E-bonds: Will They Fly?

Internet bond auctions can help corporate issuers lower their cost of capital. But savings from lower sales and marketing costs may not be as great as you might imagine.

In a Dutch auction, investors bid for a particular amount of a security at a specific price. The best bids are accepted in the amounts requested until a clearing price is reached for the entire issue. All successful bidders then get their requested allocations at the clearing price. Offline, it’s essentially the form that Treasury bond auctions take. But the Internet brings a new dimension to the process, making the model viable for securities with a smaller potential audience.

While most investment banks are fighting it every step of the way, virtually everyone in the industry agrees that the Internet is already changing the way securities are distributed. And at least some players are preparing for the future. “It’s better to be on the train than under it,” concludes Mark Millender, managing director of debt markets at Bear Stearns. Both Bear Stearns and Deutsche Bank have conducted their own auctions using proprietary software accessible through their Web sites.

Besides those from the two investment banks, the other E-bonds were priced according to the usual mysterious ways of the syndicate business. That process takes place in private among investment bankers with a long history of back-scratching and IOUs. The ultimate price of an offering has as much to do with who owes what to whom on Wall Street as it does with the level of demand in the marketplace. The Ford Motor Credit issue, notwithstanding the administrative and marketing work done on the Web, was no different from any other underwriting in this regard. “It’s just glorified email,” says Millender.

Dow, in contrast, used four co-managers for its deal: Hambrecht; Bear Stearns; HSBC; and Williams Capital Group. The two-hour auction took place at Hambrecht’s auction Web site, and, according to Leland Crabbe, a portfolio manager at Credit Suisse Asset Management in New York who participated in the bidding: “It was the first [E-bond auction] that felt real to the market.”

What makes E-bonds revolutionary is that the market, not Wall Street, sets the price. “That is the whole point of using the Internet,” says Merszei. “Without question, the pricing will be more favorable to borrowers.” He expected Dow’s issue to price between 98 and 102 basis points over Treasuries. It came in at 101, with a clearing yield of 7.108 percent. And the underwriting spread that Dow paid to its bankers was half the usual 60 basis points of a syndicate deal. “Even if we’d paid 102, the all-in price would have been very competitive,” he says.

Help Wanted

Not surprisingly, when Merszei went shopping for a manager for Dow’s online auction, the A-list underwriters that usually vie for the company’s business showed little interest. Only two banks were prepared to take the job: Hambrecht, which had plenty of experience with online equity IPOs but next to none with investment-grade debt, and Bear Stearns, a second-tier player in corporate debt underwriting.

Most, if not all, of the leading fixed-income underwriters have or are developing their own software to conduct online auctions, but few are prepared to use it for fear of cannibalizing their existing underwriting business. “We’d be kidding ourselves if we didn’t recognize that the business is changing,” admits Jim Merli, New York-based managing director for Lehman Brothers, noting that Lehman already does auctions of money-market preferred securities. “If that’s the way the market goes, we are prepared to respond.”

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