VideoWhat 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."
Like most investment bankers, however, Merli is in no hurry to see it happen. Investors who participated in the Dow and Bear Stearns auctions were reputedly discouraged by Wall Street salespeople. There were predictions that Wall Street dealers would refuse to trade the paper in the aftermarket, there would be no research to support the issue, the auction technology would fail, and not enough investors would participate.
Some suggested that without the moderating hand of the syndicate desk to set allocations, investors might end up paying too much for the bonds. It was also predicted that in a volatile market investors would beat down prices. "They were telling me it was bad for the issuer and bad for the investor," says Credit Suisse's Crabbe. "But it can't be bad for everybody." Underlying all the arguments was the not-so-subtle innuendo that auction participants could expect retaliation when it came time to allocate the next traditional deal.
For the largest, most-favored investors, that's a significant threat. But smaller investors generating less commission for dealers and CFOs who manage their company's pension fund in-house are already at the bottom of the pecking order at the syndicate desks: their allocations in traditional deals can't get much worse. In a Dutch auction, where the best bid wins, smaller, less well-connected investors are on an equal footing with the heavyweights, and are much more likely to get their allocation than they are in a syndicate underwriting.
At the end of the day, the intimidation apparently had little effect. Plenty of investors logged on for all three online auctions, pricing was good for the issuers, and investors got their full allocations. Trading volume in the aftermarket may have been light, but that was a positive sign: successful investors were hanging on to their bonds. And according to Merszei, Dow has not been blackballed by other investment bankers. "Secretly, many of them — including senior managers — say this is the wave of the future," he says.
The Merits for Issuers
The great promise of Internet bond auctions for corporate issuers is a lower cost of capital. But one of the biggest sources of expected savings — lower sales and marketing costs — may not be as large as first imagined. All the parties involved in the Dow deal insist that a successful Dutch auction requires an active effort by salespeople, no matter how good the technology. "Software doesn't answer questions," says Chris Williams, founding partner of investment bank Williams Capital Group. "It still calls for an educated salesperson to explain the underlying credit and the relative value of the issue." Williams has a dozen people in fixed-income sales, and doesn't expect that to change.
While the four managers of the Dow issue halved their commission on the deal (30 basis points versus 60), the discount may in part be a reward for Dow's willingness to serve as guinea pig for the auction. "Everyone has assumed that OpenBook is aimed at cutting fees, but it's not," says Robert Goldberg, co-head of debt markets at Hambrecht. "For the issuer, it's a method that results in a better price and more transparency."
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."
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