Municipal market firms are finding profit in New Jersey's preference for selling bonds competitively.
In interviews with executives at several large municipal firms, underwriters said they are reoffering competitively underwritten debt to retail investors at higher prices than they would to institutional investors.
Most municipal bonds are ultimately held by retail investors, but when an issuer sells bond through a negotiated sale, institutions are usually the initial buyers.
But underwriters deal more directly with retail investors when selling competitive deals. So with competitive deals on the rise in New Jersey, underwriters say they have found a way to earn higher profits.
The offering strategy works because retail investors are generally less sophisticated than institutions when it comes to purchasing bonds. Institutions usually buy huge blocks of bonds, lowering the prices they have to pay to underwriters.
In addition, retail investors are less yield conscious than institutional buyers, who go to great lengths to extract higher rates from underwriters.
As a result, retail investors are paying a premium for the state's preference for competitive bidding, while underwriters turn a profit, market executives say.
Underwriters "turn around and put a spread in the bond issue to the ultimate buyers of the bonds, so that they're working for $9, $10, sometimes $14," said the head of a municipal finance department at a New Jersey firm.
The higher profit many dealers earn in competitive deals is also a function of dealing with the specific needs of retail investors.
One underwriter said that in order to cover his costs, he is forced to increase the spread in "odd lots," or any group of bonds worth less than $100,000, that are sold to retail.
"When you're a retail firm and your average sale is $20,000 to $30,000 worth of bonds," the executive said, "you've got to put another half point in the bonds to make it worthwhile."
It's difficult to tell whether the increase in competitive deals has meant higher profits for underwriters. But while they could not say definitively which method they prefer, several underwriters pointed to advantages in competitive deals.
New Jersey issuers pay an average gross spread of $6.96 on a negotiated bond issue, compared with $10.29 on a competitive deal, according to Securities Data Co. The spread does not take into account money made on reoffering bonds to investors.
"The [competitive] process may be more open, and nobody can fault the state now for choosing the wrong underwriter," one underwriter said.
"But ultimately, the successful underwriter is making more money on a competitive sale than a negotiated sale," the underwriter added. "And the retail bond buyer is paying the difference."
New Jersey has seen negotiated issues fall off since May 1993, when former Gov. Jim Florio signed his executive Order 92. Florio's order, which came on the heels of a federal investigation of a negotiated state bond deal, says the state must bid most of its bond deals.
As a result, the order has substantially reduced the number of negotiated financings in New Jersey.
In 1992, the state issued 79.2% of its bonds on a negotiated basis, compared with 54.4% in 1993, the first year the order took effect. In 1994, New Jersey's negotiated deals have represented 43.4% of all state issuance, according to Securities Data.
Starting Jan. 1, a new executive order by Gov. Christine Todd Whitman will give the state's issuers more leeway in selling bonds through negotiated sales.
Whitman's Executive Order 26 authorizes negotiated deals for complex financing structures, volatile market conditions, large issue sizes, and variable-rate transactions.
Despite the apparent profits that can be made on competitive deals, the municipal market's top lobbying group stands behind its support of negotiated sales.
The Public Securities Association has lobbied against the Florio restrictions on negotiated sales, and other measures to restrict negotiated sales.
When asked to comment about this story, a spokesman referred to comments made by PSA president Heather Ruth, who called the Florio restrictions "unnecessary."
"Whether an issuer should issue bonds on a competitive or negotiated basis should be governed by one primary consideration," Ruth told state officials in April. "Which method will not only assure maximum investor acceptance, but also minimize interest costs now and in the future."