State and local governments are paying bankers less and less each year to underwrite municipal bond deals as new-issue volume remains muted and competition remains high.
For the first half of 2013, underwriters have been paid on average $5.25 per $1,000 of bonds sold, according to Thomson Reuters data. That’s 5.6% less than the average amount of $5.56 during 2012.
Spreads have steadily declined each year after peaking in 2009 at $6.21, when deals were riskier to underwrite and fewer banks were competing for business following the financial downturn.
In the years that followed, spreads dropped to $5.97 in 2010, $5.65 in 2011, and $5.56 in 2012.
“Perhaps the main reason is that this is a highly competitive process,” said Chris Mier, managing director of the analytical services division at Loop Capital Markets. “The fact that volume has come down in the last year and a half and there are still a considerable number of firms that compete vigorously for these bond issues is causing spreads to continue to come down.”
Through July 13, the par amount of long-term bonds sold totaled $175.6 billion — a 10% decrease from the same period the year before. In 2012, issuers sold a total amount of $195.4 billion during the first half of the year.
“The most powerful force in bringing down underwriting spreads has been a modest decline in the takedowns on bond issues,” said Herman Charbonneau, executive vice president and manager of public finance at Roosevelt & Cross. “Takedowns are lower simply because volume is down a little bit, and with fewer bonds and more competition, that tends to drive down variable costs like takedowns.”
The takedown is one component of the underwriter’s discount, and is the compensation to the underwriter for distributing the bonds.
Other components of the underwriting spread include the structuring or management fee, compensation for risk, and any related expenses.
Greater transparency in the municipal market is another factor in the continued decline of underwriting spreads, Mier noted.
“The low cost of readily available information is going to make any kind of market more efficient,” he said. “People have a stronger understanding of what it takes to win a deal, what might end up causing them to lose a deal, and people sharpen their pencils which creates a cycle of declining underwriting spreads.”
Underwriters received higher compensation on competitive deals, with an average spread of $5.63 for the first half of the year. On negotiated deals, they received an average of $5.17.
Spreads declined faster on competitive bonds, dropping from $6.17 in 2012. Spreads on negotiated deals in 2012 averaged at $5.45.
Peter Stare, a senior vice president at First Southwest, said spreads on competitive deals without much presale tend to be higher than on negotiated deals because underwriters take on more risk.
A presale is the process during which underwriters seek investor indications of interest in the bond sale before establishing final bond pricing.
“The competitive nature of the market is that you always have a little bit of extra money out there aside from expenses and your takedown, and that’s because you’re putting your company’s capital at risk,” Stare said. “And you need to be compensated for that.”
Among sectors in the municipal market, health care and housing deals offer underwriters the greatest compensation, with average spreads of $7.06 and $6.61, respectively.
Environmental bond deals had an average spread of $6.39 and utility deals had a spread of $5.46.
In general, lower quality and more complex bond deals have higher spreads, as the risk and work involved from underwriters is greater.
“Doing a hospital deal, for example, is more banker-intensive, more resource-intensive from the investment bank’s standpoint, than doing a school district general obligation bond,” Loop Capital’s Mier said. “It involves more time and effort form the bankers, so they have to build that into their bid.”
Spreads are lower on the higher-quality, less complex deals as underwriters bid more aggressively to work on those deals.
“There’s more reward for a riskier transaction or if you’re talking about a triple-B healthcare than if you’re talking about a triple-A GO bond or essential service revenue bond,” Stare said. “So I don’t think people are on a percentage basis being as aggressive on the lower-rated quality deals as they are on the higher grade deals.”
Electric power bonds, which are essential service revenue bonds, had the lowest average underwriting spread at $3.68.
Transportation bonds came in second with an average underwriting spread of $4.15, and general purpose bonds came in third at $4.79.
Mier said he doesn’t know where spreads will go in the future, but if they continue declining, business activity will become unprofitable at some point, and investment banks will start to either get out of the municipal bond business or concentrate on other business operations.
“There’s a limit on how tight spreads can get and I don’t know what that limit is,” he said. “But when you get to a point where an investment bank is engaged in an activity that’s returning suboptimal or a very small or negative return on equity, they’re going to get out of the business.”
