Bond underwriters serve an important role in municipal bond transactions. An underwriter markets an issuer’s bonds, purchases them from the issuer and resells them to investors. Any unsold bonds are generally underwritten, meaning that the underwriter utilizes their own capital to purchase the balances and takes the risk of interest rate fluctuations.
Underwriters are Compensated Through an “Underwriting Discount”
An underwriter purchases all of an issuer’s bonds at a discount, then resells them to investors for full price (assuming all bonds are initially sold, which we’ll get to later). As an example, if XYZ district has a municipal bond financing with a par amount of $100 million, an underwriter could purchase the entire financing from XYZ district at a discount, say $99.5 million. If the underwriter is able to resell all of the bonds to investors at the $100 million face value, the underwriter will have earned a compensation of $500,000, or 0.5% of the par amount, or $5 per $1,000 bond.
An underwriting discount is typically comprised of three components: (1) takedown, (2) management fee, and (3) expenses.
- The takedown is generally the largest component of the discount and is the commission paid to the underwriter’s sales team for selling the bonds to investors.
- The management fee is the compensation for the investment banker leading the transaction and bringing it to market.
- Expenses are items such as the underwriter’s counsel and other miscellaneous fees.
A Fair Underwriting Discount is a Function of Many Factors
What is a fair underwriting discount? The short answer: it’s complicated. The long answer: it’s a function of many moving parts such as the size and type of financing, the likely investor base, the involvement of the investment banking team, and the market.
As an example, a small, non-rated land-secured bond sold in a volatile interest rate environment to retail investors in which the investment banker is highly involved in all aspects of the transaction may require a higher underwriting discount percentage than a large, highly-rated general obligation bond sold in a stable market to institutional investors in which the investment banker is only minimally involved during the sale process and closing.
Theoretically, a higher takedown should incentivize the sales team to market the bonds and locate investors to lower borrowing costs. If there are no buyers, a higher takedown should also make the underwriter more willing to underwrite the balances. If all bonds are not initially sold for full price, the underwriter takes the risk of interest rate fluctuations, in which they could sell below the full price (and take a loss) or sell above (and make a gain). A higher takedown could serve as a buffer against potential losses and impact the willingness to underwrite (as opposed to increasing the interest rates to bring in buyers). This does not mean that high underwriting discounts are always warranted. In addition to the many moving parts cited above, market fees can be assessed through public sources such as the offering documents of comparable financings.