As the trickle of taxable Build America Bonds coming to market turned into a flood last year, issuers’ underwriting-designation policies followed the course charted by the corporate market. In recent months, signs have emerged that the tide is turning and there is no agreement on whether or not that’s a good thing.
When New York City priced $644.6 million of general obligation BABs yesterday, it went back to the compensation model known as “net designated” for the second time in two weeks. Prior to last week’s New York City Municipal Water Finance Authority’s $500 million deal, the city had used the “group net” model common in the corporate bond market on all of the $3.23 billion of BABs it had sold since 2009.
“We let it be known we were interested in trying out net designated,” said city deputy budget director Alan Anders. “We’re going to have to step back and look at it. We haven’t drawn any conclusions about what we’re going to do in the future.”
Issuers looked to corporate models for paying their bankers when they rolled out their first BAB deals in the months after Feb. 17, 2009, when President Obama signed the American Recovery and Reinvestment Act, which created the new form of debt.
One major difference between corporate and municipal underwriting has been the economics of compensating underwriters. Corporate bonds have long used a method commonly called group net designation, whereas municipal issuers have traditionally used net designation.
Designation is the process that assigns sales credit — and thus takedown or fees — to underwriting firms on bond deals. In the net-designation model, institutional investors buying bonds determine which firms get sales credit.
For example, when New York’s Metropolitan Transportation Authority priced its $443.2 million of BABs this week, it went back to the compensation model known as net designated as opposed to the group net model it used on the $2.33 billion of BABs it has issued since 2009. The issuer required that institutional investors designate at least three firms with no bank receiving more than 50% of any designation. It also required that a minimum of 10% be designated to the co-manager, Ramirez & Co.
In the group net model, the issuer determines underwriter compensation based on how much liability each firm has on the deal. The book-runner in a group net deal typically gets the largest percentage of the takedown and syndicate members each get a percentage, regardless of how many bonds they sell.
Which is better dep ends on who you ask, and some market participants see a place for both.
“Whether a deal goes group net or net designated, there are plenty of firms that will turn in a good performance, that will call accounts and do the job that they were put in the deal to do,” said Doreen Frasca, president of the financial advisory firm Frasca &Associates LLC. “Every issuer really wants to see the firms that they put into their transactions work for the sales commissions they get and I think there’s concern that a group net deal basically mails people a check whether they work the phones or whether they don’t.”
When BABs first came to market last year, the compensation was being done 100% group net, but Frasca said that anecdotally, she has heard that about 25% are now being done net designated.
James Lansing, managing director at JPMorgan, sees the use of the group net model for BABs as an evolutionary process in the muni world that the corporate bond world already went through.
“When you have a group net transaction, the underwriters are united in their interest — they are at that point only working in what is in the best interest of the issuer,” Lansing said.
The issuer knows “better than anyone who has been providing the best counsel and the best feedback on how to come to market, and the best amount of marketing information,” he said. “The issuer has the firsthand knowledge of who they want to reward, and it should be up to the issuer.”
Proponents of the net-designated model argue that firms will work harder for commissions and issuers will get wider distribution of their bonds.
Most orders go through the book-runner, but this allows investors to reward other firms for services provided or established business relationships.
Evan Rourke, portfolio manager at Eaton Vance, said designation policy is not a major concern.
“We don’t really care — if we like the bond, we’ll buy it based on the pricing to us,” Rourke said. The option is still nice, however.
“Most buyers like the ability to designate because it allows you to reward service — within limits,” he said. “Any kind of discretion you get does allow you to reward firms that are providing some service above and beyond just being part of that deal ... If you have someone who is bidding your bid-wanteds and actually providing liquidity, being able to designate them on a new issue is a nice way of rewarding that service.”
Howard Mackey, president of Rice Financial Products Co.’s dealer division, said the wider use of the group net model on BABs may have helped smaller firms.
“Net designated policies will tend to favor larger firms because customers … will tend to designate major firms better than they will smaller firms,” Mackey said.
Institutional investors may designate banks with access to future deals in mind.
“In an effort for a customer to be treated favorably on new deals that a major firm might lead manage, they’re going to make sure they always give them high designations when those lead managers are co-managers on other deals,” he said.
Group net can give smaller firms an opportunity to be recognized by the issuer for hard work and possibly move up in the syndicate, Mackey said.
Issuers are still sorting out the designation question. Anders said New York City used the net-designated model on its two recent GO and water authority BAB deals in part based on the recommendations of the book-runners, Siebert Brandford Shank & Co. and Jefferies & Co., respectively.
“In this case, Jefferies believed net-designated rules would broaden syndicate participation and help the process of building the BAB investor base for the authority,” Jefferies said in a statement.
The Dormitory Authority of the State of New York, the second-biggest issuer of municipal bonds last year, has used group net on the $1.23 billion of BABs it has sold since last year.
“When we first started talking about BABs, one of the things that people talked about was that the taxable market is one that is accustomed to seeing those deals go group net — again, that’s sort of a market convention issue,” said DASNY managing director of public finance and portfolio monitoring Portia Lee. DASNY is not contemplating using a net-designated model on its BABs deals, she said.
In a recent request for proposals for underwriting services last month on an upcoming school construction bond transaction, New Jersey’s Treasury Department specifically asked interested firms to detail any experience with net-designated pricing in BAB deals.
The department is reviewing whether it can use traditional net-designation pricing in taxable BAB transactions in order to obtain the lowest cost of borrowing.
“There seems to be a standing assumption that taxable bond buyers favor a group net policy and that the smaller banks in a syndicate need group net because they don’t possess sufficient corporate trading desks to succeed in the sales effort and attain designations,” James Petrino, director of the Office of Public Finance, said via e-mail. “We want to explore whether those assumptions are changing in the expanding market for BABs, which could be a component of the next [New Jersey Economic Development Authority] school construction issue. As the market for BABs has become broad and stable with crossover participation by both the taxable and tax-exempt bond buyer, the time may be right to instill the net designated order policy in our BAB issues.”
For the Empire State Development Corp., BABs haven’t changed their model. The issuer has used a variant of the group net model for the past 12 years. The book-runner and senior managers pool their designations and split them evenly on ESDC deals.
“This is the model we’ve adopted to try to spread our business around,” said ESDC chief financial officer Frances Walton. The approach originated because the ESDC was an infrequent issuer and its deals varied in size and complexity. “If you gave one deal to an underwriter today, and then the next one was 1/16th the size of it, that really isn’t fair..”
The ESDC doesn’t need to use net designation to get its bonds sold, she said.
“Our underwriters are working hard without that incentive,” Walton said. “They know that this time they may be the book-runner and sharing their compensation, but next time they’re going to be the co- and sharing somebody’s compensation.”
Michelle Kaske contributed to this story.