during the first half of 1992, while spreads on competitive offerings fell slightly, according to Securities Data Co.
But at a time when fluctuations among municipal spreads have been relatively flat, fees for housing bond offerings surged to $12.16 per bond from $8.90, Securities Data reported late last month.
The average gross underwriting spread for a negotiated offering was $9.74 per $1,000 of par value, up from $9.50 in the first quarter. Spreads on competitive issues dipped to $8.68, off from $9.39 during the previous quarter.
The average gross spread for all underwritings was $9.58 per $1,000 par value, up from $9.48 during the first quarter. For all of 1991, the average gross underwriting spread was $10.29 per bond.
The gross underwriting spread is the income earned by a dealer based on the difference in the price paid to an issuer for a new issue of bonds and the price of the bond sold to the public. The gross spread usually has four sources of revenue: the management fee, the underwriting fee, expenses, and the average takedown, which is the largest component of the spread.
Some underwriters attribute the rise in housing spreads in part to widely publicized problems in that sector, such as the financial woes of housing bond guarantors like Executive Life Insurance Co. of California and Mutual Benefit Life Insurance Co. in New Jersey.
These problems have jeopardized the status of some housing issues and soured some investors, especially institutions, on the housing sector, dealers and traders said. As a result, the sector's dwindling investor base has boosted spreads, they pointed out.
One trader who specializes in housing issues said that since the troubles of Newark, N.J.-based Mutual Benefit surfaced in 1991, "I have sold virtually no housing bonds to institutions." He added, "They just don't want any problems with guaranteed bonds."
Others cited housing bonds' often extraordinary redemption features as the pivot of institutional investors' aversion to purchasing the issues. These features can be be triggered by developer defaults or interest rate declines.
"Housing has become a real dirty animal because of the disastrous calls," said Peck Ferrin, vice president and manager of the municipal division at Bank of America, NT&SA.
"So you've got to sweeten the pie," by building in more sales credit and thereby widening the spreads, Mr. Ferrin explained.
When interest rates come down, issuers tend to call housing bonds. As a result, investors are often reluctant to return to that sector, and salesmen have to work harder to place the bonds with fewer buyers.
"There's more perceived risk because if rates fall you risk losing money," the housing trader explained. "Anytime anything is harder to sell, the spreads increase."
Despite a trend of declining municipal spreads since the historic highs of the 1980s, underwriters are confident further spread erosion is unlikely in the negotiated sector.
"I think the spreads have been fairly stable in the negotiated market," noted Steve Leslie, senior vice president of trading at M.R. Beal & Co. in New York. Mr. Leslie attributes this to the current strength of the tax-exempt market.
"The real fear about spreads is not absolute level of takedown and management fees, but the resultant risk of owning bonds without much behind them," Mr. Leslie said, adding that the robust market has allayed such qualms of underwriters.
"Deals are coming and they're getting done," Mr. Leslie added. "Issuers are getting the kind of yields they like and there's been so much buying interest in the market."
A steady growth in negotiated issuance should thwart further slippage, helping spreads to hold at current levels or to see modest growth, Mr. Ferrin of Bank of America said.
Current spreads earned by underwriters on negotiated bond offerings are justifiable, reflecting the amount of work involved in structuring and marketing a deal, Mr. Ferrin asserted.
"When doing a negotiated deal, an underwriter acts somewhat as a financial adviser, and also structures the deal," Mr. Ferrin added. "For the amount of work done, the spreads you're making are very fair."
Gross underwriting spreads should remain near current levels because the industry cannot withstand much further slippage, predicted Walter Jacobs, first vice president and manager of municipal underwriting at Morgan Keegan & Co. in Memphis.
"I think they've gone about as far as they could go," Mr. Jacobs said.
Underwriters foresee continued tight spreads in the competitive sector, brought about by a decline in the number of offerings and underwriters' heightened rivalry for those deals.
One way to make the bid more competitive is to narrow or decrease the gross spread, Mr. Leslie pointed out.
"I see people fighting for competitive deals," Mr. Ferrin said.
Indeed, in many instances the difference between the winning bid for a competitive offering and the next highest bid, or the cover, can be less than a hundredth of a basis point, several dealers said.
To counter the stricture of gross underwriting spreads, some underwriters are altering bond structures and realigning marketing efforts.
For example, firms are continuing to mark up bond prices by about 0.05 to 0.10 basis points in order to build in compensation for the sales staff, dealers said.
Through this strategy, a municipal bond dealer will boost the price of a bond slightly, by about 0.05 to 0.10 basis points. Despite the price increase, the price of the bonds will be par or lower. The markup in bond price allows dealers to build in sales credit for bond salesman. However, the bonds are still attractive to retail investors who tend to favor discount bonds, versus those on which the price is above par.
The practice "makes the bonds much more marketable," one municipal dealer noted. "Everybody loves to buy a discount bond."
Elsewhere, declining spreads and the impact on sales commissions have led to a gradual shift in the client base of some regional firms such as Morgan Keegan, Mr. Jacobs said.
Due to declining spreads, it is becoming increasingly difficult to entice salesmen to sell bonds to retail customers, Mr. Jacobs said.
As a result, Mr. Jacobs said that in the past six months he has seen a shift toward more institutional customers, such as bond funds and insurance companies, who will purchase larger blocks of bonds.
While Mr. Jacobs hopes the firm will continue to serve a largely retail clientele, he sees the necessity of altering the client base.
"When you start doing issues for single-digit spreads, you can't get the salespeople to work for it," he said. They're "going to another product.
