Ensuring a successful bond sale.
In many communities, bond issues are highly visible processes. For example, a community whose voters have recently approved general obligation bonds for popular projects such as parks or schools might be actively watching the bond sale process to make sure that these favored projects are funded and constructed on schedule. These citizens will also want to ensure that the bonds are sold at the lowest cost so as to minimize their tax burden.
At times, bonds are proposed to fund projects that might not have widespread community support. Bonds sold to fund costly federal environmental mandates or to finance public employee pension or benefit costs might be necessary undertakings, but many citizens of the community might oppose them--perhaps stridently These citizens might choose to focus their wrath on the bond sale process, and the finance officer will need to be especially aware of the need to conduct the bond sale in a manner that both minimizes the financing costs and does not trigger unwarranted claims or accusations of favoritism in selecting finance professionals to work on the transaction.
At the end of a successful bond sale, the finance officer should be able to look back and conclude that the financing achieved its goals of getting the lowest borrowing cost and obtaining the
bond proceeds in a timely manner (whether to fund a new money project or to refinance outstanding debt). There should be a third goal, as well, however: that every step in the bond sale process, from the selection of outside professionals to the selection of the method by which the bonds were sold, was made in an open, transparent, and defensible manner. (Also see "Back to Basics: What Every Government Should Check Each Time It Issues Bonds," in this issue of Government Finance Review.)
As state and local governments adjust to the market turmoil of 2008, finance officers need to ensure that their organizations have debt issuance policies and procedures in place that reflect current industry best practices. The Government Finance Officers Association (GFOA) recently updated four of its best practices relating to selecting the method of sale and hiring outside professionals: Selecting Financial Advisors, Selecting and Managing the Method of Sale of State and Local Government Bonds, Selecting Underwriters for Negotiated Bond Sales, and Pricing Bonds in a Negotiated Sale. The advice contained in these best practices is intended to help both frequent and infrequent issuers of bonds achieve the goals listed above. Finance officers planning to issue bonds should read these best practices in their entirety, and in tandem, well before starting the bond sale process. Notably, the order in which outside professionals are hired is important in assuring that best practices are followed throughout the bond sale process.
The following discussion is intended to guide finance officers through the process of assembling the financing team, determining the method of sale, and achieving the lowest cost of financing. In addition, issuers should gain an understanding of the different and distinct roles played by the financial advisor and the underwriter, and most importantly, the difference in fiduciary responsibilities of these two members of the issuer's financing team.
SELECTING FINANCIAL ADVISORS
The financial advisor represents the issuer, and only the issuer, in the bond sale process. As such, the financial advisor has a clear fiduciary responsibility solely to the issuer. It follows, then, that the financial advisor should be hired before determining how the bonds will be sold (in a competitive sale, where the bonds are advertised, or a negotiated sale, where an underwriter is selected to purchase the bonds) and prior to selecting underwriters, if the bonds are to be sold through negotiation. Once a proposed bond sale becomes public knowledge, the finance officer often becomes an especially popular person among investment bankers hoping to be hired as negotiated sale underwriters. No commitments to investment bankers or other parties should be made until the finance officer and the financial advisor have analyzed the characteristics of the proposed bond and decided on the method of sale.
The GFOA strongly recommends that the contract or agreement between the issuer and the financial advisor clearly state that the financial advisor will not be allowed to resign in order to underwrite the bonds. The Municipal Securities Rulemaking Board, which is dominated by broker-dealers, takes a weaker position on this issue in Rule G-23. Some firms have succeeded in gaining underwriting business by first getting hired as financial advisor and subsequently recommending a negotiated sale to the issuer. Once that recommendation has been accepted by the issuer, the financial advisor resigns that role with the understanding that they will be hired as underwriter. The GFOA views this role-switching relationship as a conflict of interest.
This conflict of interest can only arise when the financial advisor is also a broker-dealer engaged in the business of buying and selling bonds. Issuers that hire an independent financial advisor, meaning a firm that does not also buy and sell bonds, do not face a conflict. The debt policies or practices of many issuers require that an independent financial advisor be selected to avoid any appearance of conflict of interest.
Financial advisors should be hired through a competitive request for proposal (RFP) process. The goal of the RFP is to solicit proposals that provide relevant information allowing the finance officer to determine which firm best meets the issuer's needs. Most critical in evaluating the ability of the proposer to meet the issuer's needs is whether or not the assigned individuals within the firm have the experience with the types of bonds that the issuer expects to issue. Relevant experience includes experience with the particular type of bond (e.g., general obligation, revenue, tax increment), comparably sized bonds, bonds issued within the same state, taxable bonds (including Build America Bonds, if applicable), and other experience consistent with the issuer's proposed transaction. The proposing firm should also demonstrate familiarity with the issuer's financial condition and outstanding debt.
The RFP should require that all fee proposals be presented in a standard format. Proposers should be asked to clarify which fees are presented on a "not-to-exceed" basis and to describe any conditions attached to their fee proposals. Finally, proposers should clearly state which costs are included in the fee proposal and which are to be reimbursed by the issuer. While fees are an important part of the selection criteria, issuers should rarely, if ever, hire a financial advisor based on fees alone.
The financial advisor should also demonstrate familiarity with best practices relating to issuing bonds and should express a commitment to following such practices once it is hired as financial advisor. The financial advisor should never be selected based solely on the recommendation of a firm that seeks to underwrite the issuer's bonds through negotiation.
SELECTING AND MANAGING THE METHOD OF SALE
Having selected the financial advisor to represent the issuer's interest in the bond sale process, the finance officer and the financial advisor will likely turn to the question of how the proposed bonds should be sold. There are two primary ways in which municipal bonds are sold: through competitive bidding or through a negotiated sale with pre-selected underwriters. Few questions in the municipal bond world generate more heated discussion and debate than that of competitive versus negotiated bond sales. While most of the studies and academic research have found that competitive sales result in lower borrowing costs for issuers, these findings have not been universally accepted in the industry, especially among firms and individuals whose business relies on negotiated sales.
The GFOA's Selecting and Managing the Method of Sale of State and Local Government Bonds best practice recommends that "issuers select a method of sale based on a thorough analysis of the relevant rating, security, structure and other factors pertaining to the proposed bond sale: It also says, "due to the inherent conflict of interest, issuers should not use a broker-dealer or potential underwriter to assist in the method of sale selection unless that firm has agreed not to underwrite that transaction" In short, the method of sale decision should be based on the specific characteristics of the proposed bonds and should not be influenced by outside parties with a vested interest in the outcome of the decision.
The presence of the following characteristics can favor the selection of a competitive sale:
* The bonds are rated A or better.
* The bonds are general obligation bonds or full faith and credit obligations, or they are secured by a strong, known, and long-standing revenue stream.
* The structure of the bonds does not include unusual features that require extensive explanation to the market.
Conversely, the presence of the following characteristics may favor the use of a negotiated sale:
* The bond rating is less than A and credit enhancement is unavailable or not cost-effective.
* The structure of the bonds has features such as a pooled bond program or variable rate debt, or they are deferred interest bonds.
* The issuer wants to target underwriting participation specifically to include disadvantaged business enterprises or local firms.
* Other factors exist that the issuer, in consultation with its financial advisor, believes favor the use of a negotiated sale process.
In recent years, approximately 80 percent of the bonds sold in the municipal market have been sold through negotiation. This heavy reliance on negotiated sales suggests that many issuers are basing their method of sale decision on factors other than those outlined in the GFOA best practice. Determining what percentage of bonds "should" be sold competitively based on the criteria above is a not a perfect science, but it seems that the universe of bonds that lend themselves to competitive sale--A-rated or better, well-secured by the issuer's full faith and credit, or with proven revenue streams and relatively straightforward debt structures--is probably much larger than the 20 percent of bonds that are actually sold through competitive bidding.
SELECTING UNDERWRITERS FOR NEGOTIATED BOND SALES
If an issuer and its financial advisor determine that a negotiated sale is appropriate, based on the characteristics of the proposed bonds, the next step is to select the underwriter or group of underwriters that will offer to purchase the bonds from the issuer. The primary role of the underwriter in a negotiated sale is to market the bonds to investors. The roles of underwriter and financial advisor are separate, adversarial roles and cannot be provided by the same firm. As noted previously, only the financial advisor has a fiduciary responsibility to the issuer. The underwriter's financial responsibility is to bond investors and to their own stockholders.
Most issuers should not consider a negotiated sale unless they are represented by a financial advisor. Many negotiated sales do occur without a financial advisor, but in such cases, the underwriter is largely free to dictate the pricing of the bonds as well as its compensation on the transaction, with little if any true or informed negotiation with the issuer. Since most issuers do not have the access to real-time bond market data or sufficient experience in negotiating the pricing of their bonds, they should not undertake a negotiated sale without a financial advisor.
Underwriters should be selected through a competitive RFP process to promote fairness, objectivity, and transparency The RFP process allows issuers and their financial advisor to select the most qualified firm or firms, based on relevant selection criteria stated in the RFP As is true in selecting financial advisors, the experience the proposing firm has with the type of bonds proposed by the issuer is a key criterion for selection. Issuers should look for relevant experience both from the investment bankers who will work most closely on the transaction and from the firm's underwriting desk, which will be responsible for selling and distributing the issuer's bonds at the time of pricing. Proposals should also demonstrate an understanding of the issuer's financial condition, including ideas about how the issuer should approach the structure of the bonds, credit rating strategies, and investor marketing strategies.
Underwriters are compensated in the form of an underwriting spread, or a discount from the face amount of the bonds. Underwriters are typically compensated only if the bonds are successfully sold and closed. The RFP should request that proposers provide their best estimate of the underwriting spread, broken down into the four typical spread components:
* management fee (the compensation paid to the under writer for banking related services)
* takedown (the "sales commission")
* expenses (the reimbursement to the underwriter for fees and overhead expenses)
* underwriting (a fee sometimes paid to the underwriter if it agrees to underwrite a substantial amount of unsold bonds)
While the spread estimate provided in the proposals should not be viewed as a firm bid, it does provide a basis for the issuer and financial advisor to negotiate the final spread when the bonds are sold. If the spread proposed at the time of sale is significantly higher than what was originally proposed, the issuer and its financial advisor should require the underwriter to explain to the issuer's satisfaction the reasons behind the increase.
PRICING BONDS IN A NEGOTIATED SALE
Pricing bonds in a negotiated sale is the process of determining the bond yields, coupons, underwriting spread, optional redemption provisions, use of term bonds, and other structuring and pricing details of the proposed bonds. From the issuer's perspective, the act of pricing bonds in a negotiated sale can be simple or difficult. On the one hand, an issuer can choose to enter a negotiated sale without the benefit of a financial advisor and simply accept the interest rates, yields, and underwriting spread offered by the underwriter without any true negotiation. Such an approach is simple and easy, but unlikely to result in a desirable or defensible outcome for the issuer. On the other hand, issuers can hire a knowledgeable and experienced financial advisor, come to the pricing armed with current data on comparable transactions (especially those selling through competitive bidding), and be ready to walk away from the pricing if an agreement cannot be reached. Negotiation is often hard work, but it is the only way an issuer can be assured of achieving the pricing that best reflects current market conditions. If you are not prepared to work for the best price, then you should not be selling your bonds through a negotiated sale.
Perhaps the most critical task in preparing to negotiate the pricing of bonds is to assemble data on other bond issues that have been priced in the market at the time of the issuer's pricing, or before (sometimes referred to as comparables, or comps).The issuer should expect and require that both its underwriter and its financial advisor provide independently prepared information about comparable transactions and be prepared to recommend a scale of bond yields (the return an investor will receive by holding a bond to maturity) and coupons (a negotiable certificate attached to a bond that represents a sum of interest due) based upon other transactions in the market. This data should be accompanied with information about general bond market conditions, expected economic and financial releases that might affect the bond market, and other information to help provide an understanding of the "tone of the market" at the time the issuer plans to price its bonds. This information should be provided to the issuer several days before the proposed pricing date. Other important steps in the pricing of bonds that are intended to help the issuer realize the best possible results from its negotiated sale include preparing a marketing plan for the bonds, considering retail order periods, evaluating alternative structuring features such as premium or discount bonds, optional redemption provisions and other structuring features, negotiating priority and designation policies, monitoring order flow during the order period, and post-sale analysis of the pricing.
Finance officers frequently mention that their negotiated sales went well, citing as evidence that all the bonds were sold within the first 15 minutes of the order period. Imagine advertising a vintage Rolls Royce for $1,000. No doubt there would be many immediate takers at such a cheap price. The same is true for bonds. Bonds that are priced too cheap (bond yields set too high) are sure to sell fast. My guess is that in these cases, the finance officers did not observe best practices in the conduct of their bond sales.
By observing GFOA's best practices on the selling of bonds, issuers can help assure that their bond sale process achieves the goals of the lowest cost of financing, the timely receipt of the proceeds, and the conduct of the sale process in an open and transparent manner so as to avoid charges of favoritism after the sale is complete. Moreover, finance officers who follow these practices should be able to defend, to their elected officials, the public, and to the press, each of the key decisions involved in the process of bringing the bonds the market.
Looking to the GFOA's Best Practices
The GFOA's best practices on the sale of bonds contain several common themes and recommendations that finance officers should bear in mind when preparing to sell bonds:
* The roles of financial advisor and underwriter are separate and distinct, The same firm cannot serve both roles on the same bond issue.
* A key difference between the financial advisor and the underwriter is that the financial advisor has a fiduciary responsibility to the issuer. The underwriter's responsibility is to bond investors.
* Early in the bond sale process, issuers should hire an outside financial advisor to advise them on selecting the appropriate method of sale for the bonds,
* The method of sale decision should be based on an analysis of the relevant characteristics of the proposed bonds and should not be influenced by parties with a vested interest in the outcome of the decision.
* Issuers should not permit their financial advisor to resign in order to serve as underwriter of a negotiated sale.
* All outside finance professional should be hired through a competitive RFP process.
* Financial advisors and negotiated sale underwriters should be selected primarily on the basis of relevant experience with the bonds proposed by the issuer.
* When bonds are sold through negotiation, issuers and their financial advisor should be actively involved in the negotiation and not be reliant solely upon information provided by the underwriter
ERIC H. JOHANSEN is debt manager for the City of Portland, Oregon, and is a member of the GFOA's Committee on Governmental Debt Management.
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|Author:||Johansen, Eric H.|
|Publication:||Government Finance Review|
|Date:||Feb 1, 2010|
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