Changes in the municipal bond new issue pricing rules and reporting imposed by the Securities Exchange Commission, Internal Revenue Service, and Municipal Securities Rulemaking are bringing new clarity to the almost $4 trillion U.S. municipal bond market.
Investment advisors and investors have long recognized that purchasing municipal bonds at new issue (IPO) represent great value as state and local government issuers and their advisors demand efficient performance from their underwriters. During the new issue pricing period is when institutions place their orders. Independent advisors and their clients are wise to follow the money.
So what is the advantage and why?
During the life of a bond issue, state and local government municipal bond issuers have limits required by the IRS to rebate to the Treasury any investment earnings the issuer earns over its cost of capital. This rebate requirement has been in place since the Tax Reform Act of 1986. As a consequence, municipal bond issuers are keenly interested and engaged in how their bonds are priced, as the calculation of their cost of capital will determine rebate requirements to the Treasury.
When issuers negotiate with underwriters on new bond issue couponing and pricing, the negotiations are confirmed by a purchase contract executed by the lead underwriter representing the underwriting syndicate.
Customarily a new issue can be successfully underwritten over the course of a few hours in the morning or early afternoon and the contract executed later that day binding the issuer to sell and the underwriter to buy. Once the contract is signed, the underwriter can confirm orders with investors.
Municipal bond industry regulators have struggled over the years to provide guidance on how to conclude on the underwriting pricing, which establishes the issuer’s very important cost of capital.
About a year ago the IRS imposed new rules on underwriters directing the establishment of the market price for the purposes of calculating the issuer’s cost of capital. In summary, the price for IRS reporting purposes is set if the underwriter has sold at least 10% of each maturity at the contracted price. Unsold maturities when the purchase contract is signed now have a five-day hold-the-price requirement that obliges the underwriter to offer these bonds to investors at the contracted price.
Because negotiations between the issuer and the underwriter require transparency at initial pricing, compensation on new issue bonds can be much lower than commissions realized in the secondary market. And once the five-day hold-the-price rule is met or 10% of a maturity is sold at the original offering price, the underwriter is free to mark up the bonds, which can incentivize brokers to make a greater effort selling to individuals. As a consequence the investor client realizes a lower yield than what would have been achieved at new issue pricing.
The regulators and academics are watching post new issuance trades closely to monitor mark ups and prices paid by investors. Trade reporting and data analysis are accelerating the market’s understanding of how new issue bonds are underwritten.
So the obvious advantage to advisors in buying bonds at initial issuance is a clear understanding of the pricing on the market knowing the issuer is on the investor’s side of the table making sure the underwriter delivers.