The Primary Market

Competitive vs. Negotiated Underwriting

When a municipality decides to issue bonds, it must choose how to bring those bonds to market. The two primary methods of municipal bond underwriting are competitive and negotiated. Understanding the differences between these methods is a heavily tested topic on the Series 52 exam.

Competitive Underwriting

In a competitive underwriting, the issuer publishes a Notice of Sale (also called an Official Notice of Sale) announcing the upcoming bond issue and inviting underwriting firms or syndicates to submit sealed bids on a specified date and time. The notice contains essential details including the par amount, maturity schedule, call provisions, delivery date, legal opinion information, and the basis on which bids will be evaluated.

Each bidding syndicate submits a bid specifying the coupon rates for each maturity and the price it will pay the issuer (the reoffering yield). The issuer awards the bonds to the syndicate that offers the lowest net interest cost (NIC) or lowest true interest cost (TIC), depending on what the notice of sale specifies. NIC is a simpler calculation that does not consider the time value of money, while TIC (also called the Canadian method) is a more sophisticated measure that accounts for the time value of money, similar to an internal rate of return calculation.

Competitive underwriting is most commonly used for general obligation bonds because GO bonds are straightforward, well-understood instruments that are easy for multiple syndicates to evaluate. Many states require that GO bonds be sold through competitive bidding to ensure that the issuer obtains the best possible interest rate and to prevent favoritism.

Negotiated Underwriting

In a negotiated underwriting, the issuer selects an underwriter (or a managing underwriter that will form a syndicate) in advance, and the two parties negotiate the terms of the offering, including the interest rates, purchase price, spread, and other conditions. There is no competitive bidding process. The issuer may select the underwriter based on the firm's expertise in a particular type of financing, its distribution capabilities, its track record, or an existing relationship.

Negotiated underwriting is more commonly used for revenue bonds because these issues are often more complex, requiring specialized knowledge of the project, the revenue source, and the credit structure. The underwriter works closely with the issuer throughout the process, often helping to structure the deal, prepare the official statement, and market the bonds to investors. This collaboration is particularly valuable for first-time issuers, novel financing structures, or issues that require extensive investor education.

Negotiated deals account for the majority of municipal bond issuance in the United States, reflecting the growing complexity of municipal finance and the value that issuers place on the underwriter's advisory role.

Syndicate Operations

For most municipal bond issues, the managing underwriter forms a syndicate — a temporary group of broker-dealers that share the risk and responsibility of underwriting and distributing the bonds. The syndicate is governed by a syndicate agreement (also called an Agreement Among Underwriters or AAU), which sets out the terms of the arrangement, including each member's participation, liability, and compensation.

Syndicate Account Types

The syndicate agreement specifies how financial responsibility is allocated among members. There are three types of syndicate accounts:

• Eastern (Undivided) Account: Each syndicate member is responsible for its proportionate share of any unsold bonds, regardless of whether it has sold its own allocation. For example, if a member has a 20% participation and has sold all of its own bonds, it is still responsible for 20% of any bonds that other members failed to sell. This structure shares risk among all members and is the most common type in municipal underwriting.
• Western (Divided) Account: Each syndicate member is only responsible for selling its own allocation. If a member sells all of its bonds, it has no further liability, even if other members have unsold bonds. This structure limits each member's risk to its own participation.
• Combination Account: Features elements of both Eastern and Western accounts. A portion of the issue may be divided (each member sells its own allocation), while another portion is undivided (shared liability for unsold bonds).

The Underwriting Spread

The underwriting spread is the difference between the price the syndicate pays the issuer for the bonds and the price at which the bonds are reoffered to the public. It represents the total compensation earned by the underwriting syndicate. The spread is divided into several components:

• Management Fee: The portion retained by the managing underwriter for organizing the syndicate, negotiating terms, and managing the offering process. This is typically the smallest component of the spread.
• Underwriting Fee (Member's Allowance): The portion allocated to all syndicate members for assuming the underwriting risk. Each member receives this fee based on its participation percentage.
• Selling Concession: The portion earned by whoever actually sells the bonds to investors. This is typically the largest component of the spread. If a syndicate member sells bonds from its own allocation, it earns the full spread (management fee + underwriting fee + selling concession). If a selling group member sells bonds, it earns only the selling concession.

Order Priority and Allocation

When investors place orders for a new municipal bond issue, the syndicate must determine the order in which those orders are filled. The syndicate agreement establishes a priority of orders, which typically follows this hierarchy (from highest to lowest priority):

1. Pre-Sale Orders: Orders received before the syndicate wins the bid or finalizes the offering terms. These orders demonstrate strong investor demand and are given the highest priority.
2. Group (Syndicate) Net Orders: Orders in which the selling credit (profit) is shared among all syndicate members according to their participation. These benefit the entire group.
3. Designated Orders: The investor specifies which syndicate member(s) should receive credit for the sale. The selling concession goes to the designated member(s), typically according to percentages specified by the investor.
4. Member Orders: Orders placed by a syndicate member for its own account or for its retail customers. The member retains the full takedown (selling concession + additional takedown).

The rationale for this priority is that pre-sale and group orders benefit the entire syndicate and demonstrate broad market demand, while designated and member orders benefit specific firms. If a new issue is oversubscribed (more orders than bonds available), the priority system determines who gets filled first.

The Official Statement

The Official Statement (OS) is the municipal bond equivalent of a prospectus. It provides detailed disclosure about the bond issue, including the terms of the bonds, the security (revenue source or taxing power), the issuer's financial condition, risk factors, legal opinions, and other material information. Unlike corporate securities, municipal bonds are exempt from SEC registration requirements under the Securities Act of 1933, so there is no legal requirement for the SEC to review the Official Statement.

However, MSRB Rule G-32 requires underwriters to deliver a copy of the Official Statement to any customer who purchases bonds in the primary offering. The underwriter must also submit the Official Statement to EMMA (Electronic Municipal Market Access), the MSRB's centralized electronic system for municipal securities disclosure documents, within one business day of receiving it from the issuer.

The Preliminary Official Statement (POS) is distributed before the sale date and contains all material information except the final interest rates, reoffering yields, and other terms that are determined at the time of sale. The POS is used to market the bonds and gauge investor interest, similar to a preliminary prospectus (red herring) in the corporate market.