Chapter 07: Municipal Debt

Question 1

________ are exempt from the filing provisions of the Securities Act of 1933 and are exempt from state and federal registration requirements. However, ___________ are not exempt from anti-fraud provisions of any Securities Law

Answer 1

Municipal issues are exempt from the filing provisions of the Securities Act of 1933 and are exempt from state and federal registration requirements. However, municipal issues are not exempt from anti-fraud provisions of any Securities Law

Question 2

A __________ is a law passed by a state or local government which allows for the issuance of securities. These laws may be amended by legislative action. The ______ and Constitutional Powers may also limit the amount of debt that an issuer is able to incur. This restriction is referred to as a debt ceiling or the municipalities that debt limit.

Answer 2

A statutory power is a law passed by a state or local government which allows for the issuance of securities. These laws may be amended by legislative action. The statutory and Constitutional Powers may also limit the amount of debt that an issuer is able to incur. This restriction is referred to as a debt ceiling or the municipalities that debt limit.

Question 3

The most common source of tax revenue is from levies on _________ (ad valorem tax)

Answer 3

The most common source of tax revenue is from levies on real property (ad valorem tax)

Question 4

__________ (property tax) is determined based on the assessed value of property multiplied by the tax rate levied (expressed in terms of mills)

Answer 4

ad valorem tax (property tax) is determined based on the assessed value of property multiplied by the tax rate levied (expressed in terms of mills)

One mill is expressed a percentage of 0.1% or, if expressed as a decimal, it’s 0.001

Which equates, in terms of dollars, to a tax of $1 per $1,000 of assessed value

Question 5

Certain government entities, such as school districts, may have an imposed legal limit on the tax rate at which they may assess.

Bonds issued by these entities are called ______ general obligation bonds since the taxing power of the issuer is limited to a specific maximum rate.

Answer 5

Limited tax general obligation bonds.

Question 6

True or false. Any analysis into the nature of the issuer’s debt must review a municipalities debt trend

Answer 6

True.

This is a good indicator of the direction and which I municipality plans to spend/obtain funding.

Question 7

Estimating the revenues available to a general obligation Bond includes the communities full evaluation, the percentage of assessed value that’s taxable, and the tax (millage) rate

Answer 7

Example.

A community that has a full valuation of 250,000,000, a 40% basis of assessment, and a millage rate of 20 will produce $2,000,000 in property tax

$250,000,000 X 40% = $100,000,000

$100,000,000 X .02 = $2,000,000

(Remember, 1 mill = .001 or 0.1%)

Question 8

True or false. Revenue bonds may be issued when voter approval for General obligation bonds cannot be obtained.

Answer 8

True.

Also, revenue bonds may be issued to finance capital projects when statutory or constitutional debt limitations prevent a municipality from issuing General obligation bonds

Question 9

If 10% or more of the bond proceeds will be used to finance a project for a private entity (e.g. corporation or professional sports team) and if 10% or more of the bond proceeds will be secured by property used in the private entities business, the bonds are referred to as _____________

Answer 9

If 10% or more of the bond proceeds will be used to finance a project for a private entity (e.g. corporation or professional sports team) and if 10% or more of the bond proceeds will be secured by property used in the private entities business, the bonds are referred to as private activity bonds

Question 10

True or false. The interest earned on a private activity bond is taxable at the federal level unless the bond is deemed to be a qualified private activity bond

Answer 10

True

Although keep in mind if a bond is qualified, the interest is exempt from federal taxes, but subject to the AMT

Question 11

True or false. In certain cases, a municipality may not be able to issue bonds that are exempt from federal income tax

Answer 11

True. This may occur when the bonds are issued to finance projects that don’t provide a significant benefit to the General Public

Question 12

These bonds, also referred to as pre-refunded or defeased bonds, are outstanding debt obligations that have been collateralized by US government securities (Treasuries). These bonds will usually be paid off on their next available call date and carry High credit ratings

Answer 12

Advance-Refunded Bond’s

Question 13

What is the main difference between an Advance-Refunded Bond and a Escrowed-to-Maturity bond?

Answer 13

While both are secured by U.S. government securities, an escrowed-to-maturity bond does not have a call feature. Therefore will remain outstanding until their maturity.

Question 14

Every municipal issue must be issued with a __________.

Written by a recognized bond counsel that’s hired by the issuer to attest to thr validity and tax-exempt status of the bond issue.

Answer 14

Legal opinion

Question 15

Delivery of certificates without legal opinions will not constitute _____ delivery unless their identified as __ _____ at the time of the trade

Answer 15

Delivery of certificates without legal opinions will not constitute good delivery unless their identified as ex-legal at the time of the trade

Question 16

A _______ pledge indices that operating and maintenance expenses are deducted from the gross project revenues before the revenues are applied to debt service

Answer 16

Net revenue pledge

A “net revenue pledge” is a term commonly used in the context of municipal bonds and financing. It describes the commitment that a municipality makes to repay a certain type of bond (typically revenue bonds) with the net revenues from a specific project or source.

The term “net revenues” refers to the income that remains after all operating and maintenance expenses have been paid, but before any debt service or capital expenses are paid. This is different from gross revenues, which would be the total income generated, without any expenses deducted.

Here’s how it works:

Let’s say a city wants to build a toll bridge. To finance the construction, they issue revenue bonds with a net revenue pledge. The tolls collected from the bridge will be used to repay the bondholders. But before the bondholders are paid, all the expenses necessary to operate and maintain the bridge (like salaries for toll booth operators, maintenance and repair costs, etc.) are deducted. The remaining money (net revenues) is then used to repay the bondholders.

The net revenue pledge provides some degree of security to bondholders. Even though it doesn’t offer as much security as a gross revenue pledge (where bondholders would be paid before any expenses), it’s still more secure than bonds repaid out of the general fund, where there may be many competing needs for the money.

A net revenue pledge can also have certain implications for the credit rating of the bonds, which can impact their interest rate and marketability. Credit rating agencies will look at the expected net revenues and the stability of those revenues when assessing the creditworthiness of the bonds.

Question 17

A ________ pledge indicates that debt service is paid prior to operating and maintenance expenses being deducted

Answer 17

Gross revenue pledge

Question 18

This ratio measures the amount of available revenue compared to the amount of revenue needed to satisfy the debt service requirement.

Answer 18

Debt service coverage ratio

Question 19

The _____ is a contract between the issuer and the trustee that has been appointed to represent the bondholders interest.

Also known as the bond resolution or trust agreement

Answer 19

Indenture

Question 20

Another word for promises is ________

Some common “promises” include

Rate _____

Maintenance _____

Insurance _____

Financial reports and audits

Answer 20

Covenants

Question 21

Municipal Note - Ratings

Moodys

MIG 1 (VMIG 1): Superior credit
MIG 2 (VMIG 2): Strong credit
MIG 3 (VMIG 3): Acceptable credit
SG: Speculative credit quality

Stand & Poors

SP-1 +: very strong capacity
SP-1: strong capacity
SP-2: satisfactory capacity
SP-3: Speculative capacity

Answer 21

Note ratings!

Question 22

• are long-term debt instruments with variable interest rates that are periodically reset through a Dutch auction process.
• Investors submit bids specifying the number of securities they want to buy/sell and the lowest acceptable interest rate. Buy and sell orders are matched to determine the clearing rate. If demand is insufficient, the auction “fails,” and the rate reverts to a pre-defined maximum rate.
• Interest Rates: Set during auctions, typically every 7, 14, 28, or 35 days. The lowest rate at which all the securities can be sold at par determines the new interest rate, known as the clearing rate

Answer 22

Auctions Rate Securities

Question 23

• interest is adjusted at specified intervals (daily, weekly, monthly) and, in many cases, their adjustment allows the owner to sell or put the security back to the issuer or a 3rd party on the date that a new rate is established.
• long-term security with short-term trading features
• have an interest rate that’s reset by the dealer at a rate that allows the security to be sold at par value

Answer 23

Variable Rate Demand Obligations (VRDOs)

Question 24

This type of plan:

• allows contributions to be made with after-tax dollars, but earnings grow tax-deferred.
• may be front-loaded with an initial gift
• no residency requirement
• donor is not permitted to choose the individual securities to own; instead the donor chooses among the investment options that are stipulated in the plan.
• the donor may change the selected investment option no more than twice every 12 months (based on calendar year)

Answer 24

529 plans

Question 25

This type of plan:

• are Municipal fund Securities that can be purchased to help support individuals with disabilities without jeopardizing their disability payments received from social security, medicaid, or private insurance
• the maximum contribution is $16,000 per year and
• front-loading is not permitted

Answer 25

529 Able Plans

Question 26

The interest earned on bonds that are issued by a territory or possession of the U.S. are not subject to federal, state, and local income taxes.

These securities are referred to as ___________.

Answer 26

triple-tax-exempt bonds

Question 27

True or False. Corporate bonds are subject to both federal and state tax

Answer 27

True

Question 28

How are U.S. Government Bond’s taxed?

Answer 28

U.S. government bonds are subject to federal but not state tax

Question 29

Calculating a bond’s net yield is especially important when an investor is considering the possibility of buying a taxable corporate bond and wants to know what she will able to keep after taxes are paid.

How can she calculate this net yield?

Answer 29

Taxable yield X (1 - tax bracket)

Question 30

Calculate Tax Equivalent Yield

Answer 30

Municipal yield / (1 - tax bracket)

Question 31

are short-term investment funds specifically designed for local governments, such as cities, counties, school districts, and other public entities. These pools enable local governments to pool their funds together to achieve greater economies of scale, diversification, and professional management of their investment portfolios.

• Not open to the public

Answer 31

Local Government Investment Pools (LGIPs)

Question 32

Bonds that are initially issued at a deep discount are classified by the IRS as ____________ (OID) securities.

• the discount on an OID must be accreted.
• Therefore, each year a portion of the discount is treated as interest for tax purposes and is added to the bondholder’s cost basis.

Answer 32

Original Issue Discount

Question 33

If an exam question references a zero-coupon municipal bond, it should be considered an OID. Therefore, the discount is treated in the same manner as previously described.

Answer 33

Note

Question 34

True or False. If a municipal bond is purchased at a discount in the secondary market (Secondary Market Discount, SMD) and held to maturity, there will be a taxable gain at maturity.

• the gain is reported as ordinary income

Answer 34

True

Question 35

True or False. It’s the adjusted (accreted) basis, NOT the original purchase price, that’s used to calculate the capital gain or loss on any subsequent sale.

Answer 35

True

Question 36

If a bond is purchased at a premium (above par), the premium amount must be _ each year.

Essentially, ____ is the process used to reduce the bond’s premium over the remainder of its life

Answer 36

Amortized/Amortization.

For example, a municipal bond was purchased in the secondary market for $1,200 with 10 years to maturity. The bond’s value will be amortized downward by 2 points ($20) each year (20 points divided by the bond’s remaining 10-year life)

Question 37

Municipal bonds are traded _________ and typically quoted (bid or offered) on a yield basis.

Answer 37

Over-the-Counter (OTC)

Question 38

is a quotation that a dealer is committed to honor, usually for a set period.

Answer 38

Out Firm

In summary, “out firm” in relation to municipal bonds typically refers to the commitment of a broker-dealer or underwriter to purchase and resell a specified amount of bonds at a predetermined price, taking on the risk of being unable to sell the bonds at that price.

Question 39

an order to buy or sell a stock that must be executed in its entirety, or not executed at all.

Answer 39

All or None (AON)

However, unlike FOK orders, AON orders are not required to be filled immediately.

Question 40

an order to buy or sell a stock that must be executed immediately in its entirety; otherwise, the entire order will be canceled.

Answer 40

Fill or Kill

Question 41

________ is simultaneously selling one bond and purchasing another.

• may be done to change the coupon, maturity, quality or rating, and for tax purposes.

Answer 41

A bond swap

Question 42

Long-term security that’s marketed as a short-term investment.

• interest rate is adjusted at specified intervals (daily, weekly, monthly)
• allows the owner to sell or put the security back to the issuer or a third party on the date the new rate is established

Answer 42

Variable rate demand obligations (VRDO)

Question 43

An individual’s home has a resale value of $500,000 and an assessed value of $200,000. If the tax rate is 10 mills, the property tax is:

Answer 43



Property tax is typically assessed based on the assessed value of a property, not its resale value. A mill is a tax per dollar of assessed value, and 1 mill is equal to $1 in tax per $1,000 in assessed value.

If the tax rate is 10 mills and the assessed value is $200,000, we can calculate the property tax as follows:

1. First, convert the assessed value to thousands of dollars: $200,000 / $1,000 = 200.
2. Then multiply this by the tax rate in mills: 200 * 10 = $2,000.

So, the property tax for this home would be $2,000.

Question 44

An individual’s home has a resale value of $500,000 and an assessed value of $200,000. If the tax rate is 10 mills, the property tax is:

Answer 44

Property tax is computed by multiplying the assessed value by the millage rate. A mill equals 0.001 or $1 per $1,000 assessed value. The tax is $2,000 ($200,000 x .001 x 10 mills).

Question 45

The MSRB regulates the yield that must be disclosed on a client’s confirmation. The yield disclosed is the lower of the yield to maturity or yield to call. In other words, the yield to worst.

Answer 45

NOTE

Question 46

_ are issued by local municipal governments to build factories or other commercial properties. The plant or property is leased by the municipality to a corporation. The interest on the bonds is paid from the lease rental payments made by the corporation. The credit rating of the bond is based on the credit rating of the corporation and not on an analysis of the credit rating of the municipal government issuing the bonds.

Answer 46

industrial development revenue bonds

Question 47

All of the following information is found in a municipal revenue bond resolution, EXCEPT:

A Restrictions on the sale of additional bonds
B Rate covenants
C Sinking-fund provisions
D The yields to maturity of the bonds

Answer 47

The indenture or resolution is basically the contract between the issuer and the bondholder. It will specify the rights of the bondholders and the provisions to protect the bondholders’ interest. One of the provisions included is a rate covenant in which the issuer pledges to charge rates that are sufficient to cover expenses and debt service. An additional bonds test is included that sets requirements that must be met before additional bonds can be issued. The method of funding and the operation of the sinking fund (used to retire some bonds prior to maturity) are also included. Another important provision is flow of funds, which states how the income generated by the project will be used.

Question 48

___________ are issued by small municipalities and, to qualify, a municipality may only issue up to $10 million annually. This is done to encourage commercial banks to invest in locally issued municipal securities. Commercial banks that purchase this type of security are permitted to deduct 80% of the interest cost that’s paid to depositors on the funds being used to purchase the bonds.

Answer 48

bank-qualified municipal bonds

Question 49

• Long-term debt with short-term trading features
• Lower yield, but greater liquidity than an auction
  rate security
• Interest rate is reset to current short-term rate
  periodically (e.g., weekly or monthly)
• Investor may put bond to issuer at reset

Answer 49

Variable Rate Demand Obligation
(VRDO)

• Suitable for conservative investors seeking
  income
• Unsuitable for investors seeking growth

Question 50

• Long-term investment with short-term features
• Interest rates/dividends are reset at frequent
  intervals through an auction

Answer 50

Auction Rate Security (ARS)

• Suitable for investors in high tax brackets who
  are investing for short-term needs
• Unsuitable for investors seeking long-term
  investments or those who are in low tax
  bracket

Question 51

• Safe and liquid short-term municipal debt
  (typically a money market instrument)
• Pays federally tax-exempt interest
• Offers a low yield
• Examples include: RAN, TAN, BAN, GAN

Answer 51

Municipal Note

Question 52

another term for a zero-coupon municipal bond

Answer 52

Original Issue Discount Bonds

Question 53

True or False.

A secondary market discount (SMD) bond that is held to maturity, will incur a taxable gain. This gain is reported as ordinary income.

Answer 53

True

Question 54

True or False.

In the case of an SMD bond, the accreted amount is treated as ordinary income and is taxable.

Answer 54

True

At maturity, the difference between the purchase price and par value is reported as ordinary income and is subject to federal taxation.
If a SMD bond is sold prior to maturity, the adjusted cost basis (which reflects accretion) is used to calculate gains or losses.

Question 55

is a quotation that a dealer is committed to honor, usually for a set period.

Answer 55

Out firm

the firm providing the quote may also establish a specific recall period. For example, Dealer A offers bonds to Dealer B on a firm basis for one hour, with a five-minute recall. In this case, Dealer A cannot offer the bonds to any entity but Dealer B without giving Dealer B the opportunity to take the bonds (In this case Dealer B would have 5 mins to take the bonds if recalled).

Question 56

If a firm doesn’t intend to buy or sell the securities based on the given quote, it must identify the quote as:

Answer 56

Subject, Nominal, or Workout

Question 57

Banks that invest in these bonds are permitted to deduct 80% of the carrying cost (interest expense) they incur when borrowing funds to buy these municipal bonds.

• in addition the interest income on the bonds is tax-free
• to issue these bonds, a municipality must anticipate that it will not issue more than $10 million in bonds during a calendar year

Answer 57

Bank-Qualifed (BQ) issues

One limitation is that bank-qualified issues may not be private activity bonds.

Question 58

Occasionally, firms pariticipate together in joint accounts for the purpose of selling municipal securities in an arrangement that’s referred to as a

Answer 58

Secondary Market Trading Account

Participants in joint accounts are prohibited from distributing or publishing different quotations for the same security. As with any new issue, they may be an order period and a takedown (member’s discount)