There are two ways to buy municipal bonds: 1) Investors can buy municipal bonds when the bonds are first issued or 2) investors can buy bonds after the bonds have been issued in the secondary market. This is similar to stocks; investors can buy stock during the IPO (initial public offering) or after the stock begins trading in the market. For the purposes of this article, we will focus on how investors can buy bonds when they are originally issued. (Please read our previous article on How to Buy Municipal Bonds for information on how to buy bonds in the secondary market.)

Investors can buy new issues of municipal bonds through a process called a Retail Order Period. Municipal bond issuers such as states, school districts, and cities know that individual investors have an interest in buying municipal bonds when they are first issued (the reason is explained below). To make the bonds available to individual investors, municipal bond issuers will provision for a retail order period of 1-2 days before the bonds are officially priced and offered to institutional investors. The minimum investment during a retail order period is usually $5,000 of par value and the maximum investment is usually $1 million.

The Benefit of Retail Order Periods

Retail order periods provide individual investors with as little as $5,000 to benefit from the same yield that major, institutional investors receive. The bonds have no markups or commissions. The bankers simply receive their underwriters discount on the bonds that is negotiated with the issuer (this is the equivalent of their investment banking fee). Every investor, regardless of size or sophistication, receives the same deal. This creates a degree of safety for investors in knowing that a large dollar amount of bonds were sold at the same prices to others as was sold to them. The additional benefit for individual investors is that they get to act first and get an opportunity to buy new issues even before institutional investors.

Many states, cities, and municipalities will be making efforts to make sure that their new issues are offered through retail order periods. Investors should consider buying municipal bonds through retail order periods when they are available and accessible.

How Retail Order Periods Work

For new issues, municipal bond issuers will ask their senior banker (the banking firm that is responsible for managing the deal and bringing it to market) to coordinate a retail order period . Senior bankers are often firms such as Citigroup, Morgan Stanley, Goldman Sachs, Merrill Lynch, but can also be regional or specialty firms responsible for managing the deal. A typical bond issue will have a syndicate of bankers and perhaps a selling group. This just means that the senior banker has a list of partner firms that will help sell the new bond issue to investors, both individuals and institutional investors.

If an investor has an account at any of the firms that are a part of the syndicate or the selling group, the investor can place an order for the bonds once the retail order period commences through their broker at the respective firm. Investors can also tell their brokers to let them know of upcoming bond issues. Investors can also open an account at one of the firms that is a part of the syndicate in order to place an order for the bonds. To run an effective retail order period, the issuer and the senior banker will often run advertising to let investors know about an upcoming issue and the retail order period.

On the actual days of the retail order period, investors will be able to place orders for the bonds based on a preliminary pricing schedule that the broker will provide the investor. For instance, on California’s recent $4 billion General Obligation issue, the preliminary pricing looked like the schedule below. Most bond issues will be structured to mature over a variety of maturity years (the year when the bonds will be redeemed and the investors will be paid the face value of the bond.) In addition, the preliminary pricing includes the amount (par value) of bonds available for each maturity year as well as the expected coupon rate and yield for each maturity year.

Example: Preliminary Pricing for a Retail Order Period

Dated Date: April 1, 2009
First Coupon: October 1, 2009
Due Date: April 1, 2009

An investor that receives the preliminary pricing information has to decide on a few things:

1. Maturity - How long do they want their money tied up?
2. Coupon - What is their desired actual amount of annual interest? This is paid once every six months.
3. Yield - Is the corresponding yield acceptable or attractive to them? Remember, yield is the overall return an investor receives on their investment.

(If you are unfamiliar with the relationship between price, coupon, and yield, please read the 5 elements of a municipal bond trade.)

For instance, an investor that has $100,000 that they want to invest over 3-5 years in maturity would need to choose between the bonds available in 2013, 2014, and 2015. On this preliminary pricing schedule provided above, the proposed yields are as follows:

• 2013 - yield: 3.25 - coupons available: 3.25% and 5%
• 2014 - yield: 3.75 - coupons available: 3.75% and 5%
• 2015 - yield: 4.1 - coupons available: 4% and 5%

As you can see, the investor can also choose between 2 coupons for each maturity year even though the overall return for any given year will be the same. This simply means that the investor can choose to receive a larger interest payment each year or a smaller interest payment each year. The overall yield for each maturity year is still the same, but he will be able to pay a lower price for the bonds if he chooses the lower coupon.

The main consideration is the yield. Let’s say that our investor chooses to place an order for $50,000 of 3.25% coupon bonds maturing in 2013 and $50,000 of 3.75% coupon bonds maturing in 2014. The yield that the investor expects is 3.25 and 3.75. The order that the investor places is binding unless the issuer decides to lower the yield.

This works like this. The syndicate, combining all of the orders from their brokers collectively, tally up all of the retail orders and present it to the issuer. The issuer in consultation with their bankers decides whether the preliminary price was acceptable based on the demand. For instance, there was $83 million of bonds available collectively for 2013 and there were $86 million worth of bonds available for 2014.

If the total retail orders for each maturity year was $165 million, meaning that there was overwhelming investor demand, the issuer would look to reduce the yield since there was so much demand. If the issuer does this, all of the brokers will go back to their clients to ask if the new, lower yield is acceptable to them or not. If an issuer decides not to lower the yield and decides to issue the bonds in accordance with preliminary pricing, all of the retail investors would theoretically get a pro rata portion of the bonds that they placed an order for. Since there were twice as many orders as there were bonds available, investors will get half as much of their order as they initially wanted.

Our investor would receive $25,000 worth of the 2013 bonds and $25,000 worth of the 2014 bonds. The important thing to remember is that when you place an order during a retail order period, your order is binding meaning you will have to buy all of the bonds you ordered if they are delivered. However, if the yield or any characteristic of the bonds changes to your detriment, you will not be bound to your order, but will have an opportunity to pass. Your broker will notify you if anything changes.

Tags: bonds, new issues, retail order periods

This entry was posted on Friday, June 26th, 2009 at 5:49 pm and is filed under Education. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.