Does it make any difference anymore? Competitive versus negotiated municipal bond issuance.
The amount of municipal bond debt in the United States now totals $1.2 trillion (Stone, 1994). Municipal bond sales totalled $174 billion in 1991, $235 billion in 1992, and reached $291 billion in 1993 before falling to $164 billion in 1994 (Stone, 1994; Doran, 1994; Schuchner, 1995). The size of this market makes decisions about municipal debt important to government decision makers and the citizenry. Research undertaken during the 1970s and 1980s suggests that competitive bond sales result in lower interest costs to issuers compared to negotiated issuance, all else equal. The municipal market has evolved since this research was undertaken in ways that suggest this finding may no longer apply. In this article, we examine municipal bond sales in Oregon during 1992 and 1993 to determine if interest costs vary systematically between competitive and negotiated issuance.
Competitive versus Negotiated Sales
For a competitive sale, the municipality structures the offering itself, typically with the assistance of a professional financial adviser. This work includes the preparation of the prospectus or official statement, the design of the issue and maturity schedules, the research, to select the timing of the sale, and the acquisition of a credit agency rating. The issuer next publishes a notice of the sale. Underwriters or investment syndicates review the offering and determine how much interest they need to pay in order to resell the bonds to investors. Based on this determination, they make a bid. When the bids are opened, the group representing the lowest interest cost to the issuer wins the bidding. The winner then typically reoffers the bonds to investors. The resulting difference between the buying price and the selling price is the gross underwriter spread.
Negotiated sales are handled directly by underwriters who work with the issuer to determine the structure, price, and maturities of the offering. In some instances, a competitive bidding process may be used to select the underwriting firm. The interest costs in negotiated sales are determined by the terms of the agreement between the underwriter and the issuer. The underwriter then takes the offering to market. Again, the underwriter earnings are determined by the spread (Public Securities Association, 1990).
Competitive sales place the burden of preparing the sale and bringing it to market on the issuer and the issuer's financial advisor (if there is one). This process may be less advantageous for inexperienced or poorly rated municipalities, which may not attract many bidders for their offerings.
The evidence from empirical research of the municipal bond market indicates that interest cost to the issuer is significantly higher for both general obligation and revenue bonds sold through negotiation when compared with those sold through competitive bid (Kessel, 1971; Joehnk and Kidwell 1979; Leonard, 1983; Braswell, Nosari, and Sumners, 1983; Kidwell and Rogowski, 1983; Benson, 1979; Forbes and Peterson, 1979; Government Finance Research Center, 1993). This research also demonstrates that lower interest cost is significantly associated with the intensity of the bidding. In other words, the higher the number of bids received, the lower the interest cost to the issuer compared to negotiated sales, all else equal.
A recent report (Public Resources Advisory Group, 1992) prepared for the state of Connecticut appears to suggest that little difference remains between the two types of municipal bond sales. This study looked at eight sales and found these selected negotiated issues had spreads below the state average for competitive general obligation issues. Total interest costs (TICS) were described as relatively constant. This study, however, did not control for factors such as ratings and national interest rates, which may have affected the results.
Competition provides an incentive for each underwriter to submit the most aggressive bid at which it expects to be able to successfully market the bonds to investors (Government Finance Officers Association, 1994a). Bland's (1985) findings show, however, that experience helps equalize the influence of competition. He concludes that the most experienced negotiating issuers are able to secure interest rates comparable to those of the most competitive issues (seven or more bids).
During the past decade, negotiated sales have grown as a percentage of the market. In 1970, 83 percent of municipal bonds were sold competitively, with 17 percent sold through negotiated offerings. By 1993, this pattern had reversed itself with 80 percent of such issues priced through negotiated sale, and only 20 percent sold competitively (Public Securities Association, 1994). In some municipalities, 100 percent of bond deals are sold through negotiation (Fuerbeinger, 1993).
Issuers selling through negotiation receive the assistance of the underwriter in originating and marketing their issues. Negotiation allows more flexibility in timing the sale and in marketing issues in advance (a particular advantage when issues have unusual features).(1) Since the late 1980s, issuers have made increasing use of derivative financing techniques such as detachable call features, interest rate swaps, foreign currency denominated issues, and others. Also increasing in prominence during the 1980s were tax-exempt commercial paper and variable-rate demand obligations, These complex financings benefit from the extensive presale and marketing available when sold through negotiation.
Bond interest costs are generally measured as net interest cost (NIC) or total interest cost (TIC). NIC represents the average interest rate over the life of the bond. TIC represents the interest rate over the life of the bond, incorporating the time value of money. Because of this difference, TIC is the more accurate measure when making comparisons of interest costs between issues (Public Securities Association, 1990).
Interest cost to issuers is the sum of the underwriter spread plus the reoffering yield (Sorensen, 1979). When measured in terms of yield percent, these components are additive, or
TIC = underwriter spread + reoffering yield.
Research by Joehnk and Kidwell (1979) suggests that negotiated underwriters enjoy monopoly power because of their exclusive contractual position and are in a position which allows them to extract a spread and/or set bond prices above the market level equilibrium. Joehnk and Kidwell (1979; 730) further conclude that
although differences in underwriter spread were found
to be justified on the basis of added origination services
provided by the underwriters, our findings suggest that
the exercise of monopolistic powers by negotiated
underwriters in setting reoffering yields above market
clearing price was the major contributor to the higher
issuer borrowing costs (NIC).
Concerns about Propriety in the Municipal Bond Market
Although the use of negotiated sales has been on the rise, so has concern about possible impropriety. In May 1993, New Jersey Governor James Florio required that most state (and authority) bond issues be sold through competitive bidding. He also encouraged the state assembly to take similar actions for all issuing localities (Gasparino, 1993a). He did this in response to allegations of malfeasance in a New Jersey Turnpike refunding issue. This 2.8 billion dollar deal was a negotiated arrangement in which Merrill Lynch allegedly funneled money to Armacon, a small New Jersey firm, in exchange for the position of chief underwriter. Armacon was owned by Governor Florio's chief of staff and a close political ally (Fitzgibbons and Monsarret, 1993).
In Massachusetts, state investigators and others questioned an arrangement wherein Lazard Freres' Mark S. Ferber allegedly received a $1 million annual retainer from Merrill Lynch. State officials alleged that if these payments were compensation for recommending Merrill Lynch to underwrite interest rate swaps with the Massachusetts Water Resources Authority (MWRA) and other clients for whom Ferber and Lazard were financial advisors (Kurkjian, 1993). Massachusetts inspector general Robert A. Cerasoli suggested that Ferber provided Merrill Lynch & Co. with an "unfair advantage," essentially assuring that the firm would be selected as the MWRA's underwriter on certain large deals (Fitzgibbons, 1993). On October 26, 1995, Ferber was indicted on 63 criminal counts, including violation of bribary statutes and attempted extortion (Wayne, 1995). At the same time, Lazard Freres' and Merrill Lynch agreed to pay more than $20 million to settle both civil suits brought against them by the U.S. attorney for Massachusetts and an administrative proceeding brought by the Securities and Exchange Commission (SEC) (Wayne, 1995).
Another controversy erupted in Chicago when the Bond Buyer (Gasparino, 19936; Pierog, 1994) reported that Mayor Daleys brother Michael was allegedly paid $15,000 a month by Smith Barney for assistance in securing lead underwriter status for some of Chicago's largest bond issues. In response to this, a city alderman proposed revisions in local laws to require competitive bids on all debt issues (Hornung, 1994). The reaction from Chicago's city comptroller, Walter Knorr, was quick and sharp. In an editorial rebuttal, Knorr (1994) insisted that such limitations were unnecessarily restrictive. He listed many advantages of negotiated sales, including the flexibility to pick the best experts to handle the underwriting and the ability to time the sale to benefit the city.
Following these and other allegations of malfeasance, the Securities and Exchange Commission asked several underwriting firms to report their political contributions at the municipal level (Stamas and Dickson, 1993). In a March 1994 statement of its views, the SEC said that
increased attention needs to be directed at ... disclosure of
potential conflicts of interest and material financial relationship
among issuers, advisers and underwriters,
including those arising from political contributions
(Bond Buyer, 1994; 22).
Finally, on April 6, 1994, the SEC voted to adopt a proposal of the Municipal Securities Rulemaking Board addressing these issues. This order, known as rule G-37, bars firms from participating in a negotiated underwriting with an issuer for two years after making political contributions to officials who could influence the awarding of bond business (Stamas, 1994). Rule G-37 is opposed by the Government Finance Officers Association and is being challenged by William B. Blount, a municipal securities dealer, on the grounds that it violates the First and Fifth Amendments, and Article IV rights under the U.S. Constitution (Government Finance Officers Association, 1994a).
Miller (1993) suggests, based on work by Forbes and Peterson 1979), that (for Pennsylvania) the insularity of negotiated sales leads to the partitioning of responsibility where "no one party has the incentive to question the assumptions of others." These circumstances may make bond sales more susceptible to real or perceived wrong doing. Competitive sales may help mitigate appearances of impropriety. According to the Government Finance Officers Association (I 994a; 4),
Competitive sales promote the appearance of an open,
fair process. A growing concern of negotiated sales,
whether real or apparent, is that underwriting firms may
be awarded business to reward them for campaign contributions
or for other political reasons. Competitive
sales, if conducted properly, can remove the appearance
of impropriety in the bond sale process.
Why More Research on Competitive and Negotiated Sales?
Most of the studies that concluded that competitive sales resulted in interest cost savings to issuers were conducted in the 1970s and early 1980s. In the intervening years, the narrowing of the difference between negotiated and competitive spreads suggests that competitive sales may no longer result in systematically lower interest costs. Gross underwriter spreads have declined precipitously from 1984 to 1994 (Figure 1). In 1984, spreads averaged $2.47 and $21.16 per $1,000 of bonds for competitive and negotiated sales, respectively. By 1994, the average spread for competitive sales had fallen to $6.94, while for negotiated sales it was $6.92 per $1,000 of bonds. The narrowing of the spreads may be accompanied by fierce competition to negotiate financings. If so, the underwriters' ability to exercise monopolistic powers in setting reoffering yields may be diminished. Competitive sales may no longer enjoy an interest cost advantage if competition to negotiate offerings substantially reduces the underwriters' monopoly position.
The increase in competition between underwriting firms may have been substantially influenced by the changes in the market brought about by the passage of the Tax Reform Act of 1986. Some of the key provisions of the Act include putting a lid on the volume of private activity bonds that qualify for tax exemption and dividing the tax exempt market into tiers (Marlin and Mysak, 1991; Petersen, 1988). In particular, the act created bank-qualified and alternative-minimum tax bonds. Bank-qualified bonds are the only bonds for which commercial banks can still deduct 80 percent of the interest they incur to carry municipal bonds on their inventories, while alternative-minimum tax bonds are subject to tax when held by certain individuals and corporations (Marlin and Mysak, 1991).
After the passage of the Tax Reform Act of 1986, long-term municipal market volume decreased from $222.2 billion in 1985 to $105.7 billion in 1986 (Public Securities Association, 1990). The reduction in municipal bond volume led to increased competition among underwriters and accelerated the trend of lower spreads for negotiated issues. Despite the municipal market setting a record volume in 1993, spreads for negotiated issuance have remained at levels well below those of the early 1980s.
The decline in gross underwriter spreads over the past ten years has led us to return again to question the relationship between bond sale type and interest cost. This research has added salience because of the recent allegations of impropriety and the MSRB's newly promulgated rule G-37.
We hypothesize that because of these factors there is no longer a difference in interest cost between competitive and negotiated sales. Our expectation is that we will fail to reject the null hypothesis that TIC is the same between competitive and negotiated sales:
[H.sub.0][right arrow] Competitive TIC = Negotiated TIC.
Should we reject the null hypothesis, our alternative hypothesis is that competitive TIC is less than negotiated TIC:
[H.sub.A][right arrow] Competitive TIC < Negotiated TIC.
This alternative is suggested by the literature that has consistently shown a relationship in this direction. To test this, we have analyzed data from the state of Oregon.
In 1990, Oregon voters passed Ballot Measure No. 5, a property tax limitation measure that also changed many of the state's provisions for managing municipal debt (Simonsen, 1992). Along with these changes came the adoption of Oregon Statutes (ORS) Chapter 287, 1991, which for the first time allowed the use of negotiated bond sales for general obligation new money issues. Such sales were approved in order to increase the flexibility of local governments in responding to market demand for their issues.
The results of the first set of regressions for general obligation bonds are presented in Tables 1 and 2. The data in Table 1 indicate that, on average and all else equal, competitive bids result in about a 29 basis point lower TIC compared to negotiated sales.2 This result is significant at the .01 level. The explanatory power of the model is strong; the R(2) equals .77 and the F ratio suggests that the independent variables explain the variation in TIC significantly at the .01 level.
The results when the number of bids are taken into account are shown in Table 2. Competitive sales where only 2 or 3 bids are received result, on average and all else equal, in a 9.9 basis point TIC savings compared to negotiated sales. This result is not statistically significant. Compared to negotiated sales, competitive issues result in a 32.9 basis point savings at 4 to 5 bids, and 52.6 basis point savings when 6 to 7 bids are received. These results are significant at the .01 level. In other words, our findings agree with the earlier research -- lower TIC is associated with more intense competition through bidding. The R(2) of .78 shows the model explains over three-quarters of the variation in TIC, and the F ratio suggests that this variation is significantly explained by the model at the . 0 1 level.
This interest cost difference is translated into annual dollar savings for issuers in Tables 3 and 4. The results from Table 3 indicate that for level debt service at the mean amount of slightly under $5.9 million for 12 years (sample mean was 12.43 years) the annual savings expected for a competitive sale receiving 6 or 7 bids totals $19,754 when compared to negotiated issuance. The data in Table 4 show that for a $20 million sale with the same assumptions the annual savings is estimated at $67,175.
Control variables help to isolate the relationship of sale type with interest cost. Issuer experience is a control variable (measured by the number of issues over the previous three years) where our findings conflict with earlier research. We find that experience is not significantly associated with interest cost. This result conflicts with Bland's (1 98 5) results that experience is an important factor.
The Oregon Revised Statutes allowing local governments the option of selling general obligation bonds through negotiation contains a requirement that negotiated sales be subject to an approving opinion of an independent expert advisor (Simonsen, 1992). The requirement of an independent financial advisor's approval does not appear to result in negotiated and competitive sales having similar TICs, all else equal. However, it may help equalize for the influence of experience. Nevertheless, our results for sale type and number of bids control for issuer experience.
Table 5 contains regressions including all types of obligations (revenue bonds, general obligation bonds, bond bank, and certificates of participation). The values for control variables are not shown. There are 499 issues of which 91.6 percent are negotiated. The regression results are substantially the same as for general obligation bonds. Competitive sales result in significantly lower interest costs compared to negotiation. The dummy variables for 4 to 5 bids and for 6 to 7 bids show TICs significantly lower than negotiated sales. While the dummy for 2 to 3 bids is not significant, the sign is negative. In sum, the results are robust: similar patterns emerge whether revenue and other obligations are included.
Regression Results, Competitive versus Negotiated General Obligation Bond Issuance (Dependent Variable = TIC)
Independent Variable Coefficient t value Competitive sale -0.293217(***) -4.088 Years to final maturity 0.054697(***) 9.825 20-year Oregon bond index -0.061532 -0.193 10-year Oregon bond index 1.042601(***) 3.289 Amount(1) -1.363666(***) -5.041 Amount squared(1) 0.044117(***) 4.805 Issuer experience -0.002737 -0.175 Callable 0.404117(***) 6.231 Portland -0.469454 -1.415 Limited tax obligation -0.112474 -1.107 Credit quality Aaa insured 0.020416 0.199 Aa -0.208004(**) -2.027 A -0.191146(**) -2.510 Baa 0.191062 1.318 Constant 9.744108(***) 4.819
R(2) = .77; Adj. R(2) = .75; F ratio 45.92675(***); N = 210. (***) Significant at the .01 level; (**) Significant at the .05 level. (1) Expressed as natural logarithms. (2) Nonrated bonds the base case (the Portland dummy variable picks up the effect of the state's only Aaa without enhancement, along with Portland's nonrated bonds).
Note: Our hypothesis suggests use of a one-tailed test. The t value for competitive sale is significant at the .01 level for a one-tailed test and a two-tailed test.
Regression Results, Competitive versus Negotiated General Obligation Bond Issuance, by Number of Bids (Dependent Variable = TIC)
Independent Variable Coefficient t value Competitive 2 to 3 bids -0.099354 -0.956 Competitive 4 to 5 bids -0.328547(***) -3.023 Competitive 6 to 7 bids -0.526483(***) -4.195 Years to final maturity 0.054343(***) 9.887 20-year Oregon bond index -0.099130 -0.3l2 10-year Oregon bond index 1.078570(***) 3.422 Amount(1) -1.322004(***) -4.948 Amount squared(1) 0.042619 4.699 Issuer experience 0.001102 0.071 Callable 0.404216(***) 6.297 Portland -0.511541 -1.551 Limited tax obligation -0.144334 -1.401 Credit quality(2) Aaa insured 0.032049 0.316 Aa -0.201973(***) -1.994 A -0.144334(*) -1.847 Baa 0.210626 1.472 Constant 9.471927(***) 4.743
R(2) = .78; Adj. R(2) = .76; F ratio = 41.82648(***); N= 2 10. (***) Significant at the .01 level; (**) Significant at the .05 level; (*) Significant at the .10 level. (1) Expressed as natural logarithms. (2) Nonrated bonds the base case (the Portland dummy variable picks up the effect of the state's only Aaa without enhancement, along with Portland's nonrated bonds).
Note: Our hypothesis suggests use of a one-tailed test. The t values for competitive 4 to 5 bids and competitive 6 to 7 bids are significant at the .01 level for a one-miled test and a two-tailed test.
Competitive versus Negotiated Sales, Annual Predicted Payments and Sayings
Sale TIC Annual Difference From Characteristic (percent) Payments($) Negotiated Sale Negotiated 5.12 668,076 Competitive 4.83 657,231 -10,845 Competitive 2 to 3 bids 5.02 664,327 - 3,749 Competitive 4 to 5 bids 4.79 655,742 -12,334 Competitive 6 to 7 bids 4.59 648,322 -19,754
Note: Annual payments assumes level debt service for 12 years (sample mean is 12.43) for general obligation bonds. TIC of 5.12 is the sample mean TIC for negotiated sales. Figures based on the sample mean sale amount of $5,881,460.
Competitive versus Negotiated Sates, Predicted Annual Savings
Sale Amount (dollars)
Sale Type $1 Million $20 Million Competitive 1,844 36,881 Competitive 2 to 3 bids 638 12,751 Competitive 4 to 5 bids 2,097 41,944 Competitive 6 to 7 bids 3,359 67,175
Note: Figures represent predicted savings compared to negotiated sales of general obligation bonds. Assumes level debt service for 12 years (sample mean is 12.43). Based on TIC of 5.12 for negotiated sales which is its sample mean.
Regression Results, Competitive versus Sales Negotiated, All Obligations
Sale Type Equation 1 Equation 2 Competitive 0.281464(***)
(-2.861) Competitive 2 to 3 bids -0.045390
(-0.294) Competitive 4 to 5 bids 0.333488(**)
(-2.190) Competitive 6 to 7 bids -0.530097(***)
(-2.919) R .59 .59
Notes: Control variables common to all equations include the 10- and 20-year bond indexes of market interest rates for Oregon A rated bonds, length of the bond, natural log of the amount of the issue and its square, issuer experience, and dummy variables accounting for Portland bonds, bond ratings, whether the obligation has a call provision, whether repayment of the obligation is subject to the limit imposed by Ballot Measure No. 5, whether the bond is a school certificate of participation (COP), COPs of governments other than schools, a revenue bond, State of Oregon bond bank, or private bond bank. Equation 1 adds a dummy variable for competitive sales and equation 2 adds dummy variables for number of bids.
(**) Significant at .05 level. Our hypothesis suggests use of a one-tailed test. The t value denoted by (***) is significant at the .05 level for a one-tailed test and a two-tailed test. (***) Significant at .01 level. Our hypothesis suggests use of a one-tailed test. The t value denoted by ... is significant at the .01 level for a one-tailed test and a two-tailed test.
Nationwide, municipal bonds are increasingly being sold through negotiation rather than competitive bid. This trend continues unabated despite research in the 1970s and 1980s that suggests competitive sales result, on average, in lower interest cost to issuers. Moreover, a number of highly publicized allegations of impropriety have been made concerning underwriters and governments. These alleged improprieties have led to some backlash against negotiated sales, notably New Jerseys ex-governor Florio's restriction on state bonds being sold through negotiation and the MSRB and SEC promulgating rule G-37.
Conditions in the municipal market have changed. The gross underwriting spread for negotiated general obligation bond sales has fallen so that there is virtually no difference any longer between competitive and negotiated spreads. Both higher spreads and reoffering yields contributed to the earlier findings that competitive sales had an interest cost advantage (Joehnk and Kidwell, 1979). The narrowing of the spread led us to hypothesize that there may no longer be a difference in interest cost between competitive and negotiated sales.
Despite the narrowing of gross underwriter spreads between competitive and negotiated municipal bond issuance, our research suggests competitive general obligation sales receive, on average and all else equal, about a 29 basis point savings in TIC. As the number of bids increase, so do the estimated savings associated with competitive sale. The results are robust -- including revenue bonds, COPs, and bond bank bonds did not materially change the results. These findings are consistent with the research done in the 1970s and 1980s. Therefore, we reject our null hypothesis and conclude that TICS for competitive sales are significantly less than negotiated issues. These results are based on data from the state of Oregon and are, therefore, not directly generalizable to other states where different circumstances may exist.
What are the implications for local government debt management, particularly the choice of whether to sell municipal bonds through negotiation or with a competitive bid? The regression results indicate that on average competitive sales result in interest cost savings over negotiated sales. However, that does not suggest that a competitive sale is always preferable. Negotiation may provide additional timing flexibility during unsettled markets, and the better-developed presale marketing activities may provide advantages for bonds with unusual structures or other atypical features. Also, for competitive sales, a greater portion of the origination is the responsibility of the issuer, or the issuer's financial advisor. These costs also need to be recognized when deciding to competitively bid or negotiate an issue. The key question may be: Does the savings in origination cost to the issuer, or other timing and presale advantages of negotiation outweigh its potentially higher interest cost?
However, Joehnk and Kidwell's (1979) recommendation still appears justified: where municipalities have a Choice, they should sell their new bond issues by competitive means. The advantage of competitive sale is particularly compelling when a large number of bids is expected. Competitive sales also help avoid the appearance of impropriety and this may be especially important given the allegations of imprudence that have recently surfaced.
William Simonsen is an assistant professor in the Department of Planning, Public Policy and Management at the University of Oregon. He is the associate director of the Public Affairs Masters Program and director of the Undergraduate Program in Planning, Public Policy and Management. His work has previously been published in Publius: The Journal of Federalism, Journal of Urban Affairs, Municipal Finance Journal and Environmental Professional He was previously employed by Moodys Investors Service.
Mark D. Robbins is a doctoral student in public administration at Syracuse University. He co-authored this article while a graduate student in public affairs at the University of Oregon. His interests are in municipal finance and citizen participation processes. [Figure 1 ILLUSTRATION OMITTED]
(1.) For a discussion of the strengths and weaknesses of competitive and negotiated sales, see Government Finance Officers Association(1994b). (2.) A basis point equals 100th of an interest rate point.
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|Author:||Simonsen, William; Robbins, Mark D.|
|Publication:||Public Administration Review|
|Date:||Jan 1, 1996|
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