Underwriting spreads buck a 15-year downward trend

Underwriting spreads for all bonds surged in the first half of 2024, rising above $7 for the first time in 25 years.

Underwriting spreads rose to $7.11 in the first half of 2024 from $3.70 in the first half of 2023. Spreads on negotiated bonds rose to $6.55 in 1H 2024 from $3.78 in 1H 2023, while spreads on competitive deals increased to $9.08 from 1H 2023’s $2.61, according to LSEG data.

Refunding and new-money spreads increased, with the former rising $6.77 in 1H 2024 from $3.36 a year prior and the latter rising to $7.26 from $3.88 over the same period, per LSEG.

The gross underwriting spread is the payment or discount that an underwriter receives for marketing a deal. It is calculated as the dollar amount of the underwriting discount per $1,000 of an issue.

The last time spreads were above $7 was in 1999. From then, through 2008, spreads continued a downward trend with slight fluctuations before hitting a high of $6.21 in 2009. Spreads then continued to fall through 2023, again with slight variations.

Part of the increase in spreads stems from who is coming to market, said Wesly Pate, a senior portfolio manager at Income Research + Management.

“Underwriting costs are quite scalable, so if you have a disproportionately greater number of smaller deals hitting the market, it’s naturally going to shift that underwriting costs higher,” he said.

That has played throughout this year as there has been a rise in the number of deals, a greater increase than the market value of issuance, Pate said.

“You effectively have a lot of smaller deals — a lot of those are voter referendum passed deals coming to market — and those naturally lead to higher underwriting costs,” he said.

Borrowers have to buy “bandwidth” in the current market, which, in a sense, has more bonds than since the financial crisis, said Matt Fabian, a partner at Municipal Market Analytics

“Space in the primary market is coming at a bit more premium,” he said. “Dealers have more bonds out there, and the distribution is not as quick.”

The distribution relies on separately managed accounts (SMAs), which can be a bit slower to put away bonds, Fabian noted.

“Dealers are taking more price risk, so it makes sense that underwriting spreads have risen,” he said.

Additionally, the market saw the loss of some underwriting capacity in the last few months with Citi’s exit from the origination business and UBS’s exit from the negotiated banking business, said Michael Decker, senior vice president of policy and research at Bond Dealers of America.

“The fact that there’s a little less competition among underwriters has had an effect,” he said.

With Citi’s and UBS’s exits, part of the rise in underwriting spreads is “simply a sort of re-racking of the various entities that are known to be a large part of the market,” Pate said.

Additionally, there is the large uptick in issuance, up 32.3% to $242.162 billion in 1H 2024, and the “distribution channel” is SMAs, not mutual funds grabbing lots of bonds at once, Fabian said.

Rates have also risen, and market participants are still contending with not knowing where bond prices may be a month from now, he noted.

“Dealers are carrying a lot more risk than they were, and there’s fewer dealers doing it,” Fabian said. “This is an effect of losing Citi and an effect of market volume, so it’s reasonable to expect that underwriting prints will get wider in the second half of the year.”

This could be exacerbated if the Republicans win the presidency and Congress, and the threat to the tax-exemption “goes up,” leading to a surge of issuance, and in turn, wider underwriting spreads, he noted.

Pate, though, suggests the $7.11 figure is more of an outlier than a new trend of higher underwriting spreads.

There will most likely be a “meaningful revision that moves you back to that long-term run rate,” noting long-term rates should be with a “three-handle.”

The rise in underwriting spreads, though, is a “helpful change,” said Anthony Tanner, a research analyst and market strategist. 

“As the economics of the business and the current interest rate environment provide less margin for error when it comes to inventorying bonds in a secondary market or taking an ownership position of a new-issue compared to the higher yields of 20 years ago when market yield fluctuations provided more of a cushion,” he said.

If it only takes a few basis points for a position to go from profitable to unprofitable, it makes it challenging, so a rise in underwriting spreads is “helpful” and “welcome,” he noted.