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Do municipal bonds sold through competition have lower interest rates for issuers than negotiated sales? Research done in the 1970s and 1980s suggests that, all else equal, interest costs are generally lower for competitively hid municipal bonds compared to negotiated bond sales William Simonsen and Mark D.Robbins explore this question in light of changes in the municipal bond market that suggest a need to revisit this question. Their findings indicate that on average, and all else equal, competitive sales result in lower interest cost to issuers compared to negotiated sales, and that this difference increases with the number of bids received. This research has added salience given several recent scandals and alleged improprieties in the municipal bond market.
The amount of municipal bond debt in the United States now totals $1.2 trillion (Stone, 1994). Municipal bond sales totalled $174 billion in 1991, $235 billion in 1992, and reached $291 billion in 1993 before falling to $164 billion in 1994 (Stone, 1994; Doran, 1994; Schuchner, 1995). The size of this market makes decisions about municipal debt important to government decision makers and the citizenry. Research undertaken during the 1970s and 1980s suggests that competitive bond sales result in lower interest costs to issuers compared to negotiated issuance, all else equal. The municipal market has evolved since this research was undertaken in ways that suggest this finding may no longer apply. In this article, we examine municipal bond sales in Oregon during 1992 and 1993 to determine if interest costs vary systematically between competitive and negotiated issuance.
Competitive versus Negotiated Sales
For a competitive sale, the municipality structures the offering itself, typically with the assistance of a professional financial adviser. This work includes the preparation of the prospectus or official statement, the design of the issue and maturity schedules, the research, to select the timing of the sale, and the acquisition of a credit agency rating. The issuer next publishes a notice of the sale. Underwriters or investment syndicates review the offering and determine how much interest they need to pay in order to resell the bonds to investors. Based on this determination, they make a bid. When the bids are opened, the group representing the lowest interest cost to the issuer wins the bidding. The winner then typically reoffers the bonds to investors. The resulting difference between the buying price and the selling price is the gross underwriter spread.
Negotiated sales are handled directly by underwriters who work with the issuer to determine the structure, price, and maturities of the offering. In some instances, a competitive bidding process may be used to select the underwriting firm. The interest costs in negotiated sales are determined by the terms of the agreement between the underwriter and the issuer. The underwriter then takes the offering to market. Again, the underwriter earnings are determined by the spread (Public Securities Association, 1990).
Competitive sales place the burden of preparing the sale and bringing it to market on the issuer and the issuer's financial advisor (if there is one). This process may be less advantageous for inexperienced or poorly rated municipalities, which may not attract many bidders for their offerings.
The evidence from empirical research of the municipal bond market indicates that interest cost to the issuer is significantly higher for both general obligation and revenue bonds sold through negotiation when compared with those sold through competitive bid (Kessel, 1971; Joehnk and Kidwell 1979; Leonard, 1983; Braswell, Nosari, and Sumners, 1983; Kidwell and Rogowski, 1983; Benson, 1979; Forbes and Peterson, 1979; Government Finance Research Center, 1993). This research also demonstrates that lower interest cost is significantly associated with the intensity of the bidding. In other words, the higher the number of bids received, the lower the interest cost to the issuer compared to negotiated sales, all else equal.
A recent report (Public Resources Advisory Group, 1992) prepared for the state of Connecticut appears to suggest that little difference remains between the two types of municipal bond sales. This study looked at eight sales and found these selected negotiated issues had spreads below the state average for competitive general obligation issues. Total interest costs (TICS) were described as relatively constant. This study, however, did not control for factors such as ratings and national interest rates, which may have affected the results.
Competition provides an incentive for each underwriter to submit the most aggressive bid at which it expects to be able to successfully market the bonds to investors (Government Finance Officers Association, 1994a). Bland's (1985) findings show, however, that experience helps equalize the influence of competition. He concludes that the most experienced negotiating issuers are able to secure interest rates comparable to those of the most competitive issues (seven or more bids).
During the past decade, negotiated sales have grown as a percentage of the market. In 1970, 83 percent of municipal bonds were sold competitively, with 17 percent sold through negotiated offerings. By 1993, this pattern had reversed itself with 80 percent of such issues priced through negotiated sale, and only 20 percent sold competitively (Public …