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.

Indeed, the greater transparency of Internet auctions is the reason that issuers should realize better prices for their bonds. In traditional syndicate deals, underwriters often have an incentive to underprice the issue in order to attract big institutions with which they would like to do more business. Investors with large allocations can then make a quick profit selling the underpriced bonds in the secondary market, because of pent-up demand.

In Internet auctions, the book is built online in real time, giving participants a much better sense of the true demand for the securities in the marketplace. Consequently, they’re apt to make better bids. “Investors will accept less yield if they know the bonds are likely to go up in value,” says Bear Stearns’s Millender. And because the price reflects true demand in the market, successful bidders are also more likely to hold on to their investment. According to Stephane Paquier, Dow’s corporate finance director: “We got long-term investors instead of traders. Most of our investors are keeping our paper.”

An added benefit of an open auction appears to be a broader distribution pattern among investors — something issuers like because it can reduce the volatility of the securities in the secondary market. The Dow E-bond auction attracted 57 investors, about three times the usual number for a deal of that size. Bear Stearns ended up with 129 investors, about twice the normal number. “It may have been investor curiosity as much as anything else,” says Cioffi.

Whatever the reasons, the auctions clearly generated a lot of interest in the investor community. “The process unfolded just as our game theorists predicted: as the auction progressed, the pace of bidding increased and the spread came down,” says Cioffi, who handled Bear Stearns’s auction of its own debt.

And the initial concerns about liquidity in the aftermarket proved to be unfounded. Unlike stocks, bonds — even of large issuers — are not terribly liquid, so the market-making support of the investment community can be important. Although it is difficult to measure liquidity, Dow’s E-bond is trading at prices and volumes related to the company’s credit rating, the size of the offering and prevailing interest rates — just like any other bond issued by the company.

So what will kick-start the market for web-based bond auctions? Falling interest rates could help. So too, could the successful auction of $5 billion in three-year notes on February 9 by residential mortgage agency Freddie Mac (www.freddiemac.com) in the US. As Jon Prince, manager of debt marketing for Freddie Mac, says: “An auction is more interesting to a bull than a bear.”

Yet many investors will likely sit on the sidelines until one system is established as a de facto standard. That hasn’t happened yet, and in a shaky credit environment with a recession threatening, it may not for a while. Hambrecht, however, recently scored a huge endorsement when Freddie Mac announced it would use the system for some large tranches of its reference-note debt program.

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