Allocation Process

When a new corporate bond is issued and it is a hot issue with steamy interest from investors, the process of allocating those bonds to the interested investors is a purely subjective enterprise. There is usually a group of lead managers and those leads will make the final decision on who receives how many bonds. Many times, clients-- both big and small-- will request many more bonds than they actually need because they believe that with the rationing process they would not receive what they want or need if they requested a real number. So an investor who needs $25 million bonds will consult with his sales coverage at the leads and ascertain that he will probably receive only 50 percent of what he needs and so he consequently games the system and doubles the amount in hopes of getting what he actually needs.

In my experience the lead managers also tended to favor real investors, end users, who would not flip the bonds immediately after they are "free to trade". Suppose a 10 year issue is priced 100 basis points above the 10 year Treasury. Suppose demand is huge and when the deal begins to trade in the secondary market the bid is 90 basis points. On a 10 year security, one basis point is worth someplace close to $900 per million so the 10 basis point move is then worth $9000 per million bonds. That is a lot of wood. Lead managers in my experience tended to favor clients who would not be flipping those bonds immediately to grab that quick profit. Dealers would allocate smaller amounts to those flippers and larger amounts to buy and hold types who would not trade immediately.

The WSJ reports that the SEC is now investigating this process and has specifically asked dealers for information on the mega Verizon (VZ) deal of several years ago, which elicited tremendous demand and which tightened significantly after pricing. I believe the deal was $49 billion across many tranches and VZ priced the deal ludicrously cheap because the size dwarfed that of any corporate deal before or since.

There was much discussion at the time that the deal was too cheap and that the company had left money on the table. I think some of the tranches tightened as much as 50 basis points immediately following pricing. I always thought that though there was a modicum of truth to that argument but that deal was so large (I think the next biggest deal was a $17 billion Apple (AAPL) deal) that the company could not afford stingy pricing or the deal would have crashed and burned. Anyway, the SEC is now investigating the process of pricing and distributing a corporate bond deal and one can be sure that in the egalitarian spirit of these times, this sometimes sloppy and subjective process will undergo a transformation.

See WSJ article entitled 'Regulators Are Probing How Goldman, Citi and Others Divvied Up Bonds'.

Disclosure: No positions

Source: Allocation Process

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