Chapter 14- Municipal Bond Basics Flashcards
Municipal Bonds are issued by…
State and local government entities (schools, towns, cities, counties, authorities and the state)
Three types: General obligation (GOs), Revenue, and Notes
General obligation (GOs) Bonds
AKA Full Faith and Credit Bonds
Backed by taxes and the taxing authority of the municipality
Issued for facilities that will benefit the public (schools, parks, city hall, etc)
Must first be put on a ballot and vote on by the public
Statutory debt limits
Revenue Bonds
Primarily backed by user charges (tolls bridges airport fees). can also be backed by lease payments, licensing fees (hunting fishing etc) and special taxes (ie. cigarettes, and liquor taxes)
Backed by protective covenant
There needs to be a flow of funds provision
No voter approval needed
Must have a feasibility study completed to determine self-stability
Not statutory debt limit
Municipal Notes
Short term maturities
Used for interim or temporary financing
Most common are TANs, RANs, TRANs, and BANs
Tax anticipation note
Revenue Anticipation note
Tax and revenue anticipation note
Bond Anticipation Note
General Obligation vs. Revenue bond risk level
GO bond is safer since they are backed by taxes and not users charges (both are safe investments GO is just safer)
Municipal Bonds are at most risk from
Legislative risk. If legislators removed tax exempt status of municipal bonds there would be a large impact
Benefits of Municipal Bonds
Interest is exempt from federal income taxes
Interest may be exempt from state and local taxes
Principal and interest payments are fixed
Wide rage of issuers and maturities
Geographic diversification
State and Local GO income
State is typically through sales taxes and income tax
Local is typically through property taxes
Real Estate has two values
Market and assessed values
taxed on assessed value on mills ($0.001)
Limited Tax Bonds
AKA Limited Tax General Obligation Bonds
GOs Bonds that put a statutory limit on the tax rate that may be levied
These bonds require voter approval like all GOs
GO Credit Analysis look at the following to consider a GO bond
Outstanding Debt
Per-Capita Debt
Debt to Value Ratio
Debt to Property Value Ratio
Character of Economy
Tax Collection Records
Property Valuation
Tax Rates
Unfunded Liabilities
Operation Deficits
Attitude of municipality towards debt
Population demographics
Budget Practices
Important when evaluating different municipality bonds
For obligation bonds - debt to value ratio is important
Budgetary practices are also important
for revenue bonds - debt servicing coverage is important
Feasibility studies, covenants and competing facilities are also important
Direct debt vs overlapping debt
Direct debt is debt for which the municipality is solely responsible
Overlapping debt is debt for which more than one municipality is responsible for. Always at the local level and always supported by taxes
Never have overlapping debt at the state level, only local level
Revenue Bonds have become increasingly popular in recent years because…
Does not require a vote
does not count towards constitutional or statutory limit on debt
not payable thru taxes and will not increase taxes at a later date and time
Double barrel bonds
When a bond is back by revenues as well as the full faith and credit of the municipality it is called a double barrel bond
safer then revenue bonds
Indenture aka
Bond indenture or Trust indenture
Describes the rights and duties of the municipality as well as the trustee
The trustee represents the bond holder
Includes the reserve fund needs and the rate schedule
prepared by the bond council not the underwriter or syndicate
Protective Covenants
Maintenance Covenants - Require the facility is kept in good working order
Debt Service / Rate - Requires the issuer to charge a fee that is sufficient to meet all financial requirements plus a margin of safety (10% or higher)
Insurance - Insurance must be maintained on the facility. this will be included with a catastrophic call covenant in case there is a major insurance claim and the project is condemned.
Financial report covenant
consulting covenant
Anti discrimination covenant
Additional Bond Covenant - Closed end means they can not issue additional bonds
Open end means they can issue additional bonds
Gross Revenue flow of funds order
Services bond principal and interest first
Then services maintenance of the facility
Not a good structure
Net revenue Pledge bond flow of funds
O- operations and maintainence fund
B - bond service account for pricipal and interest
D - Debt Service reserve or sinking fund
R - Reserve maintenance fund for Renewal and Replacement (irregular maintenance)
S - Surplus fund for excess revenues
OBs are DR.S
Credit Worthiness of a Revenue Bond
Purpose for which they are issued
competing facilities
coverage ratio
rate covenant
Funded (or Capitalized) Interest
Additional capital used from the issuance of the bond in order to pay interest t the bond holders during the construction of the facility before it is generating revenue to pay them itself
New Housing Authority bonds and Public Housing Authority bonds (PHAs) are the
bonds issued to local housing authority (low income of subsidized housing)
Interest and principal is paid from rents collected (primary revenue)
Backed by Public Housing administration, which is a department of HUD. This makes them the only muni bond backed by the US government
Safest form of revenue bond
Special Assessment Bonds
principal and interest is payable from an assessment on the benefitted property
Special Tax Bonds
Paid for from taxes paid from excise (luxury) taxes levied on purchases of certain products like alcohol and tobacco
A new tax was put on cigarettes to pay for the construction of a new cancer research hospital
Lease Rental
Lease Revenue
Leaseback Bonds
A municipality will form an authority to sell bonds and construct municipal faculties (Schools, court houses etc.) The authority then leases the facility back to the city/school district. The revenue from the bond is considered the lease not tax assessments
Industrial Development Bonds
The municipality approves the sale of bonds for a corporation to construct a facility.
The corporation is responsible for repaying the bond, not the municipality
Don’t to benefit some corporation when the municipality doesn’t want them to move out.
Very risky form of Municipal Bond
Moral Obligation Bond
Issued when a municipality is either in bankruptcy or in financial difficulties
If the authority can not pay then the state legislative appropriations would be needed for the municipality to pay the bond, but they could refuse to do so
This is the other very risky form of municipal bond
Build America Bonds (BABs)
Taxable Municipal Bonds
Used for infrastructure rebuilding
Can not be used to refinance debt
Subsidized interest payment. Either the federal government pays back 35% of the interest paid to the municipality or the bondholder takes a federal tax credit equal to 35% of the interest expenses
Expanded market to pension plans and foreign investors since they did not need the tax free benefit of municipal bonds
Zero Coupon municipal bonds…
May be issued for both GOs and revenue bonds
Are the most sensitive and volatile of all municipal bonds
Are exempt from federal tax (and possibly state tax) but must be reported annually
You determine if it is being sold at a discount or premium by comparing it’s current yield to its original yield
May be callable, if so it is typically at 102% of accreted value
Private Activity Bonds
Municipal bonds issued to finance private activities for the public good, such as waste management or water treatment facilities
Typically subject to taxation or AMT preference item tax
Reasons for refunding Municipal Bonds
- lower the interest costs
- to change the maturity or amortization
- the liberalize the bonds indenture provisions
Provisions of a pre-refunding
will be used to redeem bonds at their earliest call date
can only be done within 90 days of the call date
Sometimes referred to as a current refund
redemption price or call price can be more than the par value of the bond
Provisions for Advanced refunding
used with bonds that are not callable
New bond must remain outstanding for at least 90 days
Advance Refunding, why? yes or no
It is done to restructure debt issue
to remove restrictive covenants
to reduce interest costs
improve the quality rating of the original issue
NOT DONE to pay municipalities expenses
Earn profits on the spread from original bond interest rate and new bond interest rate
Municipal notes
Are a short term debt instruments used for temporary or interim financing
Types of municipal notes
Most common
TANs - Tax anticipation notes
RANs - Revenue anticipation note
TRANs - tax and revenue anticipation note
BANs - Bond anticipation Note
GANs- Grant anticipation Note
Less common
Construction Loan Notes
Demand Notes
Tax-exempt Commerical Papers, 270 days maximum (this is never used to refund outstanding bonds)
Some investment companies invest only in municipal bonds. They would be
Unit investment trusts or Bond funds
Municipal Bond Unit trusts charactieristics
AKA- Tax exempt units
Each trust is created by an indenture
can tender a certificate for payment at any time
As the bonds mature or are called the size of the trust is reduced
no portfolio manager
(regular bond funds will have an active manager and be open ended, UTIs do neither of these things)
Municipal Bond are always delivered with…
a legal opinion printed on the bond
The legal opinion on a municipal bond determines
the tax free status of the bond (most important)
That they are legally issued by the issuer
Prepare and examine original drafts by the issuer before they are formally adopted
Examine the bonds to see they are properly executed
Covers US treasury departments arbitrage regulations
DOES NOT pay for or review the printing of the bonds
Legal opinion on a municipal bond is written by
A reputable law firm hired by the ISSUER
Bond Counsel reviews what to determine legality of bond issue
The municipalities local statutes
Judicial opinion
The constitution of the state
Legislation and procedures of the state
DOES NOT need legislative approval for a bond issue
Municipal Bond Attorney can never
guarantee that principal and interest payments will be paid on time for a particular issue
Does not considering the re-offering bond yields when forming an opinion
Qualified vs. unqualified opinions
Qualified opinions are bad- means that the bond is conditional on some future event to incur tax exemptions
Non-qualified- is absolute and unconditional. Indicates the bond is legal, valid, binding and tax free
Serial Bound Charateristics
Bonds are issued all at the same time
Bonds have staggered maturity dates
There is typically a balloon payment at the end
Since they have different maturity dates they will have different yield to maturities. This difference is called the scale
Like a bowl of cereal. Pour in the cereal all at once. take bites as time passes, drink all the milk at the end
Term Bonds
Bond issues with the same maturity dates
called dollar bonds since they are quoted in dolllars instead on their yield
Sinking fund provisions are usually connected with term bonds
When average life of a bond is less then the maturity date then part of the issue was already called
When a partial call is made it is done randomly
Variable Rate demand bonds (auction rate demand bonds)
Bond with an interest rate that is reset (daily, weekly, monthly)
Also allow the bondholder to put the bonds back to the dealer when they are reset, for par plus accrued interest rates
Issued at par in $100,000 increments
Generally do not have reinvestment risk but still hold liquidity risk and default risk
Tender offer
When the issuer wants to retire bonds that are not callable
offers to buy back bonds from bond holders
Announces a price that they are willing to pay which will usually be a premium to the value of the bond
Bond Repayments
Can be done with either cash from the issue of a new bond
or
exchanged for new issue bond for each original bond
Bond Call features
allow redemption of the bond according to a fixed price schedule prior to the maturity date
Most revenue bonds are callable
Most GOs are not callable
Callable bonds will have a higher coupon becuase of the call feature
Prior notice of a call is required
When quoting a bond to an investor you always quote the worst possible yield
When bonds are trading at a premium…
yield to call will always is the worst case scenario
Repurchase agreements
Sold by a firm with the agreement to repurchase them at a set price on a set date
Usually short term
Parity bonds
When a new issue of bonds have an equal claim or rights as other bonds that were previously issued
MIG Ratings
Moody’s investment grade- these are used to evaluate and grade the quality of municipal notes
a MIG-1 rating is similar to a AAA rating on a bond
Different ways to diversify in bonds
Geographically
Maturity
Purpose
Security
Quality
Denominations is not considered a way to diversify
Effects of inflation on bonds
INflation causes INterest rates to INcrease, causing bond prices to go down
Risks in the municipal bond market
Interest rate risk
Inflationary (purchasing power) risk
Market risk
credit risk
reinvestment risk
regulation risk
political risk
Municipal Bond Insurance Companies
3 Companies- National Public Finance Guarantee Corp
Assurance Guaranty Municipal Corp
Build America Mutual Assurance Corp
Why have municipal bond insurance
Allows municipality to pay a lower interest rate on bond
Guarantees against default and guarantees the payment of principal and interest
Is not done to change credit rating and does not guarantee the issuer or bonds credit rating
Letter of credit
Is considered a credit enhancement
Bank commits to paying principal and interest if the issuer is unable to make their payments
