There was an interesting article in Bloomberg News a couple of days ago on how some underwriters are pricing bonds at unnecessarily high yields. Why is this going on, and what can you, the borrower, do about it?
There is evidence that municipal bonds trade at a higher price/lower yield in the secondary market, just hours or days following their initial offering. Since there isn´t enough time for intrinsic value to change, the implication is that the initial yield was set too high, giving the buyers excess profits. A simple explanation is that bonds are “priced to sell” by underwriters. They do not want to be stuck with unsold paper. If that means setting the yields higher, so be it, better be safe than sorry. Good underwriters, and they are out there, will push hard to keep coupons low.
Unfortunately, no matter how diligent they are, underwriters must serve dual masters with opposite goals: the borrower trying to minimize coupons, and the institutional investor trying to maximize profits. It´s a zero-sum game involving a somewhat uneven playing field, because buyers are sophisticated and are in the markets every day, while sellers go to market relatively infrequently. On pricing day, underwriters must drum up sufficient demand and maintain relationships with investors, so it´s no surprise that borrowers end up holding the proverbial short end of the stick. Pricing bonds “on market” has become even more challenging lately due to a lack of new issues. With fewer “price checks”, underwriters are more likely to err on the side of safety by setting even higher coupons. As traders know, low volumes equate wider bid-ask spreads.
What are hospitals to do? The bond markets do not have much of a reputation for transparency, and management teams and boards generally do not have the specialized knowledge and experience to supervise underwriters. As a result, more hospitals are choosing to hire an independent financial advisor. A qualified FA with relevant investment banking experience, can create significant savings.
The process usually involves the following steps: (1) assist in identifying and selecting the best underwriter(s) for the job; (2) prepare a thorough assessment of current market conditions to ensure that pricing is aggressive; (3) evaluate and report back to management following the sale. The FA should have for objective to obtain the lowest pricing on the best possible terms. Oftentimes this requires a lot more work than many FA´s are prepared for, and some are just not up to the task, preferring to rubber-stamp proposed pricing. At other times, the process leads to underwriters that may not be household names, but have demonstrated a track record of aggressive pricing.
In today´s chaotic market environment, having someone supervising the underwriting process can have a significant impact on your ultimate cost of debt. As Reagan said, you should trust, but verify.