NATIONAL ASSOCIATION OF BOND LAWYERS

Voice from the Past
Chapter 15

One of the games bond dealers used to play was to try to win, at public sales of bonds, by capitalizing on the difference between the old Investment Bankers' Association ("IBA") method of calculating net interest rate, under which the best bidder was determined, and the yield method under which bonds were and still are sold to investors. This resembles the classical definition of "arbitrage" -- buying in one market and selling in another; but the word is used with a different meaning in the municipal bond community.

Under IBA, the net interest cost was determined simply by summing up all the interest the bonds would bear throughout their lives and adding the discount or deducting the premium exacted or paid for the issue. This amount was divided by the number of "bond years" in the life of the issue the sum of the products of the amount of bonds of maturing in each year multiplied by the number of years from date of issue until that maturity date. It had the advantage of simplicity. The calculation could be made with pencil and paper or an adding machine at the meeting where the bonds were sold, so the winning bidder could be determined in a few minutes after the bids were opened. Then the losing bidders could get their good faith checks back that same day a matter of importance, both because of the interest a firm had to pay on the bank loan involved in providing the check, and because of the desire not to tie up a firm's capital any longer than necessary. To calculate the yield on the issue before the days of computers would have taken much longer and would have exceeded the skills of most municipal employees. Dealers used slide rules to calculate yield on each separate maturity.

However, the IBA method did not take into account the time-value of the interest payments. A dollar of interest due at the maturity of the last bond counted no less than a dollar of interest due six months after the delivery of the bonds. Yet, on the date of delivery of an issue, the present value of that remote dollar is but a fraction of the present value of each dollar of interest due on the first interest payment date. The customary calculation of yield of a bond or an issue, to compare the values of different bonds to investors, is much like that used in calculating the yield of an issue under the Arbitrage Regulations. It requires determining the present value of every payment of principal and of interest at an assumed rate and determining the sum of those present values. Then the assumed rate is revised from time to time until the sum of the present values equals the adjusted purchase price. Before the days of computers and people who knew how to use them quickly, making such calculations at the time of sale was impractical.

Thus it was to a dealer's advantage, in competing with other dealers, to bid on bonds with the greatest proportion of interest falling due in the early years. Such bonds would, on the whole, bear higher yields, and thus be more attractive to investors, than bonds bearing coupon interest that more nearly reflected the rates for different maturities required by the current market. This advantage was partly offset by other marketing considerations. High interest bonds of the early maturities would be marketed to investors at a substantial premium to produce a yield appropriate to those maturities, and long, low interest bonds would have to be marketed at a substantial discount. As a general rule, investors prefer to buy bonds at or near their par value

For a few decades dealers in several States (Louisiana particularly comes to mind) adopted the practice of submitting bids that required supplemental coupons. These coupons represented interest at rates equal to the difference between the interest that those bonds paid to investors and a significantly higher rate possibly the maximum voted rate. Printed on separate sheets of paper from the regular coupons, they were detached from the bonds after delivery to the dealer and before delivery to the investors. They provided all or much of the dealer's profit on the transaction. The dealer usually sold these coupons to a bank, and the bank held them until they fell due on early interest payment dates. It may be that some dealers retained the coupons, presented them when due, and treated the proceeds as tax exempt interest. I think I recall an IRS ruling that such proceeds were not tax exempt; they were not compensation for the long term use of the dealer's money, and thus did not constitute interest.

These supplemental coupons made the greatest amounts of aggregate principal and interest fall due in the early months or years of an issue. Many issuers disliked having to levy taxes or impose utility charges that would immediately violate representations made to the voters before a bond election. Assurances that taxes or charges could be lowered next year or the year after were of little solace.

Other gimmicks also were used to exploit the difference between yield and net interest rate. One was to provide that the early maturities would bear significantly higher- than-market rates, and the last maturity would bear a rate of one percent or less. This had a similar effect as the supplemental coupons, and also greatly reduced the chance that the bonds of the last maturity would be called for redemption prior to maturity. To pay par and, perhaps, a premium, to redeem a one-percent bond is a business decision that few issuers would care to make. Any investor who bought such a bond at a discount sufficient to give him a market yield would get a very substantial boost in that yield if his bond should be redeemed prior to maturity.

This last practice, when I caught on to the significance of it, caused me to revise a drafting practice that I inherited from older lawyers -- a provision that bonds might be called for redemption only in inverse order of maturities. I checked with a dealer to learn whether omitting such a provision would make any difference in the marketability of bonds. He said it would not. One of my older partners had suggested that the reason for the provision was to prevent favoritism in determining whose bonds would be called for redemption. However, it would prevent redeeming bonds of different maturities to reduce maximum annual future principal and interest requirements. Such a reduction could help in meeting a coverage test for issuing additional bonds, or in evening out annual debt service requirements. I chose to believe that only other lawyers' clients would play favorites. My clients would responsibly use the freedom to redeem bonds prior to maturity in any order they might choose. At least I was not going to assume otherwise, and I removed that provision.

Manly W. Mumford