SYNDICATE STRUCTURE, OVERALLOCATION, AND SECONDARY MARKET OUTCOMES IN CORPORATE BOND OFFERINGS Hendrik Bessembinder W.P. Carey School of Business, Arizona State University [email protected] Stacey Jacobsen Cox School of Business, Southern Methodist University [email protected] William Maxwell Cox School of Business, Southern Methodist University [email protected] Kumar Venkataraman Cox School of Business, Southern Methodist University [email protected] Current Draft: May 2021 --------------------------------------------------------------------------------------------------------------------- * We thank Bernard Dumas, Paul Schultz, Jonathan Sokobin and seminar participants at INSEAD, Southern Methodist University, and the 2020 Shanghai Financial Forefront Symposium for helpful comments. We also thank Andrew Karp, Sonali Thiessen, Rachel Wilson, and Larry Wolfson for helping us understand institutional aspects of the bond issuance process, as well as the Financial Industry Regulatory Authority (FINRA) for provision of the data and in particular, Alie Diagne, Elliot Levine, Ola Persson, and Jonathan Sokobin for their support of the study. FINRA screened the paper to ensure that confidential dealer identities were not revealed. None of the authors received financial support specific to this project. Bessembinder, Maxwell, and Jacobsen have no conflicts of interest to report. Venkataraman is a visiting economist at the FINRA Office of Chief Economist and acknowledges financial support for other projects. SYNDICATE STRUCTURE, OVERALLOCATION, AND SECONDARY MARKET LIQUIDITY IN CORPORATE BOND OFFERINGS Abstract We study corporate bond offerings, including underwriting syndicate structure, primary placement transactions, and secondary market outcomes. Although bond offerings rarely include “Greenshoe” options, the syndicate “overallocates” many issues, thereby attaining net short positions. Overallocations are economically substantive, facilitate the syndicate’s price stabilization efforts, and are largely offset within a few days after issuance. Secondary market liquidity is better and retail participation is higher for overallocated issues, and these issues appreciate less in the aftermarket, i.e., are less underpriced, despite syndicate purchases that temporarily support the bond price. The results indicate that the syndicate overallocates issues when uncertainty regarding secondary market order flow is high and that overallocation facilitates redistribution of the offer toward retail traders. 1. Introduction Primary issuance markets, where companies raise capital from investors, are crucial to allocational efficiency in market-based economies. While dozens of research papers have studied initial and secondary offerings of common equity, issuances of corporate bonds have received less attention, despite the fact that corporations raise significantly more capital through bond than stock issuances.1 In particular, we know little about underwriters’ activities prior to the commencement of secondary market trading, or relations between underwriter decisions and secondary market outcomes. In this paper, we study the role of the underwriting syndicate throughout the issuance process, from syndicate formation, to primary allocation, and finally to secondary market trading, with a particular focus on underwriter activities intended to manage aftermarket demand uncertainty. Underwriters typically seek to ensure that the initial secondary market price move is positive, i.e., that primary investors earn a return on their allocation, but modest in magnitude, i.e., that the cost to the issuer is not excessive. We consider the role of uncertainty regarding secondary market order imbalances following the commencement of trading. During the bookbuilding process the underwriter gains information regarding both the total primary demand for the offering (i.e., the degree of oversubscription) and the composition of the primary investor base. As Fishe (2002) argues, some primary investors are more likely to “flip” their allocations by quickly selling in the secondary markets, while others (e.g., insurance companies) are more likely to be long-term investors. Based on this information, the underwriter can make subjective forecasts regarding both the likely strength and uncertainty in secondary market order flow.2 1 Bessembinder, Spatt, and Venkataraman (2020) report that the dollar amount of debt issuances by U.S. Corporations in 2017 was nearly eight times as large as equity issuances. U.S. corporate bond issuances reached a record level of $1.92 trillion in 2020, surpassing the previous annual record of $1.9 trillion set in 2017. See https://www.ft.com/content/a59c2a9d-5e0b-4cbc-b69e-a138de76a776. 2 The composition of the primary order book in terms of long-term investors versus potential “flippers” has recently been the focus of attention in the Financial press. With regard to sovereign issues, the CEO of the French public debt and treasury management recently stated: “The relationship between what could be considered as a good transaction and the sheer size of the order book is broken. One may be confronted with a skyrocketing order book, but which is in fact of poor quality. In that case, tightening the price might be challenging or risky if you are We report evidence supporting the reasoning that underwriters accommodate uncertainty regarding secondary market order flow by preemptively “overallocating” issues with greater uncertainty, such that the syndicate attains a net short position. While overallocation is also common in equity market offerings, the mechanics differ. Most equity offerings include a “Greenshoe” option which, if exercised, allows the syndicate to cover their short position with additional newly issued shares purchased at the offer price, with the combined effect of the overallocation and option exercise being that underwriters can elect to increase the size of the offering. The Greenshoe option affords the syndicate flexibility to respond to market conditions. If order flow is strong, the syndicate need not make secondary market purchases and can exercise the Greenshoe option to cover the overallocation. If order flow is weak the syndicate can stabalize prices through direct secondary market purchases and need not exercise the Greenshoe option. In contrast, corporate bond offerings rarely include Greenshoe options, implying that overallocation results in a naked short position and effectively commits the syndicate to secondary market purchases, whether prices are weak or not. Since secondary market prices are on average greater than the offer price, i.e., bonds are underpriced, these short-covering transactions are potentially costly to the syndicate. We document that overallocation is nevertheless common in bond offerings, particularly for high yield issues, and assess the effects of overallocation on syndicate profits and secondary market outcomes. Our sample includes 5,573 bond issuances during the period March 2010 (when FINRA began to collect information on primary market allocations) through March 2018. For each issue, we merge data on bond characteristics from the Mergent Fixed Income Securities Database (FISD), syndicate structure and underwriting fees from the Securities Data Company (SDC), and primary and secondary market transactions from the Trade Reporting and Compliance Engine (TRACE). In addition to the data targeting a transaction of [a] certain size.” See https://www.wsj.com/articles/hedge-funds-face-backlash-from- europe-in-bond-market-11620639114. 4 contained in the academic version of FINRA’s TRACE dataset, including masked dealer identifiers, uncapped secondary market transaction sizes, and the primary placement transactions associated with each bond issue, we obtain from FINRA additional information to link the syndicate members identified by the SDC database to individual primary and secondary market transactions completed by thirty-four prominent dealer firms. We find evidence that the underwriting syndicate is structured in anticipation of deal complexity and uncertainty. Large deals and those with multiple tranches are more widely distributed across bookrunners. However, issue characteristics and market conditions associated with greater uncertainty result in a more concentrated syndicate. In particular, issues associated with first-time issuers and issuers that have not issued in the last two years are associated with fewer bookrunners. Bonds issued when VIX levels and the dispersion of first-day returns for related issues in the prior week are high and when recent bond index returns are low are also associated with fewer bookrunners. We provide evidence that the syndicate preemptively overallocates issues when uncertainty regarding aftermarket order flow is high, implying a higher probability that temporary price support will be required. We measure the extent of overallocation by comparing the sum of the primary placement quantities to the issue amount. We focus in particular on issues overallocated by at least two percent of the issue size, documenting that over three-quarters of high yield issues, for which the long-term investor base is narrower, have overallocation that exceeds this threshold, compared to less than one-third of the less risky investment grade issues. Large issues are more likely to be overallocated than small issues. Importantly, the decision to overallocate is related to market conditions that may exacerbate aftermarket demand uncertainty. Issues are more likely to