When government entities or corporations decide to issue bonds as a means of borrowing money, they retain the services of an investment bank to serve in an intermediary capacity. The Investment banker acts as an advisory capacity and as underwriter. The underwriter's function function determines how the proceeds of a bond issue are calculated.
The Underwriter's Function
When an investment bank underwrites a bond issue, the banker buys the bonds from the issuing institution and sells them to investors. The underwriter also files required documents with the Securities and Exchange Commission and consults with the issuer to set the offering price, interest rate and terms for the bonds. The underwriter that bears the costs of these activities as well as paying for legal counsel and marketing the the bonds. Underwriters may invite institutional investors to bid on the bonds, sell them to the public or negotiate private placement with large investors such as retirement funds and insurance companies.
The Underwriter's Spread
An underwriter is compensated by means of the spread. The bond issuer sells the securities to the underwriter at a discount off of the intended price. The underwriter keeps this difference, or spread, when investors purchase the securities. A typical spread for a bond issue might be 0.5 to 1 percent. For example, the underwriter might purchase a bond issue for 99 percent of the par value and offer the bonds to investors at 100 percent par. Suppose an investment bank underwrites a $20 million bond issue at 99 percent of par. If the underwriter receives the offering price of 100 percent par, this is how the numbers work out:
- The bond issuer receives proceeds of 99 percent of $20 million, or $19.8 million.
- The underwriter receives gross proceeds from selling the bonds of$20 million.
- The underwriter keeps net proceeds -- the spread -- of $20 million less $19.8 million, or $200,000.
The underwriter must pay expenses incurred out of the spread. What remains is profit.
The Risks of Underwriting
When a bond issue is offered to investors, there is no guarantee that the securities will sell at the offering price. Bond issuers transfer this risk by selling the securities to the underwriter. It's possible investors will bid up the price of the bonds and the underwriter will collect a larger spread than expected. However, it is also possible that prevailing interest rates will change or the bond issuer's credit rating won't be good enough to attract investors. In such cases, the underwriter may have to sell the bonds at less than the offering price, thereby reducing the spread and incurring a loss. Underwriters typically form a syndicate to manage the risk by inviting other investment bankers to share the responsibility of marketing the bond issue. The risk for the underwriter is spread out among the members of the syndicate.