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