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The new world of selling bonds.


It's time for issuers to rethink how they sell municipal bonds. The world is no longer as it was in 2006, when buyers were plentiful, bond insurance was AAA, and investors trusted the rating agencies. A strong economy, combined with bond insurance, meant that investors had few worries about the underlying credit quality of the bonds they bought, and credit spreads (the yields between highly rated and lower rated bonds) were minimal. None of this is the case now.

The changes mean that most issuers will have to do more work to get their bonds sold. This is especially true for smaller, less frequent issuers with unique or complex offerings. Previously, many of those issuers bought bond insurance, got a AAA rating, and sold their bonds to insured bond funds. In the new world, they will have to sell bonds on their own credit. The rating agencies will help, but a good rating alone will no longer be sufficient to satisfy the enhanced scrutiny of investors. And since offering bonds just to a few large institutional investors might not provide the best pricing, issuers will have to sell their credits to an expanded universe of retail investors and the investment professionals who manage their money This article will review the changes the last three years have wrought, and then discuss some steps an issuer can take to deal with them, based on the state of California's experience.


The Changing Face of the Investor. In early 2007, hedge funds and tender option bond (TOB) programs dominated as large buyers of municipal bonds. They had been barely a part of the picture just two years before, but by 2006,they were buying a substantial share of new general obligation bond issues. This seemed like a good development, especially since California was looking for buyers after the state's voters had just approved the issuance of $43 billion in new general obligation bonds. One had to wonder, however, if these new buyers would be still around two years out--and of course, the answer turned out to be no. Those buyers, who were making a market play instead of buying the bonds for their intrinsic values of tax-exemption and low risk, found their strategy suddenly failing as the financial market turmoil took its toll.

So, if the hedge funds were not going to buy the state's $43 billion in bonds, who would? The answer is individuals, the investors who have been the bedrock of the municipal bond industry for decades. Individuals have become more active participants in the municipal bond market for several reasons. As baby boomers age and shift their assets more from equities to fixed income, municipal bonds are a good choice for those with substantial assets. Further, the stock market gyrations make municipal bonds a safe investment for those who want steady income and no losses. This concern about market loss has also probably driven more investors to buy bonds directly and hold them to maturity, rather than purchase mutual funds, which exposes the investor to market value changes when redeeming shares.

Bond Insurance. Perhaps nothing shook overall confidence in the municipal bond market more than the collapse of the bond insurers. The market functioned on the certainty that the insurers would always be AAA, but that turned out to be wrong. Not only did the insurers lose their AAA rating, but most of them tumbled to ratings below investment grade and just stopped writing insurance policies. Only one truly active insurer remains. Many potential new entrants have been discussed, but none have been able to solve the problem of satisfying the rating agencies and the market about their credit quality while providing a competitive return to their investors. This failure in the face of a tremendous potential market for bond insurers suggests we will have to rebuild our market without them.

Rating Agencies. While the headline news is that the rating agencies assigned generous ratings to mortgage-backed securities that subsequently failed, the criticism in the municipal market has been the opposite. Many issuers have charged that the agencies apply a more stringent criteria to municipal bonds than to corporate bonds that receive the same rating. These critics point to default statistics. As an example, Standard & Poor's reports that the cumulative default rate of investment-grade tax-supported issuers between 1986 and 2007 was only 0.03 percent. The issue reached national prominence in early 2007, when the New York Times ran a front-page article about the efforts of many major issuers to reform the double standard.

The three agencies responded in different ways. Standard & Poor's stated it did not maintain different standards and therefore no change was necessary Moody's Investors Service acknowledged that it had two standards and announced that it would begin migrating to a "global scale" in late 2007. Fitch Ratings published a discussion draft in 2007 about similar changes it was considering.

Then the economic crisis hit, and credit analysts both within and outside the agencies expressed concern about changing standards during such turmoil and uncertainty. Moody's says it still plans to migrate to global scale ratings, but it has not set a date. Fitch dropped its consideration of any changes. And Standard & Poor's, which always said it did not have a dual scale, has been quietly upgrading many issuers. One result is that split ratings are now fairly common. The State of California, for example, is rated Baal by Moody's, A by Standard & Poor's, and BBB by Fitch.

What is an investor to make of all this? Why do three agencies have three different evaluations of an issuer's credit? And if an issuer has an A rating on the municipal scale but would have a AAA rating on the global or corporate scale, which one is right? The confusion highlights two fundamental questions about ratings. First, what is being measured? And, second, who is the audience? The two questions are not independent of each other.

It could be argued that the individual investor, who wants to buy a safe bond and hold it to maturity, really wants to know only if principal and interest will be paid on time and in full. Therefore, what such an investor needs to know from a rating is the likelihood of default (and the likelihood of recovery in the event of a default). On the other hand, the institutional investor who buys and sells bonds, and hopes to make money on changes in the actual or perceived credit strength of an issuer over time, wants more subtlety and gradation in a rating. And, from the standpoint of many issuers, to have anything but an AAA rating when it will never default seems like an unnecessary cost imposed on its taxpayers or ratepayers. The rating agencies have failed to provide clarity on this debate. while acknowledging that their ratings do not simply measure default risk, they have established criteria for ratings but have not explained what risk to investors their ratings measure.

This debate is unresolved. Coupled with the damaged credibility the agencies suffered with mortgage-backed securities, this lack of definition of what a municipal rating measures has left investors pondering how much they can rely on a bond's rating in making an investment decision. Larger investors have responded, in part, by beefing up their internal credit analysis. But the smaller investor is still struggling with how to respond to a market where availability of bond insurance and the reliability of ratings can no longer be counted on.

Credit Quality and Disclosure. While the debate about global ratings and the virtually non-existent history of municipal defaults by investment grade issuers should give investors comfort about municipal bonds, the institutional credit analyst community has, instead, raised alarm bells about the riskiness of municipal bonds. They are not just talking about the traditionally risky sectors, such as senior living or assessment bonds. They are talking about general government credits.

The poster child is Vallejo, California, a city of 120,000 that filed for bankruptcy protection in 2008. Although Vallejo has not defaulted on any of its bonds, the worry is that issuers might choose to solve their financial problems (including expensive union contracts and pension and other post-employment benefits, or OPEB) by declaring bankruptcy and thereby also be relieved of their obligation to pay debt service. Municipal bankruptcy is the hot topic among municipal analysts. The National Federation of Municipal Analysts drew a few hundred participants to a two-day advanced seminar on the topic in October.

A related argument for why municipal bonds are risky is that municipal issuers do not provide updated disclosure in as timely a manner as corporate issuers. Therefore, if something is going wrong, how will investors know? This concern about disclosure has been a focus of the Securities and Exchange Commission for many years, and it is an important reason why the possibility of federal regulation of municipal bond issuers is again a topic much discussed in Washington.

The argument ignores an important way in which the municipal bond market provides much greater transparency than the corporate market. The public sector operates in the open. Documents and meetings are available to the public, in contrast to the way corporations work. Investors can go to city council meetings, but not to corporate board meetings. And all of the public's business is usually on the Internet--documents and the live streaming of meetings are available to the credit analyst sitting as his or her desk, wherever that might be.

As of now, the possibility of widespread general government defaults is just conjecture. Perhaps a silver lining of today's fiscal stress is to help answer the question whether municipal issuers are, in fact, prone to default. If they don't default now, as a result of the deepest recession since the Great Depression, it is hard to imagine when they will.


This new environment requires an issuer to do many things differently if it wants to enhance its ability to sell bonds. The following suggestions will help you make the most of the new world for municipal credits.

Market Your Bonds. The audience in pitching your credit is not only the credit analysts at the bond insurers or rating agencies. You are less likely to sell your bonds with insurance and more likely to deal directly with investors who are less likely to rely solely on what the rating agencies say. Mutual funds and other institutional investors are requiring their credit analysts to delve into great detail in evaluating a bond issue before they buy If you want them to buy your bonds, make it easy for them to do their homework.

One way to do this is to make information easily accessible, preferably on your Web site. Many issuers have an investor relations section where an investor can download financial reports, capital plans, and official statements from prior deals. Comprehensive disclosure in your official statement is also important. Rather than trying to limit disclosure to the legally required minimum, some issuers provide greater detail, answering some of the questions investors may ask and also signaling to investors an ongoing openness to updated disclosure.

Market to Retail. Individual investors, especially those who make large purchases, often buy municipal bonds directly rather than going through mutual funds. Direct purchases have two advantages. First, an investor who holds a bond to maturity is not exposed to market risk, while there is no way to avoid that with an open-end mutual fund. Second, transactions costs are lower, especially if an investor buys a new issue. An investor with a substantial portfolio who diversifies risk by holding many different bonds is likely to find direct purchases more efficient.

The growing focus on retail investors raises the question of what exactly a retail investor is. It includes the individual investor who puts in a $25,000 order through a retail broker, but such investors, while numerous, do not usually account for a large dollar volume of orders. For example, when the City of Los Angeles sold $455 million of wastewater refunding bonds in March 2009,36 percent of the bonds were purchased by retail investors. Forty percent of the 211 retail orders were for $250,000 or less, but they accounted for only 6 percent of the dollar volume of retail orders. At the same time, fewer than 10 percent of the orders accounted for almost half of the dollar volume. Retail isn't just "mom and pop" anymore, and many of the orders come from investment professionals who manage money for wealthy individuals and submit orders of $1 million or more.


Being able to access retail through money managers is advantageous for issuers. These are investment professionals who have a greater ability to evaluate investments and the credit behind them than an individual investor might. Therefore, in a market where bond insurance is rare and ratings are only one indicator of credit strength, developing relationships with money managers who control retail investment dollars is a smart investment to make.

Use a Retail Order Period. Most issuers that make a strong push for retail sales use a retail order period (ROP).The ROP occurs for one or two days before the institutional pricing. During the institutional pricing, syndicate rules dictate that retail orders get filled only if there are bonds not sold to large institutional investors. Therefore, retail buyers rarely get a chance to buy the bonds. Having an ROP first gives retail buyers a better chance to buy bonds.

For the issuer, the ROP accesses demand from additional buyers, which can translate into lower interest rates. In today's market, retail buyers can account for a very large volume of orders. When the state of California sold $8.8 billion of revenue anticipation notes in the fall of 2009, three-quarters of the notes were sold to retail. For an issuance of $163 million by the City and County of San Francisco in mid-2009, 96 percent of the bonds maturing in the first ten years went to retail investors, as did about 20 percent of the longer maturities. While retail orders are typically thought to be concentrated in the earlier maturities, the orders San Francisco received for bonds beyond the typical retail maturity range reduced the amount of bonds that needed to be placed with institutional investors and allowed for more aggressive pricing on the entire bond issue.

An issuer that typically sells bonds by competitive sale will not be able to use a retail order period. In a competitive sale, the underwriter may inform its bid for the bonds by getting a sense of where the major institutional investors will be willing to buy them. But it is not possible for an underwriter to canvass hundreds or thousands of retail investors if that underwriter does not know if it will actually have the bonds to sell. Remember, the impetus for underwriters to seek orders during the ROP is the certainty that they will be able to deliver the bonds if they get the orders. So, issuers that prefer a competitive sale must evaluate whether that approach has benefits that outweigh those of harnessing retail through a ROP.

Go Online. In November 2006, California voters approved $43 billion in new infrastructure bonds, and the state launched a BuyCaliforniaBonds campaign to expand outreach to retail investors. Prior to a bond sale, investors are urged by e-mail and advertisements--radio, newspaper and Internet--to visit to learn about the bonds. At the site, investors can download the preliminary official statement, learn about the timing of the sale, and link to the investment banks managing the bond sale. Investors can also sign up to be notified by e-mail about future bond sales. The site has helped tap a huge market of retail investors even as the state comes to market with billions of bonds against a backdrop of continuing budget woes. Other issuers have designed their own sites, such as, from the San Francisco International Airport.

The Government Finance Officers Association (GFOA) has long advocated the intelligent use of the Internet to communicate with investors, beginning with its 2002 best practice, Using a Web Site for Disclosure, supplemented with a 2009 best practice, Web Site Presentation of Official Documents (GFOA best practices can be accessed at

Use Your Co-Managers. One of the advantages of a retail effort is that it gives co-managers a role to play During the institutional order period, almost all institutional orders are placed with the senior manager. Accordingly, the co-managers have few ways to contribute. In contrast, during the retail order period, every firm can place orders that will most likely be filled. Many retail investors, including money managers investing on behalf of retail investors, have relationships with only a few underwriting firms. Therefore, co-managers can submit orders that will not be duplicated by the senior manager and, therefore, represent true additional demand for the bonds.

It may require some effort on the issuer's part to ensure that co-managers work for orders. Firms that are not acting as the senior manager can become complacent, not making much effort to sell the bonds and being content to collect designations. They can, in fact, complain about the dominance of the senior manager in the ROP. But that is usually because they have not worked to bring in their own orders. One way to ameliorate that concern is to limit the size of what can be considered a retail order--no more than $1 million, for instance.


Don't Forget Institutional Investors. Bond mutual funds remain the largest buyers of municipal bonds, especially those maturing after ten years. Even with strong retail interest, their participation in a bond issue usually remains the critical determinant of pricing. Bond funds sometimes question the use of a retail order period, saying they should have equal access to the bonds. They point out that they buy on behalf of retail investors and should therefore not be disadvantaged. It is important to ensure that institutional buyers can participate along with retail investors. At the same time, an issuer that harnesses the power of retail investors can help drive the pricing of their bonds toward lower yields. The institutional investor's participation is important in getting the deal done, but the participation of the retail investors can help set a better market price for the issuer's bonds, which all investors must accept.

Consider Build America Bonds. The American Recovery and Reinvestment Act of 2009 gives issuers the opportunity to access a new class of buyers by issuing Build America Bonds (BABs), possibly paying less in net interest costs than with traditional tax-exempt bonds. The interest on BABs is federally taxable, but the federal government also provides a subsidy for 35 percent of the interest cost. Through 2009, issuers sold $64 billion of BABs, accounting for 15.6 percent of municipal bond issuance. Many issuers have saved substantially by issuing BABs, especially in the longer maturities, although they have sometimes had to give up some flexibility to do so. In particular, the savings might not be compelling if the issuer wants to sell bonds that provide an optional par call (redeeming the bonds at a specified price, usually at par, or the face value), since the taxable market might extract a substantial penalty for that flexibility BABs are authorized only through the end of 2010, but it is expected that they will be reauthorized by Congress, though at a subsidy rate of less than 35 percent. In theory, BABs can attract new buyers to an issuer's bonds, such as pension funds, foreign investors, and endowment funds, none of which pay income taxes. To date, these investors have not participated extensively, but that may change if BABs become a permanent option for issuers.

Consider Build America Bonds. The American Recovery and Reinvestment Act of 2009 gives issuers the opportunity to access a new class of buyers by issuing Build America Bonds (BABs), possibly paying less in net interest costs than with traditional tax-exempt bonds. The interest on BABs is federally taxable, but the federal government also provides a subsidy for 35 percent of the interest cost.


It is a brave new world. There is still a lot of demand for municipal bonds, but investors have a lot of choices. Issuers that want investors to buy their bonds need to be on top of these changes and act accordingly.

PAUL ROSENSTIEL manages the San Francisco office of De La Rosa & Co., an investment bank specializing in the California public finance market. For most of the last 26 years, he has been an investment banker serving municipal issuers in California. From 2007-2009, he was deputy treasurer of the state of California, with responsibility for the state's bond issuance.
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Author:Rosenstiel, Paul
Publication:Government Finance Review
Article Type:Cover story
Geographic Code:1USA
Date:Feb 1, 2010
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