2 Understanding Municipal Finance 2.2

Question 1

General Obligation Bonds

Answer 1

-Secured by full faith, credit, and taxing power of an issuer
-Traditionally “unlimited”

Question 2

Can GO Bonds be “limited tax bonds” - why or why not

Answer 2

Yes, when security is limited by the local government’s constitution or statutes

Question 3

Ad Valorem (according to value) tax

Answer 3

One that can be raised or lowered by a local governing body without the sanction of superior levels of government

Question 4

What happens in the event of default on GO bonds?

Answer 4

The holders of GO bonds have the right to compel a tax levy or legislative appropriation.

Question 5

Nationally, how are GO bonds approved?

Answer 5

By referendum

Question 6

Revenue Bonds

Answer 6

-Payable from a specific source of revenue and to which the full faith and credit of an issuer with taxing power is NOT pledged
-Paid from identified sources
-Doesn’t permit bondholders to compel taxation or legislative appropriations of funds
-Pledged revenues may be derived from the operation of the project, grants and excise taxes, and other specified non-ad-valorem taxes (e.g., income taxes)
-May include covenants to assure the adequacy of the pledged revenue sources

Question 7

Special Tax Bond

Answer 7

A bond secured by revenues derived from one or more designated taxes other than ad valorem taxes

Question 8

What is an example of a Special Tax Bond?

Answer 8

Bonds for a particular purpose might be supported by sales, cigarette, fuel or business license taxes

Question 9

Special Assessment Bonds

Answer 9

-Obligation payable from a special assessment

Question 10

What is a Special Assessment

Answer 10

-A charge imposed against a property in a particular locality because that property receives a special benefit from some public improvement that is separate from the benefit enjoyed by the public at large
-May be apportioned according to the value of the benefit received, rather than the cost of the improvement
-Part of one of the most rapidly growing areas of tax-backed financings

Question 11

Moral Obligation Bond

Answer 11

A bond that, in addition to its primary source of security, is also secured by a non-binding covenant that any amount necessary to make up any deficiency in debt service will be included in the budget recommendation made to the governing body, which may appropriate funds to make up the shortfall.
-The governing body, however, is not legally obligated to make such an appropriation

Question 12

Double-barreled Bond

Answer 12

A bond secured by both a defined source of revenue (other than property taxes) and the full faith and credit or taxing power of an issuer that has taxing powers.

Question 13

Tax Increment/Allocation Financing

Answer 13

-Payable from the incremental increase in tax revenues realized from any increase in property value resulting from capital improvements benefitting the properties that are financed with bond proceeds

Question 14

What type of bond/financing is often used to finance the development of blighted areas?

Answer 14

Tax Increment/Allocation Financing

Question 15

Build America Bonds (BABs)

Answer 15

-Taxable municipal securities issued through December 31, 2010 under the American Recovery and Reinvestment Act of 2009 (ARRA). –BABs may be direct pay subsidy bonds or tax credit bonds.

Question 16

Recovery Zone Economic Development Bonds (RZEDBs)

Answer 16

-A category of taxable Build America Bonds to fund infrastructure and facility improvement in areas of significant unemployment and poverty.
-RZEDBs are direct pay subsidy bonds that provide a higher subsidy rate than other direct pay subsidy BABs.

Question 17

Taxable Credit Bonds

Answer 17

Municipal securities that entitle the bondholder to receive, in lieu of interest payments, a credit against federal income tax.

Question 18

Variable Rate Demand Obligations (VRDOs)

Answer 18

Debt securities that bear interest at a floating, or variable, rate adjusted at specified intervals (daily, weekly, or monthly) according to a specific index or through a remarketing process. The investor has the option to put the bond back to the tender agent at any time with specified notice (e.g., seven days). The put price is par plus accrued interest. These securities typically are supported by a liquidity facility, (i.e., letter of credit, standby bond purchase credit or self-liquidity), which assists in making these securities money market fund eligible.

Question 19

Tax Anticipation Notes (TANs)

Answer 19

Notes issued in anticipation of future tax receipts, such as receipts of ad valorem taxes that are due and payable at a set time of year.

Question 20

Tax and Revenue Anticipation Notes (TARNs)

Answer 20

Notes issued in anticipation of receiving future tax receipts and revenues at a future date.

Question 21

What is a Tax-exempt Commercial Paper?

Answer 21

A short-term unsecured debt where the bondholder does not pay federal, state, or local taxes on the interest payments.

Question 22

Key Takeaways re: Tax-exempt Commercial Paper

Answer 22

-Issued with a fixed interest rate
-Has a maturity date of fewer than 270 days
-Is commonly denominated in increments of $1,000

Question 23

Are interest rates on Tax-exempt Commercial Paper usually higher or lower than other short-term cash instruments? And are Tax-exempt Commercial Paper higher or lower than taxable debt?

Answer 23

Interest rates on tax-exempt commercial paper are typically higher than other short-term cash instruments but will be lower than taxable debt.

Question 24

Tax-exempt commercial paper is usually issued to finance short-term liabilities, which provides the debt holders (bondholders) with some level of tax preference on their debt investment earnings. Tax-exempt commercial paper is issued with a fixed interest rate, has a maturity date of fewer than 270 days, and is commonly denominated in increments of $1,000.

Question 25

Commercial paper is mostly a promissory note backed by the financial intuition’s health. Federal government policy does not cover losses incurred from investing in commercial paper. Furthermore, the Federal Deposit Insurance Company (FDIC) does not insure against losses from investing in tax-exempt commercial paper.

An investor’s due diligence should include checking the desired tax-exempt commercial paper’s quality ratings listed by agencies such as Standard & Poor’s or Moody’s.

Question 26

Tax-exempt Commercial Paper interest rates should rise as the economy grows.

Question 27

Tax-exempt commercial paper issued by the government is an indirect method of support for those specific entities as opposed to directly funding these entities. The government forgoes the collection of taxes on the interest income, but the logic is that the entity issuing the tax-exempt commercial paper will engage in activities that serve the community that will end up generating more value than the lost tax revenue. Thus, tax-exempt commercial paper can be viewed as an instrument of public policy.

Only companies with an investment-grade rating may issue commercial paper.

Institutions, such as universities and governments, typically issue tax-exempt commercial paper, while banks, mutual funds, or brokerage firms buy the tax-exempt commercial paper. The buyers may hold the commercial paper as an investment or act as an intermediary and resell the investment to their customers. There is a limited market for tax-exempt commercial paper issued directly to smaller investors. Due to the 2008 financial recession, new legislation limits the type and amount of commercial paper held in money market funds.

The Federal Reserve Board (FRB) publishes current borrowing rates on commercial paper on its website. The FRB also publishes the rates of highly rated commercial paper in a statistical release occurring each Friday.

Information relating to the total amount of outstanding paper issued is also released once per week.

Board of Governors of the Federal Reserve System. “Commercial Paper Rates and Outstanding Summary: Volume Statistics for Commercial Paper Issuance.”

Question 28

The tax-exempt commercial paper is beneficial for the borrower (issuer) as they are able to access funds at lower rates than they might otherwise have to pay if they had borrowed the money from a traditional financial institution, such as a bank. Tax-exempt commercial paper can be beneficial for the lender (bond buyer) as the net rate of return may end up being higher than if they had invested in taxable commercial paper.

Question 29

Municipalities and local governments may issue tax-exempt commercial paper as a way to meet short-term financial obligations, such as payroll or government expenses. They may also issue commercial paper as a way to meet expenses while pursuing longer-term capital raises.

Question 30

Most commercial paper is sold in very large increments that are not available to the average retail investor. However, you can gain exposure to the commercial paper market by investing in a mutual fund or money market fund that invests in tax-exempt commercial paper.

Question 31

Only governments and affiiliated bodies can issue tax-exempt commercial paper. The rules for issuance are determined by the tax code of the issuing state.

Question 32

Tax-exempt commercial paper refers to short-term securities whose interest is exempt from certain state or local income taxes. This is frequently used by local and municipal governments as a way to finance their short-term debt obligations. Due to certain associated risks, the interest rates on tax-exempt commercial paper are typically higher than other short-term cash instruments.

Question 33

Lease Rental, Lease Revenue, or Leasehold Revenue Bond

Answer 33

A bond that is secured by lease payments made by the party leasing the facilities that were financed by the bond issue. Typically,
lease rental bonds are used to finance construction of facilities (e.g., schools or office buildings) used by a state or municipality. In many cases, lease payments may be subject to annual appropriation or
will be made only from revenues associated with the facility financed. In other cases, the leasing state or municipality is obligated to appropriate funds from its general tax revenues to make lease payments as long as it utilizes the leased property

Question 34

Installment Purchase Agreements

Answer 34

A contract where a seller will let a buyer incrementally pay for a property or asset. If the buyer cannot purchase the asset all at once, they can seek out consent from the seller to split up the payments into installments.

Question 35

Certificate of Participation (COP)

Answer 35

An instrument evidencing a pro rata share in a specific pledged revenue stream, usually lease payments by the issuer that are typically subject to annual appropriation. The certificate generally entitles the holder to receive a share, or participation, in the
payments from a particular project. The payments are passed through the lessor to the certificate holders. The lessor typically assigns the lease and the payments to a trustee, which then distributes the payments to the certificate holders.

Question 36

Annual Appropriation Pledge/Lease

Answer 36

A pledge typically found in the bond contract for lease revenue
bonds or securing a certificate of participation financing that commits the issuer or other obligor to make lease payments or other periodic debt service payments but only to the extent that funds are
budgeted and appropriated on an annual basis by the issuer’s governing body. The governing body is not legally obligated to make such appropriation in any year. An annual appropriation pledge typically is used only in connection with projects that are considered to be essential to the issuer’s operations and therefore the governing body is likely to appropriate the money needed to pay debt service on an on-going basis. In many jurisdictions, this clause permits a borrowing entity to undertake a long-term certificate of participation or other lease revenue obligation financing without technically incurring debt, thereby avoiding statutory or constitutional debt limitations and referendum requirements because the lease payments are characterized as payments for use of the facilities rather than as payments on a promise to repay bonded debt

Question 37

Abatement Clause

Answer 37

A provision of a lease that relieves a lessee of the obligation to make lease payments in the event that the leased property cannot be utilized (e.g., because of construction delays, property damage or other causes).

Question 38

Bank Loan/Direct Loan

Answer 38

A loan to a municipal issuer from a banking institution or another lender. The obligations my constitute municipal securities.

Question 39

Escrow Security Bond

Answer 39

This type of bond is used to protect an obligation or promise to pay from one party, the obligee, to a second party, such as a contract holder. The bond will protect the obligee if the second party fails to meet the obligation.

Question 40

Escrow

Answer 40

Escrow is a financial arrangement where a neutral third party holds assets or funds on behalf of two parties in a transaction. The third party, called an escrow agent, releases the funds only when the parties have fulfilled their contractual obligations.

Question 41

Escrow Account

Answer 41

A fund established to hold funds pledged and to be used solely for a designated purpose, typically to pay debt service on an outstanding issue in an advance refunding.

Question 42

Escrow Deposit Agreement

Answer 42

An agreement that typically provides for the deposit of funds or
securities in an escrow account to refund an outstanding issue of municipal securities. The agreement sets forth the manner in which funds are to be invested (generally in eligible securities) pending their
expenditure and the schedule on which on-going debt service payments are to be made and early redemptions, if any, of securities are to occur.

Question 43

Escrowed Securities

Answer 43

Securities that are held, typically in an escrow account, to be used solely for a designated purpose

Question 44

Treasury Securities

Answer 44

Debt obligations of the United States Government sold by the Treasury Department in the form of bills, notes and bonds (as well as SLGS sold to issuers of municipal securities) backed by the full faith and credit of the United States Government:
-Bills – Short-term obligations that mature in one year or less and are sold on the basis of a rate of discount.
-Notes – Obligations that mature between one year and ten years.
-Bonds – Long-term obligations that mature in ten years or more.

Question 45

Bills (a type of treasury security)

Answer 45

Short-term obligations that mature in one year or less and are sold on the basis of a rate of discount.

Question 46

Notes (a type of treasury security)

Answer 46

Obligations that mature between one year and ten years.

Question 47

Bonds (a type of treasury security)

Answer 47

Long-term obligations that mature in ten years or more.

Question 48

Federal Agencies

Answer 48

-Commodity Futures Trading Commission (CFTC)
-Federal Deposit Insurance Corp (FDIC)
-Federal Reserve Board
-Office of the Comptroller of Currency (OCC)
-Securities and Exchange Commission (SEC or The Commission)

Question 49

Commodity Futures Trading Commission (CFTC)

Answer 49

An independent federal agency charged with the regulation of commodity futures and option markets in the United States.

Question 50

Federal Deposit Insurance Corporation (FDIC)

Answer 50

Federal agency that guarantees (within limits) funds on deposit (other than securities) in member banks and thrift institutions, and performs other functions relating to the safety and soundness of its member institutions. The FDIC also enforces MSRB rules applicable to its member banks (other than banks that are members of the Federal Reserve System) that are municipal securities dealers.

Question 51

Federal Reserve Board

Answer 51

The Board of Governors of the Federal Reserve System, which is
the federal agency responsible for making national monetary policy and supervising and regulating certain banking institutions. In addition, the Federal Reserve Board enforces MSRB rules applicable
to the system’s member banks that are municipal securities dealers.

Question 52

Office of the Comptroller of Currency (OCC)

Answer 52

Federal agency within the Treasury Department responsible for supervising and regulating national banks. The OCC also enforces MSRB rules applicable to bank dealers that are national banks.

Question 53

Securities and Exchange Commission (SEC or The Commission)

Answer 53

The federal agency responsible for supervising and regulating the securities industry. Although municipal securities are exempt from the SEC’s registration requirements, municipal securities dealers and municipal advisors are subject to SEC regulation and oversight. The SEC also has responsibility for the approval of MSRB rules and enforces anti-fraud provisions of the federal securities laws in the sale and purchase of municipal securities.

Question 54

Investment Contracts

Answer 54

-Guaranteed Investment Contracts (GICs)
-Forward Delivery Agreement

Question 55

Guaranteed Investment Contracts (GICs)

Answer 55

An investment, secured by a contract with a financial institution, that guarantees a fixed rate of return and a fixed maturity.

Question 56

Forward Delivery Agreement

Answer 56

A two-stage process where a bond’s price is set on a specific date, but the bonds are not issued until a later date:
-Pricing: The bonds are priced, or the interest rate is determined, at the beginning of the forward delivery arrangement.
-Issuance: The bonds are issued and the offering is closed at a future date.

Question 57

Forward delivery bonds are a way for issuers to protect against interest rate increases and lock in savings when interest rates are low. They can also be used to refund tax-exempt bonds that aren’t eligible for advance or current refunding.

Issuers typically pay a premium to lock in the interest rate until the bonds are issued. They don’t recognize the bonds as an asset or liability until the offering is closed.

Question 58

Money Market Instruments

Answer 58

-CDs
-Commercial Paper
-Interbank Loans
-Money Market Mutual Funds
-Treasury Bills
-Securities Lending and Repurchase Agreements (Repos)

Question 59

Certificates of Deposit (CDs)

Answer 59

The most familiar money market instruments are bank deposits, which are not considered securities, even though certificates of deposit are sometimes traded like securities. Depositors, who are lending money to the bank, look to the institution’s creditworthiness, as well as to any government programs that insure bank deposits.

Question 60

Commercial Paper (CP)

Answer 60

A promissory note (an unsecured debt) issued by highly rated banks and some large nonfinancial corporations. Because the instrument is unsecured (no more than a promise to pay, hence the name), investors look solely to the creditworthiness of the issuer for repayment of their savings. Commercial paper is issued and traded like a security. But because it is short term by nature and not purchased by retail investors, it is exempt from most securities laws. In the United States, for example, commercial paper is issued in maturities of 1 to 270 days, and in denominations that are deemed too large for retail investors (typically $1 million, but sometimes as small as $10,000).

Question 61

Interbank Loans

Answer 61

Interbank loans are not secured by collateral, so a lender looks exclusively to a borrower’s creditworthiness to assess repayment probabilities. The most closely watched interbank market is in England, where the London interbank offered rate (LIBOR) is determined daily and represents the average price at which major banks are willing to lend to each other. That market did not prove to be a reliable source of funding during the crisis. LIBOR rates rose sharply in comparison to other money market rates once the creditworthiness of banks was called into question. Moreover, lending volume decreased significantly as banks struggled to fund their existing assets and were less interested in new lending. Emergency lending by central banks helped make up for the contraction of this funding source. Recent investigations by regulatory authorities have also called into question the integrity of the pricing process by which LIBOR is determined.

Question 62

Treasury Bills

Answer 62

Treasury bills, which are issued by the government, are securities with maturities of less than a year. U.S. Treasury bills, sold at a discount from face value and actively bought and sold after they are issued, are the safest instrument in which to place short-term savings. The markets are deep and liquid, and trading is covered by securities laws. U.S. Treasury bills are not only savings instruments; they can be used to settle transactions. Treasury bills, which are issued electronically, can be sent through the payments system as readily as money.

Question 63

Repos

Answer 63

Repos are an important large, but more complicated, segment of money markets. Repos offer competitive interest rates for borrowing and lending on a short-term basis—usually no more than two weeks and often overnight. A borrower sells a security it owns for cash and agrees to buy it back from the purchaser (who is in effect a lender) at a specified date and at a price that reflects the interest charge for borrowing over the period. The security at the heart of the transaction serves as collateral for the lender.

Question 64

Money Market Mutual Funds

Answer 64

Money market mutual funds (MMMFs) are securities offered by companies that invest in other money market instruments—such as commercial paper, certificates of deposit,

Question 65

Municipal Fund Securities

Answer 65

-Local Government Investment Pools (LGIPs)
-529 College Savings Plans

Question 66

Local Government Investment Pools (LGIPs)

Answer 66

An investment pool established by a state or local governmental entity or instrumentality that serves as a vehicle for investing public funds of participating governmental units. Participants purchase shares or units in the pool (often formed as a trust) and assets are invested in a manner consistent with the portfolio’s stated investment objectives. The investment advisor invests in a manner consistent with the cash management needs of the governmental unit participants.

Question 67

529 College Savings Plans

Answer 67

A program established by a state as a “qualified tuition program” pursuant to Section 529 of the Internal Revenue Code. Under a 529 savings plan, a person may make contributions to an account established for the purpose of meeting the qualified higher education expenses of the designated beneficiary of the account. Effective January 1, 2018, qualified higher education expenses include expenses for tuition at an elementary or secondary public, private, or religious school. Contributions generally are used to acquire units in a state trust, with trust assets invested in a manner consistent with the trust’s stated investment objectives. Units typically constitute municipal fund securities. Under current federal tax law, earnings from a 529 savings plan used for qualified higher education expenses of the designated beneficiary are excluded from gross income for federal income tax purposes.

Question 68

Possible Financing Solutions for Municipal Issuers

Answer 68

-Bonds
-Notes
-Bond Proceeds Investment Strategies
-Municipal Fund Securities
-Swaps/Derivatives

Question 69

Bond

Answer 69

(1) The written evidence of debt, which upon presentation entitles the bondholder or owner to a fixed sum of money plus interest. The debt bears a stated rate(s) of interest or states a formula for determining that rate and matures on a date certain. (2) For purposes of computations made on a “per bond” basis, a $1,000 increment of a security (no matter what the actual denominations are) (e.g. 10
bonds refers to a $10,000 investment). (3) Generally refers to debt securities with a maturity of greater than the short-term range.

Question 70

Note

Answer 70

A short-term obligation of an issuer to repay a specified principal amount on a certain date, together with interest at a stated rate, usually payable from a defined source of anticipated revenues. Notes usually mature in one year or less, although notes of longer maturities are also issued. The following types of notes are common in the municipal market:

Question 71

Types of Notes

Answer 71

-BAN
-Commercial Paper (CP)
-Construction Loan Notes (CLNs)
-Grant Anticipation Notes (GANs)
-Revenue Anticipation Notes (RANs)
-Tax Anticipation Notes (TANs)
-Tax and Revenue Anticipation Notes (TRANs)

Question 72

BANs

Answer 72

Notes issued by a governmental unit, usually for capital projects,
that are repaid from the proceeds of the issuance of long-term bonds.

Question 73

Commercial Paper (CP)

Answer 73

Short-term obligations issued by municipal entities usually backed by a line of credit with a bank that mature within 270 days. The issuer typically pays maturing principal of outstanding commercial paper with newly issued commercial paper, referred to as a “roll over,” thereby borrowing funds on a short-term basis for an extended period of time. Rate reset periods may vary from one to 270 days and different portions of a single issue of commercial paper may simultaneously have different reset periods.

Question 74

Construction Loan Notes (CLNs)

Answer 74

Notes issued to fund construction of projects (typically housing
projects). CLNs are repaid by the permanent financing, which may be provided from bond proceeds or some pre-arranged commitment.

Question 75

Grant Application Notes (GANs)

Answer 75

Notes issued on the expectation of receiving grant funds, usually
from the federal government. The notes are payable from the grant funds, when received.

Question 76

Revenue Anticipation Notes (RANs)

Answer 76

Notes issued in anticipation of receiving revenues at a future
date

Question 77

Tax anticipation notes (TANs)

Answer 77

Notes issued in anticipation of future tax receipts, such as receipts
of ad valorem taxes that are due and payable at a set time of year.

Question 78

Tax and revenue anticipation notes (TRANs)

Answer 78

Notes issued in anticipation of receiving future tax
receipts and revenues at a future date.

Question 79

Bond Proceeds Investment Strategies

Answer 79

-Cash Flow Driven Accounts
-Reserves
-Investment Agreements (IAs)

Question 80

-Cash Flow Driven Accounts

Answer 80

These accounts include capitalized interest funds, debt service funds, and project funds. Debt service and capitalized interest funds are usually more straightforward because cash needs are typically known in advance. Project funds are more dependent on factors like contractors and weather, which are harder to predict.

Question 81

Reserves

Answer 81

These accounts are designed to be accessible if the underlying project experiences a revenue shortfall.

Question 82

Investment Agreements (IAs)

Answer 82

IAs are contracts that allow a financial institution to lend issuer funds, which are then repaid with interest. The terms of IAs can vary significantly, but they can be an attractive way to invest bond proceeds under favorable market conditions.

Question 83

When developing an investment strategy for bond proceeds, you can consider the following:
-Client objectives: Understand the client’s objectives.
-Investment vehicles: Determine what vehicles the client can invest in, based on state code and the client’s Investment Policy.
-Risk tolerances and preferences: Determine what strategy fulfills the client’s objectives within their risk tolerances and preferences.

Question 84

Municipal Fund Security

Answer 84

A municipal security that, but for section 2(b) of the Investment
Company Act of 1940, would constitute an investment company.

Question 85

Examples of Municipal Fund Securities

Answer 85

Interests in local government investment pools, 529 savings plans, and ABLE programs

Question 86

Municipal Securities

Answer 86

A general term referring to a bond, note, warrant, certificate of participation or other obligation issued by a state or local government or their agencies or authorities (such as cities,
towns, villages, counties or special districts or authorities). A prime feature of most municipal securities is that interest or other investment earnings on them are generally excluded from gross income of the bondholder for federal income tax purposes. Some municipal securities are subject to federal income tax, although the issuers or bondholders may receive other federal tax advantages for certain types of taxable municipal securities.

Question 87

Examples of Municipal Securities

Answer 87

-Build America Bonds
-Mutual Fund Securities
-Direct Pay Subsidy Bonds

Question 88

Municipal Advisor

Answer 88

A person or entity (with certain exceptions) that (a) provides advice to or on behalf of a municipal entity or obligated person with respect to municipal financial products or the issuance of municipal securities, including advice with respect to the structure, timing, terms, and
other similar matters concerning such financial products or issues, or (b) solicits a municipal entity, for compensation, on behalf of an unaffiliated municipal securities dealer, municipal advisor, or investment adviser to engage such party in connection with municipal financial products, the issuance of municipal
securities, or investment advisory services.

Question 89

Municipal Bond

Answer 89

A debt security issued by or on behalf of a state or its political subdivision, or an agency or instrumentality of a state, its political subdivision, or a municipal corporation. Municipal bonds, for example, may be issued by states, cities, counties, special tax districts or special agencies or authorities of state or local governments.

Question 90

Municipal Entity

Answer 90

A state, political subdivision of a state, or municipal corporate instrumentality of a state, including (a) any agency, authority, or instrumentality of the state, political subdivision, or municipal
corporate instrumentality; (b) any plan, program, or pool of assets sponsored or established by the state, political subdivision, or municipal corporate instrumentality or any agency, authority, or instrumentality thereof; and (c) any other issuer of municipal securities.

Question 91

Municipal Securities Business (aka Municipal Securities Activities)

Answer 91

A term generally encompassing all of the activities of municipal securities dealers in the municipal securities market.

Question 92

Municipal Securities Dealer

Answer 92

A dealer or bank dealer engaged in the business of effecting
principal trades in municipal securities. This term is often used colloquially, and is used in this glossary (unless the context otherwise requires), as a collective term to describe all brokers, dealers and municipal securities dealers engaged in municipal securities activities.

Question 93

Municipal Securities Rulemaking Board (MSRB)

Answer 93

A self-regulatory organization, consisting of representatives of securities firms, bank dealers, municipal advisors, issuers, investors and the public, that is charged with primary rulemaking authority over municipal securities dealers and municipal advisors in connection with their municipal securities and municipal advisory activities. MSRB rules are approved by the SEC, and enforced by the SEC, FINRA and the federal banking regulators depending on the regulated entity

Question 94

Derivative

Answer 94

A product whose value is derived from an underlying security or other asset structured to deliver varying benefits to different market segments and participants. The term encompasses a wide range of products offered in the marketplace including interest rate swaps, caps, floors, collars and other synthetic variable rate products.

Question 95

Swap

Answer 95

(1) A generic term used to describe a broad range of derivative products, including but not limited to interest rate swap contracts.
(2) A sale of a security and the simultaneous purchase of another security for purposes of enhancing the investor’s holdings. The swap may be used to achieve desired tax results, to gain income or principal, or to alter various features of a bond portfolio, including call protection, diversification or consolidation, and marketability of holdings.

Question 96

Collar

Answer 96

A swap agreement entered into by an issuer or obligor with a swap counterparty in connection with variable rate debt that combines an interest rate cap and an interest rate floor. Such arrangement is typically used to establish a minimum and maximum interest rate range that defines the payment obligations of the swap parties with respect to the swap. The obligor remains responsible for the payment of debt service on the bonds and typically will apply payments received under the collar to offset such payments

Question 97

Credit Default Swap

Answer 97

An agreement that transfers the credit risk of a third party from the protection buyer to a protection seller in exchange for a premium.

Question 98

Fixed-to-Floating Rate Swap

Answer 98

An agreement whereby an issuer synthetically converts fixed rate
debt into variable rate debt through an interest rate swap or similar arrangement. In this process, the issuer makes payments to the counterparty at a variable rate determined according to the terms of the swap while the counterparty pays a fixed rate also according to the terms of the swap, which may be equivalent to the rate due to bondholders as determined under the bond contract.

Question 99

Floating-to-Fixed Rate Swap

Answer 99

An agreement whereby an issuer synthetically converts variable
rate debt to fixed rate debt through an interest rate swap or similar arrangement. In this process, the issuer makes payments to the counterparty at a fixed rate according to the terms of the swap and the counterparty makes payments on a variable rate or rates according to the terms of the swap, which may be equivalent to the rates payable to bondholders under the bond contract.

Question 100

Forward Swap Agreement

Answer 100

An agreement whereby two parties enter into an interest rate swap
agreement to begin at a future date.

Question 101

Interest Rate Swap Contract or Agreement

Answer 101

A specific derivative contract entered into by an issuer or obligor with a swap provider to exchange periodic interest payments. Typically, one party agrees to make payments to the other based upon a fixed rate of interest in exchange for payments based upon a variable rate. The swap contract may provide that the issuer will pay to the swap counterparty a fixed rate of interest in exchange for the counter-party making variable payments equal to the amount payable on the variable rate debt.

Question 102

Swap Advisor

Answer 102

An advisor to a municipal entity or borrower in connection with the entity’s or borrower’s consideration of entering into an interest rate swap transaction

Question 103

Swaption or Swap Option

Answer 103

An option held by one party that provides that party the right to
require that a counter-party enter into a swap contract on certain specified terms.

Question 104

Tax Swap

Answer 104

The sale of a security at a loss and the simultaneous purchase of another similar security. By creating a loss, the tax swap reduces the investor’s current tax liability. The tax swap may also serve
purposes similar to those of other types of swaps. There are specific Internal Revenue Service regulations governing tax swaps

Question 105

Total Return Swap (TRS)

Answer 105

A swap designed to transfer the credit exposure of an asset between
parties in which all investment earnings from a particular asset are exchanged for payments based on an established rate or rate-setting mechanism.

Question 106

Wash Sale

Answer 106

A transaction in which securities are sold for the purpose of establishing a tax loss but are reacquired (or a substantially identical security is acquired) within 30 days prior to or 30 days after the
date of the sale. Under such circumstances the deduction of the loss for tax purposes would be deferred.

Question 107

Swaps - Key Takeaways
-In finance, a swap is a derivative contract in which one party exchanges or swaps the values or cash flows of one asset for another.
-Of the two cash flows, one value is fixed and one is variable and based on an index price, interest rate, or currency exchange rate.
-Swaps are customized contracts traded in the over-the-counter (OTC) market privately, versus options and futures traded on a public exchange.
-Plain vanilla interest rate, equity, CDS, and currency swaps are among the most common types of swaps.

Question 108

Intro to Swaps
A swap is a derivative instrument allowing counterparties to exchange (or “swap”) a series of cash flows based on a specified time horizon. Typically, one series of cash flows is considered the “fixed leg” of the agreement, while the less predictable “floating leg” includes cash flows based on interest rate benchmarks or foreign exchange rates. The swap contract, which is agreed on by both parties, specifies the terms of the swap, including the underlying values of the legs, plus payment frequency and dates. People typically enter swaps either to hedge against other positions or to speculate on the future value of the floating leg’s underlying index/currency/etc.

For speculators like hedge fund managers looking to place bets on the direction of interest rates, interest rate swaps are an ideal instrument. While one traditionally trades bonds to make such bets, entering into either side of an interest rate swap agreement gives immediate exposure to interest rate movements with virtually no initial cash outlay.

Counterparty risk is a major consideration for swap investors. Since any gains over the course of a swap agreement are considered unrealized until the next settlement date, timely payment from the counterparty determines profit. A counterparty’s failure to meet its obligation could make it difficult for swap investors to collect rightful payments.

Question 109

The Swap Market
Since swaps are highly customized and not easily standardized, the swap market is considered an over-the-counter (OTC) market, meaning that swap contracts cannot typically be easily traded on an exchange. But that does not necessarily mean swaps are illiquid instruments. The swap market is one of the largest and most liquid global marketplaces, with many willing participants eager to take either side of a contract. According to the Bank for International Settlements, the notional amount outstanding in over-the-counter interest rate swaps was $5.2 trillion in April 2022.

Question 110

Types of Swaps

Answer 110

Plain Vanilla Swaps

Question 111

Plain Vanilla Swaps

Answer 111

Plain vanilla interest rate swaps are the most common swap instrument. They are widely used by governments, corporations, institutional investors, hedge funds, and numerous other financial entities.

In a plain vanilla swap, Party X agrees to pay Party Y a fixed amount based upon a fixed interest rate and a notional dollar amount. In the exchange, Party Y will pay Party X an amount based upon that same notional amount as well as a floating interest rate, typically based upon a short-term benchmark rate like the Fed Funds Rate or LIBOR.

The notional amount, however, is never exchanged between parties, as the next effect would be equal. At the start, the value of the swap to either party is zero. However, as interest rates fluctuate, the value of the swap fluctuates as well, with either Party X or Party Y having an equivalent unrealized gain to the other party’s unrealized loss. Upon each settlement date, if the floating rate has appreciated relative to the fixed, the floating rate payer will owe a net payment to the fixed payer.

Take the following scenario: Party X has agreed to pay a fixed rate of 4% while receiving a floating rate of LIBOR+50 bps from Party Y, on a notional amount of 1,000,000. At the time of the first settlement date, LIBOR is 4.25%, meaning that the floating rate is now 4.75% and Party Y must make a payment to Party X. The net payment would, therefore, be the difference between the two rates multiplied by the notional amount [4.75% - 4% *(1,000,000)], or $7,500.

Question 112

Currency Swap

Answer 112

In a currency swap, two counterparties aim to exchange principal amounts and pay interest in their respective currencies. Such swap agreements let the counterparties gain both interest rate exposure and foreign exchange exposure, as all payments are made in the counterparty’s currency.

For example, say a U.S.-based firm wishes to hedge a future liability it has in the U.K., while a U.K.-based business wishes to do the same for a deal expected to close in the U.S. By entering into a currency swap, the parties can exchange an equivalent notional amount (based on the spot exchange rate) and agree to make periodic interest payments based on their domestic rates. The currency swap forces both sides to exchange payments based upon fluctuations in both domestic rates and the exchange rate between the U.S. dollar and the British pound over the life of the agreement.

Question 113

Equity Swap

Answer 113

An equity swap is similar to an interest rate swap, but rather than one leg being the “fixed” side, it is based on the return of an equity index. For example, one party will pay the floating leg (typically linked to LIBOR) and receive the returns on a pre-agreed-upon index of stocks relative to the notional amount of the contract.

If the index traded at a value of 500 at inception on a notional amount of $1,000,000, and after three months the index is now valued at 550, the value of the swap to the index receiving party has increased by 10% (assuming LIBOR has not changed). Equity swaps can be based upon popular global indexes such as the S&P 500 or Russell 2000 or can be made up of a customized basket of securities decided upon by the counterparties.

Question 114

Credit Default Swaps

Answer 114

A credit default swap, or CDS, acts differently than other types of swaps. A CDS can be viewed almost as a type of insurance policy, by which the purchaser makes periodic payments to the issuer in exchange for the assurance that if the underlying fixed income security goes into default, the purchaser will be reimbursed for the loss.

The payments, or premiums, are based upon the default swap spread for the underlying security (also referred to as the default swap premium).

Say a portfolio manager holds a $1 million bond (par value) and wishes to protect their portfolio from a possible default. They can seek a counterparty willing to issue them a credit default swap (typically an insurance company) and pay the annual 50 basis point swap premium to enter into the contract.

So, every year, the portfolio manager will pay the insurance company $5,000 ($1,000,000 x 0.50%) as part of the CDS agreement, for the life of the swap. If in one year the issuer of the bond defaults on its obligations and the bond’s value falls 50%, the CDS issuer is obligated to pay the portfolio manager the difference between the bond’s notional par value and its current market value, $500,000.

Question 115

Swap Market Participants

Answer 115

-Swap dealer
-Major swap participant
-Eligible contract participant

Question 116

Swap Dealer

Answer 116

A swap dealer is an individual or entity that serves as a swaps broker, makes markets in swaps, or enters into swaps contracts with counterparties.

-An individual who acts as the counterparty in a swap agreement for a fee called a spread. Swap dealers are the market makers for the swap market. The spread represents the difference between the wholesale price for trades and the retail price. Because swap arrangements aren’t actively traded, swap dealers allow brokers to standardize swap contracts to some extent.

Question 117

Swap Dealer Key Takeaways
-A swap dealer facilitates transactions in swaps contracts, acting as principal or agent.
-Swap dealers are legally identified in the 2010 Dodd-Frank Wall Street Reform.
-The de minimus threshold for swap trading has been set at $8 billion. This means that an entity will not be considered a swap dealer unless the aggregate notional amount of its deals exceeds that figure.

Question 118

Understanding Swap Dealers
A swap is a type of derivative contract whereby two parties exchange the cash flows or liabilities from a pair of different financial instruments. Most swaps involve cash flows based on a notional principal amount such as a loan or bond, although the instrument can be almost anything. Usually, the principal does not change hands. Each cash flow comprises one leg of the swap. One cash flow is generally fixed, while the other is variable and based on a benchmark interest rate, floating currency exchange rate, or index price.

The most common kind of swap is an interest rate swap. Swaps do not trade on exchanges, and retail investors do not generally engage in swaps. Rather, swaps are over-the-counter (OTC) contracts primarily between businesses or financial institutions that are customized to the needs of both parties. Since these are OTC products, they are more opaque than exchange-traded products.

Prior to the financial crisis, swaps had been largely unregulated, taking place mainly between firms and financial institutions, in largely unregulated transactions. In 2011 the Securities and Exchange Commission (SEC) finalized proposals requiring security-based swap dealers and participants to register with the commission, as part of the Dodd-Frank legislation.

Question 119

Who oversees the Swap market?

Answer 119

SEC and Commodity Futures Trading Commission (CFTC)

Question 120

According to Section 721 of the Dodd-Frank Act, a swap dealer is an entity that:
-Holds itself out as dealer in swaps;
-Makes a market in swaps;
-Regularly enters into swaps with counterparties as an ordinary course of business for its own account; or
-Engages in activity causing itself to be commonly known in the trade as a dealer or market maker in swaps, provided, however, in no event shall an insured depository institution be considered to be a swap dealer to the extent it offers to enter into a swap with a customer in connection with originating a loan with that customer.

Question 121

Major swap participant

Answer 121

There are three parts to the Dodd-Frank Act definition. A person that satisfies any one of them is an MSP:
-A person that maintains a “substantial position” in any of the major swap categories, excluding positions
held for hedging or mitigating commercial risk and positions maintained by certain employee benefit plans
for hedging or mitigating risks in the operation of the plan.
-A person whose outstanding swaps create “substantial counterparty exposure that could have serious
adverse effects on the financial stability of the United States banking system or financial markets.”
-Any “financial entity” that is “highly leveraged relative to the amount of capital such entity holds and that is
not subject to capital requirements established by an appropriate Federal banking agency” and that
maintains a “substantial position” in any of the major swap categories.

The statutory definition excludes swap dealers and certain financing affiliates.

Question 122

Eligible Contract Participant (ECP)

Answer 122

Section 723(a)(2) of the Dodd-Frank Act added new subsection (e) to CEA section 2. Under CEA section 2(e), a person who is not an ECP cannot enter into a swap except on or subject to the rules of a designated contract market. Section 741(b)(10) of the Dodd-Frank Act also amended the ECP definition by providing that, for purposes of certain foreign exchange transactions specified in CEA sections 2(c)(2)(B) and 2(c)(2)(C) (retail forex transactions), a commodity pool is not an ECP if any participant in the pool is not itself an ECP.

Question 123

What is the current value of a swap called?

Answer 123

Mark-to-market (MTM) value

Question 124

Mark-to-market (MTM)

Answer 124

The current value of a swap is called the mark-to-market value. This is what the swap is worth using current market interest rates. For banks daily valuation is important. It provides profit and loss figures, shows whether hedging is effective and provides information for collateral support. And should you need to cancel or break a swap before it has matured the valuation will provide the basis of the cost you pay or the benefit you receive.

Question 125

Interest Rate Swaps (IRS)

Answer 125

An interest rate swap is an over-the-counter derivative transaction. The two parties to the trade periodically exchange interest payments. There is no principal exchange.

One party pays a fixed rate of interest, the other pays a floating rate of interest. The fixed interest payment remains unchanged throughout the life of the deal. It is paid annually, semi-annually or quarterly in arrears.

The floating interest is paid on a three or six monthly basis. Because it is reset using the relevant Libor rate it will vary depending on short term interest rates. It too is paid in arrears

Question 126

What is the longest interest rate swap you can do?

Answer 126

The major currencies have very liquid interest rate swap markets. Interest Rate Swaps can have maturities of between 2 and 20 years but it is possible to trade swaps that have maturities exceeding 50 years. If you intend to do long dated deals you may be asked to collateralise the transactions.

Question 127

What documentation is used for interest rate swaps?

Answer 127

The standard documentation is the International Securities Dealers Agreement, (ISDA master agreement). This is negotiated and signed by both parties. Confirmations then cover individual transactions and refer to the master agreement.

Question 128

What can interest rate swaps be used for?

Answer 128

Interest rate swaps can be used to manage interest rate risk, an example follows. A bond issuer can sell a fixed rate bond to an investor. The fixed funding cost of the borrower is then swapped to a floating rate using an IRS.

The investor obtains a fixed rate asset; this may suit interest rate expectations or match investment criteria. But many borrowers prefer to fund on a floating rate basis with the cost of borrowing expressed as a spread over or under Libor. By using a swap the issuer and investor can both get the interest basis they want.

The net floating rate cost of funds to the issuer, (Libor plus/minus), is dependent on the difference between the fixed cost of funding and the swap rate. If the fixed cost of funds is below the equivalent swap rate then the floating rate funding cost is Libor less a margin. If the fixed cost of funds is above the equivalent swap rate then the floating rate funding cost is Libor plus a margin.

Question 129

How are interest rate swaps used for trading?

Answer 129

If a trader anticipates interest rates to fall he could receive fixed interest on a swap and pay floating. If rates do fall the trader will now be receiving a higher interest rate than the market rate. The interest rate swap will have a positive value. But the trader has taken risk. This could have gone wrong, rates could have risen.

Interest rate swaps can also be used to trade the shape of the yield curve. This can include the difference between the 2 year swap rate and the 5 year rate, the 2 year rate and the 10 year rate, the 5 year rate and 10 year rate and the 10 year rate and the 30 year rate. If the trader thinks the relative yields between two parts of the curve are “out of line” he can receive fixed interest in one maturity and pay fixed in the other.

The nominal amounts of the two swaps are adjusted by the duration of the swaps. (This means the nominal amount of the near dated swap is greater than that of the far dated swap). This type of trade will benefit the trader if the slope of the yield curve moves as expected. A variation on this trade takes three points on the yield curve trading the spread differential between centre point and the outside two points.

Question 130

Can you lose money with interest rate swaps?

Answer 130

You can make and lose money with interest rate swaps. The current value of a swap is called the mark-to-market value. This is what the swap is worth using current market interest rates. For banks daily valuation is important. It provides profit and loss figures, shows whether hedging is effective and provides information for collateral support. And should you need to cancel or break a swap before it has matured the valuation will provide the basis of the cost you pay or the benefit you receive.

If it is in your favour you should receive a payment from your counterparty that equals the market value. If you are losing money on the swap you will have to pay the market value to your counterparty. This has a practical significance.

Let’s suppose you used a swap to convert floating rate funding to a fixed rate and that funding was linked to the purchase of an asset.

If you sell the asset and make money you will be left with the swap. If interest rates have fallen you will be losing money on the swap. You will have to pay your counterparty to cancel it. You need to include this cost in the realisation of your asset.

If you don’t like the cost of cancellation do not fall into the trap of leaving the interest rate swap in place hoping that it will improve. Otherwise, your hedge will become a speculative trade.

Question 131

Basis Rate Swap

Answer 131

A type of swap in which two parties swap variable interest rates based on different money markets. This is usually done to limit interest-rate risk that a company faces as a result of having differing lending and borrowing rates.

Question 132

Interest Rate Option

Answer 132

An investment tool whose payoff depends on the future level of interest rates. Interest rate options are both exchange traded and over-the-counter instruments.

Question 133

Hedge

Answer 133

An investment entered into to reduce or offset the risk of adverse price movements in a security by taking an offsetting position in another investment.

Question 134

Cash Flow Hedge

Answer 134

A hedge of the exposure to the variability of cash flow that
1. is attributable to a particular risk associated with a recognized asset or liability. Such as all or some future interest payments on variable rate debt or a highly probable forecast transaction and
2. could affect profit or loss

Question 135

Future Issuance Hedge

Answer 135

Enable issuers to secure current market rates for future fixed-rate funding.

Question 136

Treasury Lock

Answer 136

A hedging tool used to manage interest-rate risk by effectively securing the current day’s interest rates on federal government securities, to cover future expenses that will be financed by borrowing. Treasury locks are a type of customized derivative security that usually have a duration of one week to 12 months. They are cash settled, usually on a net basis, without the actual purchase of any Treasuries.

Question 137

Basis Risk

Answer 137

In finance is the risk associated with imperfect hedging. It arises because of the difference between the price of the asset to be hedged and the price of the asset serving as the hedge, or because of a mismatch between the expiration date of the hedge asset and the actual selling date of the asset (calendar basis risk), or—as in energy—due to the difference in the location of the asset to be hedged and the asset serving as the hedge (locational basis risk).

Question 137

Swap Termination Risk

Answer 137

If a swap terminates at its normal maturity date, there are no further cash flows and therefore the swap has a price of zero. If one of the counterparties decides to terminate the IRS before its term is up, the price of the swap at the time of the early termination will have to be exchanged. If interest rates have risen, the fixed counterparty makes payment to the floating, i.e. the floating counterparty is the winner. The reverse is true for falling interest rates. The amount exchanged is the net present value of the remaining netted cash flows. Should a losing counterparty choose to terminate an IRS by selling it to a third party, that counterparty will have to pay the third party the price, if any, of the swap on the date of sale.

Question 138

Interest Rate Swap Collateral

Answer 138

Held to reduce counterparty credit exposures, see link for more detail

Question 139

Counterparty Risk

Answer 139

A type (or sub-class) of credit risk and is the risk of default by the counterparty in many forms of derivative contracts. Link has example of counterparty risk in context of an interest rate swap.

Question 140

ISDA (International Swaps and Derivatives Association) Documentation

Answer 140

A standard agreement used in over-the-counter derivatives transactions. The ISDA Master Agreement, published by the International Swaps and Derivatives Association (ISDA), is a document that outlines the terms applied to a derivatives transaction between two parties. Once the two parties agree to the standard terms, they do not have to renegotiate each time a new transaction is entered into.

Question 141

The Dodd-Frank Act requires Swap Dealers to act in municipalities’ best interests when advising them on swaps. Please read more about the regulations at the link.

Question 142

Risks associated with products

Answer 142

The management of market and credit risk has become an important aspect of all financial markets, including the over the counter municipal market. Investors and dealers alike have placed a greater emphasis on risk management. By measuring how many bonds are owned and how long they have been in an investment portfolio, and by layering the credit risk, investors and their advisors can quantify the risks involved in holding different bonds

Question 143

Types of Risk

Answer 143

-Credit Risk (aka Default Risk)
-Counterparty Risk
-Interest Rate Risk
-Liquidity Risk (for variable debt)
-Market Access Risk
-Basis Risk
-Political Risk

Question 144

Credit Risk (aka Default Risk)

Answer 144

i. Risk that interest and/or principal on the securities will not be paid on time and in full
ii. By definition, a bond that carries less credit risk will have a better rating than a bond with more credit risk (1)
iii. If the credit standing of the issue improves, the bonds may be worth more in the market
iv. If the issuer’s credit standing weakens, the bonds may fall in value
v. Investors need to know who is responsible for repayment of the securities and the financial condition of that entity to assess the credit risk and decide whether to purchase the securities
vi. Investors can work with a broker to evaluate a bond’s default risk
vii. MSRB definition – the risk that a bond issuer will be unable to make interest or principal payments as they become due. Significant events that transpired after an investor purchased a bond, such as ratings downgrades or other material events which may reflect an increased likelihood of default on the bond, may cause potential investors to value the bond at a lower value than the price paid by the investor.

Question 145

Counterparty Risk

Answer 145

i. A type of credit risk - The risk to each party of a contract that the counterparty will not live up to its contractual obligations.
ii. Idea is often applied specifically to swap agreements in which no clearinghouse guarantees the performance of the contract
iii. Can be reduced by having an organization with extremely good credit act as an intermediary between the two parties

Question 146

Interest Rate Risk

Answer 146

i. The rate of most municipal bonds is paid at a fixed rate. The rate does not change over the life of the bond. If interest rates in the marketplace rise, the bond you own will be paying a lower yield relative to the yield offered by newly issued bonds.
ii. Evaluating a Municipal Bond’s Interest Rate Risk (published by MSRB)
1. One of the principal risks facing municipal bond investors is interest rate risk, or the risk posed to a bond as a result of interest rate fluctuations. In general, the longer the maturity of a bond, the greater the risk. If a bond is sold prior to its maturity in any interest rate environment, whether rates are high or low, its price or market value will likely be affected by the prevailing interest rates at the time of the sale. When interest rates rise, investors attempting to sell a fixed rate bond may not receive the full par value. When interest rates fall, the same investors may receive more than the par value in a secondary market sale.
iii. MSRB definition – the risk posed to the owner of a bond as a result of interest rate fluctuations. When interest rates rise, bond prices tend to fall; conversely, when rates decline, bond prices tend to rise. Accordingly, if interest rates are higher at the time that an investor attempts to sell a municipal bond than they were when the investor initially purchased the bond, the price at which he or she will likely be able to sell the bond would be lower than the price at which the bond was originally purchased by the investor, all other factors unchange

Question 147

Liquidity Risk (for variable debt)

Answer 147

i. Risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss.
ii. Typically reflected in unusually wide bid-ask spreads or large price movements
1. Rule of thumb – the smaller the size of the security or its issuer, the larger the liquidity risk
iii. Issuers should have a plan that specifies their actions and backup provisions should one or more guarantors to the transaction fail to perform. This also applies to a government’s ability to renew its liquidity agreements during a difficult market. (2)
iv. MSRB description– the risk that there may not be a significant market for the purchase and sale of the bond. Liquidity refers to the likelihood of finding a willing buyer for a specific bond. The risk of not finding a buyer, or the liquidity risk, is dependent on a number of factors. For example, liquidity risk may generally be greater for lower-rated bonds, bonds that were part of a small issue, bonds that have recently had their credit ratings downgraded or bonds sold by an infrequent issuer, among other factors. More liquid bonds are typically those for which there is a large trading volume and a large number of dealers that routinely buy and sell such bonds. In general, greater liquidity enhances the market value of the bond. The converse is also true. The more illiquid a bond, the more likely the bond will have a lower price in the secondary market and there may be fewer bids for the bonds. Generally, the fewer the bids, the greater the price disparity between the bids and current market levels.

Question 148

Market Access Risk

Answer 148

i. The underlying price of a particular bond changes in response to market conditions. When interest rates fall, newly issued bonds will pay a lower yield than existing issues, which makes the older bonds more attractive. Investors who want the higher yield may be willing to pay a premium to get it. Likewise, if interest rates rise, newly issued bonds will pay a higher yield that existing issues. Investors who buy the older issues are likely to do so only if they get it at a discount. If you buy a bond and hold it until maturity, market risk is not a factor because your principal investment will be returned in full as maturity. Should you choose to sell prior to the maturity date, your gain or loss will be dictated by market conditions, and the appropriate tax consequences for capital gains or losses will apply. (3)
ii. The term given to potential price fluctuations in a bond that are caused by changes in the general level of municipal interest rates. If the level of these rates has changed since the bonds were bought, the resale value of those bonds will of course reflect that shift. Thus, if interest rates are currently higher than they were when the bonds were bought, the bonds may be worth less; conversely, if interest rates have declined, bond prices generally will have risen and the bonds may fall in value.

Question 149

Basis Risk

Answer 149

i. The risk that offsetting investments in a hedging strategy will not experience price changes in entirely opposite directions from each other. This imperfect correlation between the two investments creates the potential for excess gains or losses in hedging strategy, thus adding risk to the position. (4)
ii. Basis risk arises when the instrument used to hedge your exposure fails to act as predicted and most frequently occurs when using future contracts. Since a hedge involves two financial instruments, basis risk refers to the possibility that the second asset or financial contract, which is referred to as the basis, will fail to exhibit the expected behavior in response to the adverse movements in the price of the original investment. In some instances, basis risk may result in the hedge providing less protection than you had expected. In extreme cases, the hedge can do more harm than good and you may lose more money as a result of the hedge than you would have without it. Example

Question 150

Political Risk

Answer 150

i. Risk is tied to the civic climate in a state or local governmental unit, and may be reflected by tax-limitations referendums or voter rejection of bond issues. (1)
ii. A subset of credit risk as it assesses the issuer’s willingness to pay (1)
iii. If an investor’s goal is in-state tax exemption and voter referendums with negative implications for bonds have been passed in that state, that investor could be incurring more political risk than an investor with a portfolio of national names not concentrated in any one state

Question 151

Issuer Risk Management - Policies, Monitoring, Metrics

Answer 151

A debt management policy should be designed to fit the specific needs and policy goals of the city that’s adopting it. The policy may contain provisions about:
i. What types of projects will be financed with debt.
ii. The maximum amount of debt a city will issue and how maximum debt load will be measured (e.g., total dollar amount, debt per capita, debt as a percent of total market value, debt service as a percent of budget, etc.).
iii. Whether competitive sales are generally preferred, unless circumstances warrant otherwise.
iv. When existing debt should be refunded.
v. Managing a city’s rating, if any.
vi. Designating staff responsible for managing debt-related activities.
vii. How and when debt status reports will be provided to the governing body.
viii. Post-issuance compliance activities and requirements.
ix. Rules on the use of derivatives.
x. Use of variable rate or other non-traditional debt products.
xi. Use of third-party providers with respect to managing debt obligations (paying agents, etc.).
xii. Every city, regardless of size, should consider adopting and annually reviewing a debt management policy. Besides providing important guiding principles for staff and officials, doing so helps promote regular discussion of the city’s financial picture and future needs.