With regard to a new issue of bonds, the underwriter’s discount, also known as the underwriter’s spread, is the difference between the price the underwriter pays the issuer for the bonds, and the price at which the underwriter then sells those bonds to investors.
Underwriters make their money through the spread, which has four components:
· The management fee is paid to the underwriter for its investment banking services.
· Expenses are costs incurred by the underwriter that may be reimbursed by the issuer, such as travel, advertising costs, or fees to the Municipal Securities Rulemaking Board (MSRB).
· The underwriting fee compensates the underwriter for the risk that it may not be able to sell all of the bonds at a favorable price and so may need to hold them until the market improves. The size of the fee relates to the bonds’ risk – for high-quality bonds in a strong market, the fee may be low or waived entirely.
· The takedown is the largest part of the spread, and is essentially a commission paid to the underwriter for selling the bonds. The takedown varies for each individual maturity in an issue, and will normally be smaller for bonds with a high rating and larger for longer maturities. The average takedown for all maturities in the issue is often quoted for convenience.
The underwriter’s discount is of less concern to an issuer in a competitive sale, because it is embedded in the underwriter’s overall bid. For example, an underwriter with a larger spread may also be willing to pay more for the bonds, and so have a lower overall bid than an underwriter with a smaller spread. In a negotiated sale, however, the issuer agrees to sell the bonds to one underwriter or group of underwriters, and so cannot rely on competition to keep underwriting costs low.