The Interest Cost Savings from Experience in the Municipal Bond Market

Abstract

When issuing bonds for purposes of financing capital improvements, issuers sell their securities to an underwriting syndicate through one of two methods of sale. Traditionally, governments have sold their bonds through competitive bidding. Under this method, each underwriting syndicate interested in purchasing the issue submits a sealed bid for the price it is willing to pay. The syndicate submitting the lowest bid wins the purchase of the issue. Most general obligation bonds continue to be brought to market through this method of sale. An alternative method known as the negotiated sale has gained popularity with issuers and underwriters. With this method, representatives from a unit of government with a proposed offering meet with a preselected underwriting syndicate to negotiate an interest rate for the issue. Whereas competitive bidding relies upon competition among underwriters to obtain the most favorable interest rate, negotiation places the burden on the management team representing the issuer. The popularity of the negotiated method has grown with the increasing use of revenue bonds; for example, in 1982, 69 percent of the total dollar volume of both types of issues was sold through negotiation compared to 17 percent in 1970.1 The criticism of negotiation has been that it results in a higher interest rate than competitive bidding. The nearly unanimous conclusion of research supports this assertion.2 The implication is that administrators representing the issuer lack knowledge of the municipal bond market to negotiate successfully with the representatives of the underwriter.3 However, that research does not distinguish among negotiating issuers based on their experience in the marketplace. Yet, previous experience in the bond market should be a significant determinant of effectiveness in negotiations. Negotiating issuers with more experience should have a lower interest cost, ceteris paribus, than those with less experience. If experience is a determinant of interest rates in negotiated sales, failure to control for its effect in previous research may have produced biased estimates of the cost differential between the two methods of sale. This study examines the following two research questions: first, what effect does previous experience in the bond market have on the net interest cost of bonds sold through negotiation; second, what is the difference in cost between the two methods of sale when the previous experience of negotiating issuers is controlled.