Underwriting spreads fall to historic lows in 1H 2022

Bonds

Heavy competition for a significantly lower volume of municipal bonds drove a sharp decline in overall underwriting spreads to $3.54 in the first half of 2022, the lowest level in 20 years.

The latest data from Refinitiv representing the first six months of 2022 underscores what has been a steady and developing trend over the last two decades, the data showed.

For the first time in 20 years, gross underwriting spreads — the payment or underwriting discount an underwriter receives to market a deal — fell to under $4 per $1,000 for all bonds, compared with 2003 when spreads were at $5.20, according to the data.

Gross spread is expressed as the dollar amount of underwriting discount per $1,000 of the issue.

Some say the decades-old dilemma of shrinking spreads is nothing new, but the latest decline to historically low levels is driven by rough market conditions and uncertain Federal Reserve policy that has curtailed new issuance.

“Municipal securities underwriting spreads have generally declined over time due to competition, market factors, and increased use of technology,” Leslie Norwood, managing director and associate general counsel, head of municipal securities at the Securities Industry & Finance Markets Association, said.

Lower bond volume and competition were the main culprits and driving force behind the latest historic drop in overall underwriting spreads in 2022, said Michael Decker, senior vice president of public policy at The Bond Dealers of America.

“As volume goes down you have dealers chasing fewer transactions and they pressure each other on price,” Decker said, noting that 2022 was a particular “outlier” when it comes to volume.

Overall underwriting spreads in the first half of 2022 saw a big reduction — nearly 15% — compared to 2021, Decker noted.

In fact, he said that over the last decade underwriting spreads have fallen by one-third, which Decker called significant.

That “acute” trend was fueled by a corresponding drop in volume over the same time period, as long-term volume for 2022 is about a third less of what it was in 2021, chiefly due to rising interest rates, Decker said.

“It’s been a really big and sustained trend and led to a reduced cost of spread to issuers,” he said.

The pandemic played a role in the declining volume, which led to the historic drop in underwriting spreads in 2022, another underwriter pointed out.

“With many cities and municipalities receiving federal money due to COVID-19 assistance, a lot of issuers did not have the same need to issue paper because they were flush with cash,” a New York underwriter said.

Negotiated underwriting spreads fell to $3.53 per $1,000 from $4.26 in all of 2021. The lowest level of negotiated underwriting spreads was in 2020, when the spread dipped as low as $4.04, according to Refinitiv. The spread peaked at $6.22 in 2009.

“Those spreads are the result of direct negotiation between issuer and underwriter and are directly affected by competition and marketing and maintaining market share in a low-volume market,” Decker said.  

Competitive underwriting spreads, in contrast, rose slightly to $3.79 per $1,000 in the first half of 2022 from $2.68 in 2021 — its lowest level since 2003. The spreads have fluctuated in the last 20 years, peaking at $6.31 in 2004. 

Other contributing factors have helped maintain the steady declining spread trend over the last two decades, such as new regulation, an uptick in automated underwriting platforms leading to cost reductions, as well as a fluctuation in the overall deal size in recent years, according to Decker.

Increased technology in general, he said, triggered cost reductions in underwriting. Many of the functions associated with the underwriting process became automated and led to lower spreads.

To some extent, electronic trading has helped offset the loss of underwriting spreads as it “allows dealers to trim their team, especially sales and some levels of support,” noted Richard A. Ciccarone, president of Merritt Research Services and a veteran of the municipal bond industry over 40 years.

“More advanced technology systems to run an underwriting operation have made a difference to allow the big players to manage the lower fees,” he said.

In addition, the debut in 2008 of the Municipal Securities Rulemaking Board’s Electronic Municipal Market Access repository platform for real-time bond reporting, for instance, impacted bid-ask spreads lower over the last two decades, according to Decker.

“As underwriters faced lower costs, they passed that on to the issuers,” and that resulted in sustained lower spreads for more than the last 20 years, Decker said

“We have seen this long term trend of spreads consistently declining, even dating back before 2003 to the 1980s and 1990s, continuing now,” Decker confirmed. 

Deal size and volume levels also contribute to lower spreads.

As the average deal size increases, the cost of underwriting is spread over a larger amount of bonds, which also led to cost reduction, Decker said.

For instance, he said, if the average deal size in any given year is higher than the average size in the prior year, the costs don’t scale with the size.

“As the average deal size increases, it spreads the costs over a larger volume of bonds and the spread per bond can be lower,” he added. 

As the Federal Reserve Board continues to raise rates, the market responds and issuers postpone their deals, Decker noted.

“Refunding volume is especially sensitive to changes in yield,” he said. “As the shape of the yield curve changes, that [refunding] volume can go up or down quickly.”

In addition, refunding bonds demand somewhat higher spreads since they are considered more complex to structure and match with buyers, earning underwriters more than plain vanilla financings, Ciccarone noted.

In the first six months of 2022, while the Fed was raising rates, negotiated underwriting spreads fell to a 20-year low, while competitive underwriting fell to its second lowest level over the same time frame, according to Refinitiv.

He said market conditions typically lead to more volatility and fluctuation in competitive volume, and consequently underwriting spreads in that sector, year over year.

Sector specific spreads
Other sectors experienced noticeable increases and decreases in underwriting spreads dating back to 2003, with the development and stimulus sectors both rising to the highest level and transportation dropping to its lowest level in the first half of 2022, according to Refinitiv.

Development increased to $9.72 per $1,000 in the first six months of 2022 from $6.28 in 2021. Its lowest level dipped to $3.43 in 2012.

Stimulus also rose in the first half of 2022, rising to $8.88 from $5.85  the prior year. The sector dropped drastically low to $0.25 in 2019.

Transportation on the other hand remained at $2.87 in the first half of 2022, unchanged from 2021, but down noticeably from $3.88 in 2020.

Meanwhile, public facilities, healthcare, and utilities were three of the sectors that saw the most volatility in underwriting spreads over two decades, culminating with the most recent first half of 2022, the data showed.

For instance, underwriting spreads in public facilities saw the most dramatic drop in the first half, falling to $3.23 from a whopping $17.14 in 2021.

Healthcare spreads, meanwhile, declined to $4.48 from $4.79 in the prior year, and utilities fell to $3.36 from $3.90 in 2021.

Decker could not speak to what drove specific trends in individual sectors other than to say that if volume is fairly low in any particular sector, a single deal can affect the average for the entire sector.

“One deal with a higher or lower than typical underwriting spread could skew the average for that sector if there’s a relatively low volume of transactions,” he said.

“An inordinate spread could skew the average for the sector and have a disproportionate effect on the average underwriting spread,” he added.

Continued erosion
While there are new challenges causing an erosion of underwriting spreads, some of the underlying market conditions from years ago are unchanged and still a risk, according to Ciccarone.

“The question of whether underwriting spreads will continue to go down further has been on the table for decades,” he said.

“Competition, technology, regulation, constrained supply and a healthy market appetite for municipal bonds in general have all factored into lower margins benefitting issuers,” he said. “The biggest threats to low underwriting margins will always be related to supply-demand conditions,” he said, adding that interest rates and credit remain “vital” components of the equation as well.

“Supply hasn’t been able to keep up with demand over most of the past 20 years,” Ciccarone continued. “More recently, the elimination of advanced refundings reduced tax-exempt supply even more.”

Both of which push underwriting fees down, Ciccarone said.

“Credit quality has mostly been generally supportive over the last 20 years except during the fallout years of the Great Recession or Great Financial Crisis,” Ciccarone said. 

Meanwhile, over the years, industry consolidation has occurred to achieve regulatory requirements, technological capabilities, and economic scale, he noted.

Ciccarone said some of the historic factors driving lower spreads are still present.

“Bonds have been enjoying a bull market since 1982, so steady investor demand for tax-exempts has been generally helpful to lowering spreads,” he said.

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