We examine the role of underwriter reputation in the tax-exempt municipal bond market. Using a large sample of 10,239 tax-exempt municipal bonds, we show that generally, reputation matters. Municipal bond issues lead managed by larger and more prestigious underwriters have significantly lower borrowing costs, lower yields, and lower underwriting gross spreads. Our results are consistent with the view that reputation facilitates underwriter activities that leads to reducing information asymmetries between borrowers and issuers in the municipal bond market. Our results are also consistent with larger and more reputable underwriters providing a certificatory role for issues underwritten by them.
This study examines the impact of underwriter reputation on issuer borrowing costs, bond re-offering yields (yields), and underwriter gross spread (spreads), in the tax-exempt municipal bond market. We study this issue in the municipal sector because the municipal bond market is large (for example, a record US$ 419 billion issuance volume in 2004 alone),2 has several unique features that distinguish it from the corporate securities market (for example, the tax-exempt status and segmentation by types of issue, issuer, and region), and because the issue of underwriter reputation in this market has not been adequately examined. Besides, given the contradictory findings concerning underwriter reputation effects in the corporate sector, additional evidence from the municipal sector can permit a better understanding of underwriter reputation effects overall.3
We use a large sample of 10,239 tax-exempt municipal issues covering the period 1990–1999 to analyze underwriter reputation effects for issuers and investors. We examine if issuers benefit by incurring lower borrowing costs (true interest cost)4 if they utilize the services of more prestigious underwriters. We study if investors accept higher prices and lower yields for bonds underwritten by more prestigious underwriters. We analyze underwriter benefits and behavior by examining the relationship between underwriter reputation and underwriter gross spreads. We examine if results are uniform across sample partitions based on factors such as bid type (negotiated or competitively bid), and credit quality (investment grade bonds or non-investment grade/non-rated bonds). Given that the municipal market is segmented on regional lines (Feroz & Wilson, 1992), we consider both national and regional reputation effects for underwriters in our analyses. In addition, our measure of underwriter reputation is contemporaneous and takes into account changes over the time period of our study.
Our results show that using a more prestigious underwriter results in significantly lower borrowing costs for issuers. This result is seen not just for our full sample, but also for sub-samples using competitively bid and negotiated bonds, and non-investment grade bonds.5 Similar results are seen for yields also.6 Examining underwriter gross spreads, our results show that spreads are lower for our full sample, and for the competitively bid and negotiated sub-samples. Our results for spread are similar to the results obtained in the corporate sector (Chen & Mohan, 2002). Also, as noted by Livingston and Miller (2000), these results may also be consistent with more prestigious underwriters striving to maintain or increase market share. Overall, these results suggest that in general, reputation effects for more prestigious underwriters observed in the corporate IPO market (for example, Carter et al., 1998; Carter & Manaster, 1990), and in the corporate bond market (for example, Livingston & Miller, 2000), are also prevalent in the municipal market. These results also lend credence to the view posited by Logue, Rogalski, Seward, and Foster-Johnson (2002) that underwriter reputation facilitates underwriter pre-market activities that leads to a reduction in information asymmetries associated with the issue.
This paper studies the role of underwriter reputation in influencing issuer borrowing costs and investor yields. The results obtained suggest that reputation effects are prevalent in the municipal sector, and are consistent with literature in the corporate sector discussed earlier that generally associate reputation effects for more prestigious underwriters.
Our results suggest that issuers, particularly issuers of non-investment grade municipal bonds benefit from using the larger, more prestigious underwriting firms. These issuers using more prestigious underwriters are observed to obtain lowered borrowing costs in comparison to issuers using the services of less prestigious underwriters. Our results are consistent with both certificatory and information disseminating, information asymmetry reducing roles for more prestigious underwriters.
Our research results need to be interpreted with caution. Even though we use a widely used measure of reputation (market share), and carry out various sensitivity tests, it is possible that our results may be sensitive to using other proxies for reputation. Future research could perhaps examine this.
