Background: The underwriters' discount is the traditional mechanism through which the underwriting firms are compensated for their work in structuring and marketing a bond issue. The underwriters' discount for a bond financing is divided into four components: Management Fee, Expenses, Underwriting, and Takedown. These components are described in detail below:
Management Fee: This is the fee paid to the managers, compensating them for their professional services in implementing the financing, including (1) assisting in the design of the transaction, (2) preparing certain documents associated with the transaction, (3) managing the underwriting syndicate (the group of firms which actually sells the bonds to investors), and (4) coordinating the sale and marketing of the issue.
Expenses: This component is reimbursement to the managers for the out-of-pocket expenses incurred in connection with the structuring, syndication, and marketing of the bond issue. Normally, such expenses will include (1) fees and expenses of underwriters' counsel, (2) preparation and printing of the Blue Sky and Legal Investment memoranda, (3) expenses incurred by the managers (travel, communications, computer time, advertising, etc.), and (4) day loans (for the purchase of the bonds).
Underwriting: The underwriters are compensated for participating in and committing their financial resources and sales organization to marketing the bond issue through this component. This component further reflects the market risk incurred by the syndicate members in underwriting the issue. While the management fee and the expenses are typically split between the members of the issue, the underwriting compensation is paid to all of the members of the syndicate according to their respective participation in the underwriting.
Takedown: The largest component of the underwriters' discount is the takedown, which is, in essence, selling commission or incentive to sell given to a member of a syndicate for selling bonds. The takedown is realized only if the syndicate member resells the bonds purchased from the syndicate at the initially established terms. It must be competitive in amount with commissions available on other offerings of similar security, size and maturity, and reflect the degree of difficulty in marketing the bonds.
The underwriters' discount (or "spread") is usually expressed as dollars per thousand dollars of bonds, as a percent of a bond, or as a percent of a bond issue. Thus, on a $10,000,000 bond issue, an underwriters' discount of $200,000 is commonly expressed as a 2% or $20 spread.
Federal law limits the amount of bond proceeds that can be used to pay both the discount and the costs of issuance. In general, if the discount and the costs exceed 2% or $20 per $1,000 bond, the institution must pay the excess from its own funds. While this limit has put pressure on underwriters to lower their fees, on small to medium size bond issues it is often hard to be below the 2% level because that amount can be quite small and there are certain dollar costs associated with a financing regardless of its size.
Time of Sale: The interest rates are set early on the morning the bonds become available for sale. The underwriters will present the terms of the sale (the interest rates on each maturity on bonds) to the institution, the Authority, and the Authority’s financial advisor. The Authority and its financial advisor will consult with the institution on the appropriateness of the terms of the pricing prior to its release in the marketplace. The interest rates will be based largely upon a determination of prevailing market conditions including the bond rating, type of credit enhancement (if any), and perceived financial strength of the institution. (top)
