Negotiated vs. Competitive New Bond Issues – Does It Matter to the Investor?

When investors buy municipal bonds, they give very little attention to how the issue comes to market. The question here is, does it really matter? The answer is yes and no. Yes, it is possible to achieve a better yield on a new issue negotiated deal, and no, it does not matter once the bonds are free to trade in the secondary market.

When an underwriting firm brings an issue to market (known as the Primary Market), it has the exclusive right to sell those specific bonds for a specified period. Underwriters have a built-in commission for each maturity, and the price to investors remains fixed during the order period.

In the early stages of underwriting, no other firm can sell the name until there is an unsold balance, and the bonds are free to trade in the Secondary Marketplace. The secondary market is the over-the-counter trading between all dealers and dealer banks. Every day, millions of bonds change hands between these parties on platforms, facilitating the efficiency of bond trading.

After the order period, the underwriter lifts all price restrictions, and the bonds are then available for trading in the secondary market. Typically, when bonds are free to trade, market conditions determine whether there are price increases or decreases in the securities.

To elaborate, let’s begin with the differences between a negotiated and a competitive bond issue.

A negotiated issue is one where the municipality has one specific underwriter in place to bring the bonds to market. The firm assists the issuer in setting pricing expectations and is solely responsible for selling the securities, with the flexibility to adjust prices as needed to meet market conditions and client interests. Negotiated issues are generally smaller loans. The underwriter also has the ability to conduct presale marketing, which involves promoting the upcoming bond issue to potential investors to gauge their interest. They have no competition from other underwriting firms in this process. Despite the ability to adjust the issue as described, the underwriter must be mindful of the values of similar securities in the secondary market to remain competitive.

In a Competitive issue, the municipality seeks bids on a specific date and time. The bidding process is open to all underwriters with the capital to pay for the bonds. The specifications for entering a bid are stated in advance, and the winning bid is typically the one with the lowest interest cost to the municipality. Competitive issues are usually associated with large loans and involve multiple bidders competing to sell the bonds. While underwriters can do presale marketing on a new issue, there is no guarantee they will buy the deal, unlike in a negotiated underwriting. Competitive issues are typically purchased by selling groups, which are a preorganized group of dealers who agree to sell the issue and assume liability for buying it and any unsold balances.

Does it matter to the investor?

Yes, it does in a couple of areas. First, since the underwriter in a negotiated deal has more flexibility on pricing and timing, they can bring the issue with slightly better yields to attract clients. This flexibility means that even in challenging market conditions, there’s potential for a better return. For instance, if the market tanks while they are gauging the correct price to bring the deal, they have the flexibility to adjust the price accordingly. This flexibility can lead to a better return for the investor. There is also a desire to sell the entire issue so as not to be left with a balance that could quickly deteriorate in value.

Whereas in the competitive deal, there is no flexibility once the bid has been submitted. In addition, competition tends to cause the bids to be tighter (lower yield for investors) to buy the deal. Additionally, since sales credits are built into the price of new issues, there is an incentive to sell the entire deal in-house. Once the bonds are free to trade, the winning underwriter can lose the built-in commission if market conditions deteriorate.

Secondly, since negotiated issues are usually smaller, once bonds are sold, they are no longer available to the secondary market. Therefore, if an investor is interested in a specific bond, particularly if it is a negotiated deal, it may be advantageous to be a client of the underwriter for that issue or ask your bond broker if they can submit an order to that underwriter for you. If it is a competitive issue, there are usually plenty of bonds in the market, and if a selling group is involved, many firms will have access to the bonds.

In summary, the way municipal bonds are issued—through negotiated or competitive methods—can impact investors. Negotiated issues offer the potential for better yields and pricing flexibility, while competitive issues generally provide lower borrowing costs for municipalities but no advantage to investors. However, once bonds transition to the secondary market, those advantages dissipate as market forces take precedence. As the landscape shifts, competitive underwriting may become more dominant, influencing the future of municipal bond financing.

Delving into the municipal bond market can seem daunting, but gaining a deep understanding of its intricacies is key to unlocking significant long-term gains. This is where the expertise of seasoned bond specialists becomes a game-changer for your investment strategy.

When you choose to invest in bonds, partnering with an experienced advisor is not just important, it’s essential. At The DRL Group, we have over 30 years of unparalleled bond trading experience, navigating clients through even the most turbulent market conditions. Our dedicated team has successfully led investors through critical periods, from the Dot-Com bust to the COVID-19 pandemic. This extraordinary level of experience is not only rare, but an invaluable asset, empowering you to make confident decisions in the complex arena of municipal bond investing. Let us be your strategic partner in achieving investment success.