CDFA Spotlight: Examining the Best Method of Sale for IDBs By Stan Provus

Preface

Competitive, negotiated and private placement in bond sales all have pros and cons and depend greatly on the type of project and issuance needs of all parties involved. This Learning Corner article examines the best method of sale for qualified small issue bonds (aka: IDBs) and provides guidance for issuers to consider when determine which method of sale is most beneficial.

Method of Sale

Regardless of the type of bond (i.e. IDBs, 501 (c)(3), TIF, etc.), new issues of municipal bonds are sold by one of three methods: (1) competitive; (2) negotiated; and (3) private placement. It is important to understand these three basic methods before examining which one(s) may be best for IDBs. Most articles on the best methods of sale focus on competitive vs. negotiated sales—private placements account for only a very small percentage of new issue sales but, as we shall see later, are significant with IDBs.

Competitive Sales

In a competitive offering underwriters bid to purchase bonds. The issuer usually engages a financial adviser to work with bond counsel to perform the tasks necessary for a competitive bid sale. Once an offering is structured, the sale begins with the publication of an official notice of sale that often is advertised in the Bond Buyer, the industry’s national trade newspaper, as well as local and national publications and by sending the notice of sale to prospective bidders. Certain information appears in the notice of sale, including the amount, structure, authorization, type of bond, time and place of sale, denominations, date, bidding specifications, etc.

A competitive sale is an auction with bonds sold to the underwriter that bids the lowest interest cost. It is a very transparent form of sale. A number of competitive sales today are submitted via the Internet to financial advisers who prepared the documents or industry on-line auction sites. The competitive sale process is increasingly electronic. In 2005, 76.1 billion of tax-exempt bonds were sold through competitive sales. Seventy-six (76%) were plain vanilla general obligation bonds, and the balance was revenue bonds.

In 2005, competitive sales accounted for about 19% of all bond sales. Negotiated sales totaled $330.4 billion in 2005 or about 81% of total bond volume. The vast majority of negotiated sales are revenue bond transactions—73% and the balance are general obligation bonds. Private placements typically account for less than 3% of annual municipal bond sales.

Online bond auctions allow issuers to accept real time competitive bids on bond issuances over the Internet. Issuers that use on-line auctions do not host them themselves. Instead, issuers contract with one of the online auction providers or firms that house the online bidding systems which make online auctions possible, some at no cost to issuers. Using Web page templates, bids are submitted electronically to the proprietary bidding systems operated by the online auction provider hosting the auction. Currently, at least three online auction providers perform this service nationally.

Proponents of on-line auctions say there are several advantages to using the Internet to sell municipal bonds. Through electronic notification of a bond sale and the ability to accept bids electronically, an issuer could realize considerable savings in printing costs alone. However, online bond auctions may provide an even greater advantage, which is the increased competition due to the potentially global community of bidders. More participants aggressively bidding against each other could result in lowered interest rates, or true interest costs (TIC), to issuers. Most if not all of the fees associated with online bond auctions are absorbed with the bond sale proceeds.

Negotiated Sale

In a negotiated sale the underwriter(s) is selected before bonds are sold and is given the exclusive right to purchase an issuer’s bonds at agreed upon prices. In return, the underwriter provides financial advisory services to structure and size an issue and assumes responsibility for marketing bonds to ultimate investors. Negotiated sales differ from competitive sales in the following ways: (1) use of a single underwriter (or underwriting team) and thus elimination of a competitive bid process; (2) selection of an underwriter prior to offering bonds for sale; (3) origination services performed by the underwriter rather than a financial advisor, although a financial advisor may be engaged to lend additional technical support; (4) the extent of presale distribution; and (5) negotiation of the interest cost at which bonds will be sold to the underwriter.

Private Placements

Private placements are bond sales transacted directly between an investor(s) and the issuer. The placement agent acts as a middleman between the issuer and bond investors. Unlike negotiated sales, the placement agent does not purchase bonds from issuers and sell them to investors.

Many Qualified Small Issues secured by bank letters of credit, particularly low floater variable-rate issues, are transacted as Private Placements, in part to avoid disclosure of company financial information to the public (and competitors). Usually, the same bank that provides the letter of credit also acts as placement agent for the bonds. Unlike competitive and negotiated sales, where bonds are purchased by an underwriter and resold to investors, with private placements, the placement agent directly places bonds with ultimate investors on behalf of the issuer.

Proponents of negotiated sales contend that the opportunity to undertake pre-marketing of bonds, the ability to better customize structures maturities for targeted investors along with more flexibility in timing sales results in lower borrowing costs.

Generally, competitive sales are viewed as effecting the lowest all-in borrowing cost when the issuer is well known, the security is strong and predictable such as G.O. bonds, and the market is stable. A negotiated or private placement is more appropriate for an unknown issuer, for “story bonds” where security for bonds is complex, and/or the market is unstable. These generalizations, however, have become a somewhat more suspect over the past two decades as more issuers, including G.O. bond issuers have switched from competitive to negotiated sales. This is because although competitive sales offer several benefits, disadvantages can include less flexibility, risk premiums because the underwriter cannot market the sale in advance, and the issuer has limited control over underwriter selection and bond distribution. Negotiated sales also have disadvantages including a lack of competition in the pricing, fluctuations in the spread or underwriter’s discount and the potential appearance of favoritism, since the underwriter(s) are selected based on quantitative and qualitative factors.

No one knows for sure which method of sale will yield the lowest all-in borrowing costs. Issuers would have to conduct simultaneous bond sales using all three methods to determine this and this, of course, is not possible. Issuers generally select what they believe to be the best method of sale based on the characteristics of the transaction.

Best Method of Sale for IDBs

All three of the primary methods of sale have been employed to sell IDBs, although competitive sales are very rare and have only been transacted, to the best of our knowledge, where state credit enhancement and/or state credit enhancement wrapped by bond insurance is used. Not unlike any other type of bond issue, the best method of sale, meaning the one that will deliver the lowest all-in borrowing cost, will vary based on the characteristics of the transaction, fixed vs. variable rate financing, size of the transaction, risks, and which methods are available to a conduit IDB borrower in any given state or area.

Fixed vs. Variable Rate Financing

Many IDB conduit borrowers cannot access fixed rate financing directly because they are unrated, closely held, and relatively small manufacturing companies. As a result, borrowers who desire fixed rate financing must issue variable rate demand obligation bonds (VRDO) secured by bank letters of credit and then enter into interest rate swaps with counter parties. As noted below, these transactions are sold through private placements and carry certain risks that are not present when fixed rate financing can be accessed directly.

Composite vs. Stand-Alone Financings

Several states (AR, FL, OH, and PA) operate composite or umbrella negotiated sale
programs, under which several projects are pooled together into a single bond offering to realize savings on bond issuance costs, including both up-front and annual costs. Since bond issuance costs are spread among many borrowers, smaller projects that might otherwise find tax-exempt financing uneconomical on a stand-alone basis become cost-effective.

Size of Issue

By law, IDBs cannot exceed $10 million and many are in the $3-$6 million range. This issue size is relatively small and can compromise net borrowing costs when upfront and annual fees are taken into account.

Competitive and Negotiated Sales

In the past, the Arkansas Development Finance Authority (ADFA) has sold IDB composite bonds on a competitive and negotiated basis. ADFA’s Bond Guaranty Program and a AAA-rated bond insurer secured these bonds. Unlike the vast majority of states, ADFA has its own credit enhancement tool which is rated “A” on a stand-alone basis and secured by interest earnings on the state’s general fund and a cash reserve of about $22 million.

The ADFA program is ideal for IDB borrowers who desire the certainty of low fixed rate financing. ADFA’s guaranty is not subject to annual renewals like letters of credit that secure variable rate demand obligation bonds. In addition, as a result of the composite bond structure, borrowers get lower up-front and annual fees than they could otherwise achieve on a stand-alone basis. Finally, ADFA’s fixed rate borrowers are also not subject to the risks of interest rate swaps.

Borrowers in states with composite bond programs (AR, PA, OH, FL) may find these programs the best method of sale. Most of these state programs sell their composite issues through negotiated sales.

Private Placements

Although there is no source of information that tracks how IDBs are sold, in our view various forms of private placements are the predominate method of sale. The majority of IDBs are probably privately placed as variable rate demand obligation (VRDO) bonds secured by a rated bank letter of credit. Other forms of sale really do not make sense when interest rates on the bonds change very frequently. Benefits of VRDO bonds include access to the lowest tax-exempt short-term interest rates such as low-floaters where the rate changes weekly. This is long-term financing at short-term interest rates. Banks take the same risk on a letter of credit (L/C) that they do for a loan; therefore, the L/C is priced based on the creditworthiness of the borrower. The cost of the L/C (annual cost typically ranges from 50-200 basis points), of course, must be factored into calculations of all-in borrowing cost. L/Cs generally expire prior to the maturity date of the bonds, requiring the borrower to renew the L/C periodically during the life of the bonds (typical L/C terms are from 3 to 5 years). At each renewal date the cost of the L/C may be higher or lower. The variable rate financing can be swapped for fixed but there are attendant risks such as basis, tax and counter party risks.

Over the past decade a relatively new form of private placement has emerged that closely resembles the way almost all IDBs were sold prior to the 1986 Tax Act. We call these transactions “direct purchase”. In recent years, a number of issuers have undertaken private placements directly with ultimate investors, (particularly fixed-rate issues) without the services (or cost) of a placement agent.

Several non-bank financial institution investors have facilitated this process by providing standardized documentation and terms that may affect a lower all-in borrowing cost for issuers. These investors have an appetite for creditworthy deals, particularly equipment only transactions that would otherwise require a letter of credit to come to market. In effect, these investors purchase bonds at a somewhat higher yield than an issue, such as an IDB, secured by a letter of credit. Savings on the letter of credit fee may make it cost effective to sell bonds at a somewhat higher yield. Additionally, in many of these transactions there are no trustees (and related costs).

Banks also purchase bonds directly. It has been reported that up to 30% of IDBs are sold to banks in some states even though they do not qualify for bank-qualified status. Direct placement transactions eliminate many of the industry professionals (and related costs) common to the more traditional VRDO/L/C structure. There is no L/C required or any other form of credit enhancement and related legal fees, remarketing agent, rating agency fee, or trustee/fiscal agent (if required, it will be less expensive). The basic bond players are reduced to the issuer, borrower, bond counsel, and lender.

Several states and localities have put in place “streamlined” direct purchase IDB programs such as Oregon’s Express Bond Program and the St. Louis County Mini-Bond program. These programs are designed for small transactions $500,000-$2 million. Bond counsel fees are substantially reduced in these programs and the bond documents are highly standardized. Smaller transactions can benefit from these types of programs as well as other direct purchase products.

Finally, there are also investment-banking firms that specialize in placing unrated/unenhanced IDBs. IDBs sold without a letter of credit from a bank are termed unenhanced; they promise repayment solely based on the company’s credit. These bonds are sold at fixed interest rates and are fixed for the entire amortization term. There are no lender calls or balloons, and they function as a permanent mortgage. The interest rates on unenhanced bonds are higher than enhanced bonds, but the borrower does not have interest rate or market risk. Unenhanced bonds are typically not rated by the major rating agencies. The method of sale for these bonds can be through a private placement, direct to an institutional investor.

In conclusion, the best method of sale for IDBs depends on the characteristics of the transaction and the availability of various IDB sales products in any given locality. Conduit issuers should at least make IDB borrowers aware of the options available to borrowers in their jurisdictions. Borrowers, in turn, should prepare their own spreadsheets to estimate all-in borrowing costs (NPV or IRR) under the various sales methods available to them.

This article is intended to provide accurate and authoritative information in regard to the subject matter covered. The author and CDFA are not herein engaged in rendering legal, accounting or other professional services, nor does it intend that the material included herein be relied upon to the exclusion of outside counsel. CDFA is not responsible for the accuracy of the information provided in this fact sheet. The information provided has been collected from a variety of sources. Those seeking to conduct complex financial deals using the tools mentioned in this document are encouraged to seek the advice of a skilled legal/consulting professional.