PROBLEMS
4.2 P RIMARY C APITAL M ARKETS
The primary market is where new issues of bonds, preferred stock, or common stock are sold by government units, municipalities, or companies who want to acquire new capital. For a re- view of studies on the primary market, see Jensen and Smith (1986).
4.2.1 Government Bond Issues
U.S. government bond issues are subdivided into three segments based on their original matu- rities.Treasury bills are negotiable, non-interest-bearing securities with original maturities of one year or less. Treasury notes have original maturities of 2 to 10 years. Finally, Treasury bondshave original maturities of more than 10 years.
To sell bills, notes, and bonds, the Treasury relies on Federal Reserve System auctions. (The bidding process and pricing are discussed in Chapter 17.)
4.2.2 Municipal Bond Issues
New municipal bond issues are sold by one of three methods: competitive bid, negotiation, or private placement.Competitive bid sales typically involve sealed bids. The bond issue is sold to the bidding syndicate of underwriters that submits the bid with the lowest interest cost in accordance with the stipulations set forth by the issuer. Negotiated sales involve contractual arrangements between underwriters and issuers wherein the underwriter helps the issuer pre- pare the bond issue and set the price and has the exclusive right to sell the issue. Private placements involve the sale of a bond issue by the issuer directly to an investor or a small group of investors (usually institutions).
Note that two of the three methods require anunderwritingfunction. Specifically, in a com- petitive bid or a negotiated transaction, the investment banker typically underwrites the issue, which means the investment firm purchases the entire issue at a specified price, relieving the issuer from the risk and responsibility of selling and distributing the bonds. Subsequently, the underwriter sells the issue to the investing public. For municipal bonds, this underwriting function is performed by both investment banking firms and commercial banks.
The underwriting function can involve three services: origination, risk-bearing, and distribu- tion. Origination involves the design of the bond issue and initial planning. To fulfill the risk- bearing function, the underwriter acquires the total issue at a price dictated by the competitive bid or through negotiation and accepts the responsibility and risk of reselling it for more than the purchase price. Distribution means selling it to investors, typically with the help of a selling syndicate that includes other investment banking firms and/or commercial banks.
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In a negotiated bid, the underwriter will carry out all three services. In a competitive bid, the issuer specifies the amount, maturities, coupons, and call features of the issue and the com- peting syndicates submit a bid for the entire issue that reflects the yields they estimate for the bonds. The issuer may have received advice from an investment firm on the desirable charac- teristics for a forthcoming issue, but this advice would have been on a fee basis and would not necessarily involve the ultimate underwriter who is responsible for risk-bearing and distribu- tion. Finally, a private placement involves no risk-bearing, but an investment banker would typically assist in designing the characteristics of the issue and locating potential buyers.
4.2.3 Corporate Bond Issues
Corporate bond issues are almost always sold through a negotiated arrangement with an in- vestment banking firm that maintains a relationship with the issuing firm. In a global capital market there has been an explosion of new instruments, which means that the origination function, which involves designing the characteristics and currency for the security, is becom- ing more important because the corporate chief financial officer (CFO) may not be completely familiar with the availability and issuing requirements of many new instruments and the alter- native capital markets around the world. Investment banking firms compete for underwriting business by creating new instruments that appeal to existing investors and by advising issuers regarding desirable countries and currencies. As a result, the expertise of the investment banker can help reduce the issuer’s cost of new capital.
Once a stock or bond issue is specified, the underwriter will put together an underwriting syndicate of other major underwriters and a selling group of smaller firms for its distribution, as shown in Exhibit 4.1.
4.2.4 Corporate Stock Issues
In addition to issuing fixed-income securities, corporations can also issue equity securities—
generally common stock. For corporations, new stock issues are typically divided into two groups: (1) seasoned equity issues, and (2) initial public offerings (IPOs).
Exhibit 4.1T h e U n d e r w r i t i n g O r g a n i z a t i o n S t r u c t u r e
Underwriting Group
Selling Group Issuing Firm
Investment Banker A
Investment Banker B
Investment Banker C
Investors
Institutions Individuals
Investment Firm A
Investment Firm B
Investment Firm C
Investment Firm D
Investment Firm E
Investment Firm F
Investment Firm G Investment
Banker D Lead Underwriter
Seasoned equity issuesare new shares offered by firms that already have stock outstanding. An example would be General Electric, which is a large, well-regarded firm that has had public stock trading on the NYSE for longer than 50 years. If General Electric needed additional capital, it could sell additional shares of its common stock to the public at a price very close to the current market price of the firm’s stock.
Initial public offerings (IPOs)involve a firm selling its common stock to the public for the first time. At the time of an IPO, there is no existing public market for the stock; that is, the company has been closely held. An example was an IPO by Polo Ralph Lauren, a leading man- ufacturer and distributor of men’s clothing. The purpose of the offering was to get additional capital to expand its operations and to create a public market for future seasonal offerings.
New issues (seasoned or IPOs) are typically underwritten by investment bankers, who ac- quire the total issue from the company and sell the securities to interested investors. The lead underwriter gives advice to the corporation on the general characteristics of the issue, its pric- ing, the timing of the offering, and participates in a“road show”visiting potential institutional investors. The underwriter also accepts the risk of selling the new issue after acquiring it from the corporation. For further discussion, see Brealey and Myers (2010, Chapter 15).
Relationships with Investment BankersThe underwriting of corporate issues typically takes one of three forms: negotiated, competitive bids, or best-efforts arrangements. As noted, negoti- ated underwritings are the most common, and the procedure is the same as for municipal issues.
A corporation may also specify the type of securities to be offered (common stock, pre- ferred stock, or bonds) and then solicit competitive bids from investment banking firms. This is rare for industrial firms but is typical for utilities, which may be required by law to sell the issue via a competitive bid. Although a competitive bid typically reduces the cost of an issue, it also means that the investment banker gives less advice but still accepts the risk-bearing func- tion by underwriting the issue and fulfills the distribution function.
Alternatively, an investment banker can agree to sell an issue on abest-efforts basis. This is usually done with speculative new issues. In this arrangement, the investment banker does not underwrite the issue because it does not buy any securities. The stock is owned by the com- pany, and the investment banker acts as a broker to sell whatever it can at a stipulated price.
Because it bears no risk, the investment banker earns a lower commission on such an issue than on an underwritten issue.
Introduction of Rule 415The typical practice of negotiated arrangements involving numer- ous investment banking firms in syndicates and selling groups has changed with the introduc- tion of Rule 415, which allows large firms to register security issues and sell them piecemeal during the following two years. These issues are referred to as shelf registrationsbecause, after they are registered, the issues lie on the shelf and can be taken down and sold on short notice whenever it suits the issuing firm. As an example, Apple Computer could register an issue of 5 million shares of common stock during 2012 and sell a million shares in early 2012, another million shares in late 2012, 2 million shares in early 2013, and the rest in late 2013.
Each offering can be made with little notice or paperwork by one underwriter or several. In fact, because relatively few shares may be involved, the lead underwriter often handles the whole deal without a syndicate or uses only one or two other firms. This arrangement has benefited large corporations because it provides great flexibility, reduces registration fees and expenses, and allows issuing firms to request competitive bids from several investment banking firms.
On the other hand, some observers fear that shelf registrations do not allow investors en- ough time to examine the current status of the firm issuing the securities. Also, the follow-up offerings reduce the participation of small underwriters. Shelf registrations have typically been used for the sale of straight debentures rather than common stock or convertible issues. For further discussion of Rule 415, see Rogowski and Sorensen (1985).
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4.2.5 Private Placements and Rule 144A
Rather than a public sale using one of these arrangements, primary offerings can be sold pri- vately. In such an arrangement, referred to as a private placement, the firm designs an issue with the assistance of an investment banker and sells it to a small group of institutions. The firm enjoys lower issuing costs because it does not need to prepare the extensive registration statement required for a public offering. Institutions buying the issue typically benefit because the issuing firm passes some of the cost savings on to the investor as a higher return. In fact, pre-Rule 144A an institution required a higher return because of the absence of any secondary market for these securities, which implied higher liquidity risk.
The private placement market changed dramatically when Rule 144A was introduced by the SEC. This rule allows corporations—including non-U.S. firms—to place securities privately with large, sophisticated institutional investors without extensive registration documents. A major innovation is that these securities can subsequently be traded among these large sophisticated investors (those with assets in excess of $100 million). The SEC introduced this innovation to provide more financing alternatives for U.S. and non-U.S. firms and possibly increase the num- ber, size, and liquidity of private placements, as discussed by Milligan (1990) and Hanks (1990).
Presently, more than 85 percent of high-yield bonds are 144A issues.