Securities Markets - Primary Market for Bonds
Trust Indenture Act of 1939
The Trust Indenture Act of 1939 applies to debt securities. Even if a bond is registered under the Securities Act of 1933, it cannot be offered for sale unless a formal agreement between the issuer of bonds and the bondholder, known as the trust indenture, conforms to the standards of the 1939 act.
Primary Offering Process for Bonds
On the subject of debt obligations, let's discuss the primary market for municipal bonds. Like other securities, munis can be sold publicly or placed privately. The underwriters set prices and yields, and they purchase bonds from the issuers through one of two methods:
- Competitive sale: Prospective underwriters submit sealed bids to the issuer, and the bonds are awarded to the bidder who offers to pay the lowest interest. Underwriters often bid as part of a syndicate.
- Negotiated sale: Before the public sale date, the issuer selects the lead underwriter who in turn manages the financing. The issuer's selection process includes writing a request for proposals, responding to those proposals, interviewing prospective underwriters, selecting the lead manager and selecting co-managers from competing firms. The managers purchase the bonds at a price that will produce the lowest interest cost and then sell the bonds to investors.
- When a new offering is publicized by its issuer, the manager selected in the negotiated sale - or the prospective managers, in the case of a competitive sale - get in contact with their "usual suspects".
- The invitation to their historical syndicate members is usually a simple form letter, which is signed and returned by all parties interested in participating.
- Members, or at least the top-bracket members in terms of proportion of the issue they are underwriting, are then polled to establish a price.
- If it is a competitive sale, the underwriters' agreement authorizes the manager to serve as agent for the group and insulates him or her from liability if his or her efforts on behalf of the syndicate do not result in a successful bid.
- The manager who does succeed sends out a confirmation of purchase letter detailing the following:
- Par value
- Coupon rate
- Gross spread
- Net proceeds to the issuer
- Proportion of issue to be allocated to each syndicate member
Allocation of a muni offering can follow either of two methods:
- Eastern, or undivided, accounts, in which each member is responsible for selling a proportion of bonds held in common by the manager; or
- Western, or divided, accounts, in which each member is responsible for selling a set number of bonds.
Every muni carries an opinion of a bond attorney who represents the bondholders' interests. This opinion attests that the issue is legal, valid and binding, and that interest on the bonds is exempt from federal taxation. Providing such an opinion requires the bond attorney to review all applicable laws authorizing the bond issue and exempting it from federal taxation and to ascertain that all required procedural steps have been completed. The bond attorney then compiles a transcript of proceedings containing all relevant documentation. The bond attorney should not be confused with the underwriter's counsel, who represents the investment bankers, particularly in the due diligence process.
Within 10 business days after agreeing to underwrite a muni issue, each dealer must promulgate the final official statement it received from the issuer. This statement will include details, if applicable, of advance refunding, a refunding in which the issue remains outstanding for a period of more than 90 days after issuance.
Once a security has been publicly traded, it joins the secondary market, in which it is sold and bought repeatedly, changing hands from investor to investor.
There are two types of secondary markets:
- The NYSE and Amex are organized as auction markets, in which buyers compete with each other and, at the same time, sellers compete with each other. The highest price any buyer will pay for a security is called its bid price, and the lowest price at which a seller will part with the same security is called its ask or offer price.
- The Nasdaq is organized as a negotiated market, in which the price of a security is hammered out between a buyer and a seller.