Chapter 2 Study Notes Flashcards
Municipal Issues Securities Act of 33
Municipal issues are exempt from the filing provisions of the Securities Act of 1933 and are therefore not registered with the SEC. However, municipal securities are not exempt from the anti-fraud provisions of the Act.
General Obligation (GO) Bonds
A general obligation bond is secured by the full faith, credit, and taxing power of the issuer. Only issuers that possess the ability to levy and collect taxes may issue general obligation bonds. Essentially, state or local governments are able to issue general obligation bonds based on statutory or constitutional powers.
Statutory Power
A statutory power is a law that’s passed by a state or local government which allows for the sale of the security. These laws can be amended by legislative action.
Constitutional Powers
Constitutional powers to issue general obligation bonds are derived from the state constitution—a law or statute is not required to be passed first. These statutory and constitutional powers can also limit the amount of debt an issuer is able to incur.
State general obligation bonds are usually secured by
income, sales, gasoline, excise, and other taxes that are collected on the state level.
Local general obligation bonds are usually secured by
For local jurisdictions, such as counties and cities, the most common taxing power is on property. An ad valorem tax (property tax) on the assessed value of real estate is the source of funds the local government uses to support its expenses and debt (GO bonds). School taxes are also charged at the local level.
mills.
As stated, property tax is based on the assessed value of property and the tax rate levied. The tax rate is expressed in terms of mills. One mill equals 0.1% of the assessed value, which equates to a tax of $1 per thousand dollars of assessed value. If expressed as a decimal, one mill equals .001.
GO Bond
Sources of funding
In addition to the different taxes, non-tax revenue such as parking fees, park and recreational expenses, and licensing fees can be used to pay the debt service on GO bonds.
limited tax general obligation bonds
Certain governmental entities, such as school districts, have a legal limit on the tax rate that they can levy. Bonds that are issued by these entities are referred to as limited tax general obligation bonds.
Unlimited tax bonds
Unlimited tax bonds are issued by government units that have no legal limitation on their power to tax.
When evaluating the risk of default for a general obligation bond, analysts will look at factors such as:
* The overall economic health of the community including changes in property values, its largest employers, average income, and demographic factors * The tax burden and source of payments * The budgetary structure and financial condition of the issuer * Existing debt using such measures as debt per capita and overlapping debt (described later)
Analyzing General Obligation Bonds Demographics
The population comprising the issuing municipality is an important indicator of a bond’s quality. Since many general obligation bonds are dependent on property tax revenues, a growing population is a sign of economic strength, whereas a declining population may signal a deterioration in the tax base, and therefore a weak economy. (Although a city may lose population to its suburbs, it may still retain its economic strength as a place of employment.)
Analyzing General Obligation Bonds Geography
Geography (where a bond is issued) plays an important role in analyzing GO bonds. If an area of the country (e.g., the industrial northeast) is experiencing negative population trends, that is a factor that might cause concern for the agency that’s providing the rating of a bond
Analyzing General Obligation Bonds Nature of the Issuer’s Debt
Examining the fiscal responsibility of the issuer’s past attitudes towards debt will be an indicator of the issuer’s present, and possibly future, ability to engage in fiscally sound behavior. Important indicators are whether the issuer has maintained a balanced budget over the last five years and how well the issuer has maintained fund reserves.
Analyzing General Obligation Bonds debt trend
If a community uses debt to support the growth of its suburbs (by building roads and schools needed to support that growth), debt is not necessarily bad. Conversely, issuing debt to finance budget deficits or to increase spending in a weak local economy might be an indication of unwise fiscal policy.
Analyzing General Obligation Bonds schedule of debt repayment.
Another aspect in the analysis of the debt is the schedule of debt repayment. A serial bond issue (where maturities are staggered) will provide greater flexibility to meet debt requirements than a term issue (one maturity date), because serial maturities can be organized to coincide with expected revenues.
Analyzing General Obligation Bonds Future financing
Issuers that borrow now to finance school improvements or new water systems for expected increases in the future, might be better off than the municipality that waits until it’s too late to support an over-burdened infrastructure.
Analyzing General Obligation Bonds Fiscal Responsibility
The soundness of the budget process is critical because it shows how well the particular governmental entity is managing its fiscal affairs. Fiscal responsibility, such as balancing the budget, creating rainy-day funds for use in business cycle downturns when fewer tax receipts are collected, a string of budget surpluses over five years, and reducing expenditures by monitoring the conditions on which services are provided, are issues to consider when analyzing GO bonds.
Analyzing General Obligation Bonds Financial Condition
A strong financial condition depends on sound budgetary practices. How well public officials manage in times of economic and financial stress is particularly important to the credit quality of an issuer. A sound financial condition means that the governmental entity is able to meet all of its obligations to creditors, employees, taxpayers, suppliers, and others, as they come due. Measuring the financial resources that are necessary to make payments determines the financial condition.
Analyzing General Obligation Bonds Unfunded Pension Liabilities
Another factor to examine is the municipality’s pension fund. The existence of unfunded pension liabilities (the money available is less than the amount that’s required to pay projected pensions) will have a negative impact on the quality of the issuer’s debt.
Analyzing General Obligation Bonds Tax Issues
A community’s tax limitations must be examined in addition to budget considerations. Attempts to limit a municipality’s taxing power will positively influence general obligation bonds, as projected revenues will service the already-issued debt; fiscal responsibility is imposed and the creditworthiness of the issuer is enhanced.
Analyzing General Obligation Bonds Tax Red Flags
Since most general obligation issues are secured by property taxes, the tax collection record of the community is an essential component of quality analysis. A poor collection record might be a red flag indicating an inefficient local government which results in bonds with low credit ratings. Another red flag or negative trend that impacts an issuer’s credit is whether property taxes were increasing in the face of a declining population, if there was an increasing tax burden on the community in comparison to other regions, or if general obligation debt was increasing and property values remained stagnant.
Analyzing General Obligation Bonds litigation
If a community is involved in a lawsuit, any liability that a municipality is obligated to pay will place a large financial burden on the community. This litigation might negatively affect the community’s ability to pay the debt service on outstanding bonds and will be a relevant factor to consider when analyzing the issue.
Analyzing General Obligation Bonds real estate valuation
Tracking trends in real estate valuation provides a good indication of a community’s health. Analysts concentrate more on the market value of real estate rather than the assessed value. Estimating the revenues available to a general obligation bond involves the community’s full evaluation, percentage of assessed value that’s taxable, and the tax rate (millage rate).
The Debt Statement Components
* Direct Debt * Net Direct Debt: * Overlapping Debt: * Total Bonded Debt:
Direct Debt
All the debt (bonds and notes) issued by the municipality.
Net Direct Debt:
The direct debt (all issues) minus any self-supporting debt, such as revenue issues and note issues. In general, the net direct debt is only the general obligation debt (bonds supported by taxes).
Overlapping Debt:
Debt of a political entity, such as a county or school district, where its tax base overlaps the tax base of another political entity, such as a city or town within a county or school district.
Total Bonded Debt:
The sum of both the long- and short-term debt of a municipality, plus its applicable share of overlapping debt.
coterminous
When examining the debt of a city, if a city and school district lie within the same boundaries, they are considered to be coterminous and the school district’s debt must be shown as overlapping debt.
ratio of annual debt service to tax and other income
An analyst could also use the ratio of annual debt service to tax and other income to assess the quality of a GO issue. A high ratio indicates a decreasing margin of safety to repay principal and interest. If the debt service increases and tax and other income remain stagnant or decreases, there are fewer funds available to pay the debt service.
Revenue Bonds
Revenue bonds are issued for either projects or enterprise financing in which a bond issuer pledges to bondholders the revenues that are generated by the financed project.
Issuers of revenue bonds
an be authorized political entities, such as state or local governments, or an authority (such as the Port Authority of New York and New Jersey), or a commission that’s created to issue bonds and build and operate a project.
Revenue vs. GO Bonds Issuance
Revenue bonds can be issued when voter approval for general obligation bonds cannot be obtained. Revenue bonds can also be used to finance capital projects when statutory or constitutional debt limitations prevent a municipality from issuing general obligation bonds.
Types of Revenue Bonds
* Housing Revenue Bonds * Utility Revenue Bonds *Health Care Revenue Bonds * Transportation Bonds * Industrial Development Revenue Bonds (IDB) and Pollution Control Revenue (PCR) Bonds * Special Tax Bonds *Special Assessment Bonds * Moral Obligation Bonds * Education Bonds * Lease Rental Bonds * Certificates of Participation (COPs) * Taxable Municipal Bonds * Build America Bonds (BABs) * Double-Barreled * Advance Refunded Municipal Bonds * Escrowed-to-Maturity Bonds * parity Bonds
A Tax Credit Bond
A Tax Credit Bond allows the bondholder to receive a credit against their federal income tax in lieu of an interest payment
Direct Pay Bonds
Direct Pay Bonds were issued by municipalities to raise capital for all the traditional purposes except for refundings, private activity bonds, and 501(c)(3) borrowers. The Treasury will reimburse 35% of the interest paid on the bonds to the issuer, which helps to defray the costs of borrowing.
Build America Bonds (BABs) Issuer Filing
Despite the fact that Build America Bonds are taxable, they were issued by municipal governments and subject to MSRB rules. Broker-dealers that were involved in the underwriting of these bonds were required to provide official statements (MSRB Rule G-32) and all sales activities had to be supervised by a Municipal Securities Principal.
501(c)(3) Organization Revenue Bonds
Under IRS guidelines, a 501(c)(3) organization is a not-for-profit entity such as an educational, charitable, or religious entity. The beneficiary is a 501(c)(3) organization such as a not-for-profit Cornell University. It’s important to remember that the payments and credit strength of these bonds are based on the 501(c)(3) borrower , not the issuer.
Housing Revenue Bonds
These bonds are issued by state or local housing finance agencies to help fund single family or multifamily housing, typically for low or moderate income families. In some cases, the proceeds of the bond offering are loaned to real estate developers to construct property. In other situations, the money raised through the offering is used to support the mortgage markets.
Utility Revenue Bonds
These bonds are used to finance gas, water and sewer, and electric power systems that are owned by a governmental unit. The bonds are normally backed by the user fees being charged to customers. When assessing the credit risk, environmental factors and the growth rate of the area served by the utility are important.
Health Care Revenue Bonds
These bonds are used for the construction of non-profit hospitals and health care facilities. The bonds typically pay their debt service out of gross revenue (i.e. revenues received will be used for debt service prior to deductions for any costs or expenses). In some cases, the existence of nearby competing facilities will influence the quality of the bonds.
Transportation Bonds
These bonds are used to finance projects such as bridges, tunnels, toll roads, airports, and transit systems. The user fees (e.g., tolls) are used to pay the debt service on the bonds. When analyzing bridge, tunnel, and turnpike bonds, the investigation must include the availability of fuel and the existence of competing non-toll facilities. In addition, the analysis of airport revenue bonds must investigate the level of tourism in an area, fuel costs, and competing airports
Industrial Development Revenue Bonds (IDB) and Pollution Control Revenue (PCR) Bonds
These bonds are issued by a municipality and are secured by a lease agreement with a corporation. The bonds are issued to build a facility for a private company. The credit risk on these types of bonds is based on the corporation’s ability to make lease payments since the municipality doesn’t back the bonds.
Special Tax Bonds
These bonds are payable only from the proceeds of a special tax. An example of a special tax bond includes a highway bond that’s payable from a gasoline tax.
Special Assessment Bonds
These bonds are backed by charges which are imposed against the properties that receive specific benefits Ultimately, the higher the value of the property, the greater the benefit and the greater the assessment for the property owner.
Moral Obligation Bonds
These bonds are first secured by the revenues of a project; however, if revenues are not sufficient to pay debt service requirements, the state (or state agency) is morally obligated (but not required) to provide the necessary funds. These bonds need legislative approval by the state government since the state government is agreeing to make up the difference of any needed funds.
Education Bonds
These bonds are secured by the repayment of loans by students, money contained in the fund that’s established by the bond’s indenture, and insurance payments that are made by the state or federal government.
Lease Rental Bonds
These bonds involve one municipal entity leasing a facility from another.
Certificates of Participation (COPs)
A Certificate of Participation (COP) is a type of lease financing agreement and is typically issued in the form of a tax-exempt or municipal revenue bond. Traditionally, COPs have been used as a method of monetizing existing surplus real estate. This financing technique provides long-term funding through a lease that doesn’t legally constitute a loan, thereby eliminating the need for a public referendum or vote.
Taxable Municipal Bonds
In some situations, municipality may not be able to issue bonds that are exempt from federal income tax. This may occur if the use of the proceeds doesn’t meet federal tax law requirements. Some examples include the proceeds being used to build a sports facility, certain types of housing, and borrowing funds to replenish a municipality’s unfunded pension liabilities. These bonds will have higher yields and may be suitable for taxable investors, such as pension funds and foreign investors
Build America Bonds (BABs)
Build America Bonds (BABs) are municipal bonds that were issued under the American Recovery and Reinvestment Act of 2009 (ARRA). Although the BAB program officially ended in 2010, a person should still be aware of their fundamental characteristics. BABs were designed to assist municipal issuers in raising funds for certain infrastructure projects; they were issued for capital expenditures, not for working capital. The interest on these bonds is taxable, but the Treasury offers a tax incentive to either the issuer or the bondholder depending on whether the bond is a tax credit bond or a direct pay bond.
Double-Barreled
These bonds are backed by a specific revenue source (other than property taxes) as well as the full faith and credit of an issuer that has taxing powers. Normally, a combination of tax dollars and revenue dollars from the project being constructed will be used to pay the debt service on the bonds. Essentially, a double-barreled bond is a municipal security that’s paid from the revenues of a project and is also a general (binding) obligation of a municipal government.
Advance Refunded Municipal Bonds
These bonds, also referred to as prerefunded or defeased bonds, are outstanding obligations that have been collateralized by U.S. government securities. These bonds are usually paid off on their next call date
Escrowed-to-Maturity Bonds
Escrowed-to-maturity municipal bonds are secured in the same manner as refunded bonds, but they don’t have a call feature. For that reason, these bonds remain outstanding until they mature.
Parity Bonds
These bonds exist when two or more revenue bond issues are backed by the same revenue pledge.
debt service coverage ratio
This ratio is one of the most important factors used when analyzing a revenue issue. The ratio of net revenue (gross revenue minus operating and maintenance expenses) to debt service Gross Revenue minus Expenses =net revenue Net revenue over Debt service is the ratio
The indenture
The indenture is a contract between the borrower (the issuer) and the lender (the trustee, which represents the bondholders’ interests). The indenture includes a variety of provisions that establish the issuer’s responsibilities and the bondholders’ rights. Since the indenture describes the legal protections that are afforded to bondholders, it’s essential to analyze some of the provisions (e.g., the flow of funds and the various covenants).
Rate Covenant
The issuer pledges to maintain rates at a level sufficient to meet operation and maintenance costs, debt service, and certain reserve funds.
Maintenance Covenant
The issuer pledges to maintain the project in good working order
Insurance Covenant
The issuer pledges to carry insurance on the property
Financial Reports and Audits Covenant
An accounting firm will be retained to do an outside audit and the issuer pledges to maintain proper records. This avoids the possibility of the misuse of funds.
closed-end indenture
If there’s a closed-end indenture, no additional bonds which have an equal claim on the pledged revenues may be issued against the same security.
open end indenture,
If there’s an open-end indenture, additional bonds may be issued in the future for expansion of the project. Typically, before additional bonds can be issued, the project must meet certain earnings tests.
Non-Discrimination Covenant
The issuing body pledges not to grant special rates to any person/group
Flow of Funds
Most revenue bonds have a series of funds (or accounts) which provide for the security of the bonds as the funds are used to pay for operations and debt service and to establish reserves. Found in the bond’s indenture, the flow of funds describes the priority for disbursing the revenues generated by the facility. To accomplish this, the indenture will establish accounts into which monies will be deposited. Revenues generated by the project fill each of the funds to a prescribed level and then flow to the next fund.
Revenue Fund
The account where all receipts and income (gross revenues) are deposited and recorded
Operation and Maintenance Fund
A prorated amount is deposited to meet costs of operating and maintaining the project. Occasionally, there are enough funds deposited to set up a reserve.
Debt Service (Bond Service) Fund
Amounts are deposited that will be sufficient to pay semiannual interest and maturing principal.
Debt Service Reserve Fund
Money is apportioned here after annual debt service is ensured. These funds are tapped only if the debt service fund itself is insufficient to meet annual payments.
Reserve Maintenance Fund
Money is allocated to this fund to meet unexpected maintenance expenses.
Replacement and Renewal Fund
Based on the engineer’s reports, funds are deposited to meet new equipment and repair costs.
Sinking Fund
Money is accumulated to retire bonds prior to maturity. If there’s a mandatory sinking fund provision in the indenture, this fund will receive money prior to the replacement fund. An issue with a mandatory sinking fund will retire a portion of the issue prior to its stated maturity. Since the entire issue will not reach maturity, the issue will have an average life that’s less than the stated maturity.
Surplus Fund
Excess money will be placed in this fund and can be used in emergencies.
Construction Fund
Money is allocated here for the use of future construction
gross revenue issue.
If gross revenues are pledged to pay debt service (where debt service is paid first, before the operation and maintenance fund), it’s known as a gross revenue issue.
net revenue issue.
If net revenues (gross revenues less operating and maintenance expenses) are pledged toward paying debt service, the bond is known as a net revenue
Ratings
Investment Grade
Ratings
Speculative Grade
Letters of Credit
Letters of Credit (LOCs) are used in the municipal bond market to enhance the credit of a bond issue. There might be a perceived weakness in the issuer’s ability to meet its debt obligations, so a bank will issue a letter of credit, substituting the bank’s ability to pay interest and principal for the issuer’s ability. The letter then serves two purposes; it enhances both the credit and liquidity of the issue.
Advance Refunded
Another credit enhancement for municipal bond issues is an issue that’s advance refunded. This occurs when the debt service on a bond is replaced before the original call date by issuing refunding bonds. (Refunding is discussed in more detail at the end of this chapter.)
Insured
There are a number of insurance companies or groups that currently insure new issues of municipal bonds. When a policy is in effect, the insurer agrees to pay all interest and principal if, for any reason, the issuer fails to pay these costs. The issuer will pay a fee to the insurer, but the cost is offset by the issuer’s ability to pay a lower coupon.
Moody’s and Standard & Poor’s will usually assign a higher rating to an issue that’s insured.
Guaranteed Investment Contract (GIC)
A Guaranteed Investment Contract allows municipal issuers to invest the proceeds of bond sales at a guaranteed rate of return for a specified period of time with a guarantee of principal and interest earnings. The purpose is to reduce market risk, investment risk, and provide a higher return than an investment in Treasuries. (In some cases, the return can be more than 30 basis points higher.)
Municipal Notes
Municipal notes are short-term issues that are normally used to assist in financing a project. They may also be issued to help a municipality manage its cash flow. Municipal notes are interest-bearing securities that pay interest at maturity.
Tax anticipation notes (TANs)
are issued to finance current municipal operations in anticipation of future tax receipts from property taxes. They are usually general obligation securities
Revenue anticipation notes (RANs)
are issued for the same purpose as TANs except that the anticipated revenues are typically federal or state subsidies. They are also usually general obligation securities.
Tax and revenue anticipation notes
TRANs) are created when TANs and RANs are issued together.
Bond anticipation notes
BANs) are issued to obtain financing for projects that will eventually be financed through the sale of long-term bonds.
Grant anticipation notes
(GANs) are issued in expectation of receiving funds (grants) from the federal government.
Construction Loan Notes (CLNs)
are issued by municipalities to provide funds for construction of a project that will eventually be funded by a bond issue.
tax-exempt commercial paper
Investors can also purchase other tax-free money-market instruments such as tax-exempt commercial paper and tax free money-market funds. Tax-exempt commercial paper has a maximum maturity of 270 days and is normally backed by a bank line of credit.
Auction Rate Securities
Auction rate securities have a variable interest or dividend rate that’s set periodically through a single price or “Dutch Auction” process. Auction rate securities are long-term securities that are marketed as short-term investments. They are generally issued by municipalities, corporations, student loan organizations, and closed-end funds as either bonds or preferred stock.
Auction Rate Securities
reset time frames
The interest or dividend rate is reset at established intervals, typically 7, 28 or 35 days, based on an auction in which investors who already hold the security indicate their interest in continuing to hold, or selling it while investors who wish to acquire the security indicate their interest at rates that they specify to broker-dealers who have been appointed to participate in auction.
Auction Rate Securities
Hold Order:
A holder may indicate to the auction dealer the amount of the security they wish to continue to hold regardless of the clearing rate that’s set by the auction. This type of order may be referred to as a “roll” order. If a holder of securities doesn’t place an order, the auction procedures generally provide that the holder will be deemed to have elected to continue to hold the securities regardless of the clearing rate.
Auction Rate Securities
Bid
A prospective holder/owner may indicate to the auction dealer that they wish to acquire a specified amount of the security, at or above a desired interest or dividend rate. A current holder may indicate their desire to continue to hold only if the rate is set at or above a specified rate. If the clearing rate sets below the interest or dividend rate that the holder or prospective holder specifies in their bid, the holder will be required to sell the securities subject to their bid, and the prospective buyer will not acquire the securities. Auction dealers refer to bids by prospective holders as “buy” orders and bids by holders as “roll-at-rate” orders.
Auction Rate Securities
Sell Order:
If a holder desires to sell a specified amount of the security in the auction without regard to the clearing rate that’s set in the auction, they place a “sell” order with the auction dealer.
exposed for sale”
Auction dealers use the term “exposed for sale” to refer to the total amount of securities that’s the subject of sell orders and roll-at-rate orders. Based on the submitted bids, the auction agent will set the next interest rate as the lowest rate to match supply and demand.
Auction Rate Securities
After the deadline for submission of orders,
the auction agent assembles all the orders from lowest to highest bid and determines the clearing rate. The clearing rate is the lowest rate bid sufficient to cover all the securities exposed for sale. If, however, the quantity of bids is insufficient to meet the quantity that’s exposed for sale, the auction is deemed to have failed. In this situation, the holders would continue to hold the securities and the interest rate would be set to the maximum rate allowed in the program documents. This rate is normally higher than the rate that would have cleared a successful auction.
Auction Rate Securities
Disclosure
These securities are usually sold as an alternative to other short-term money-market instruments. An RR must disclose to a client that if the auction fails the client may not have immediate access to their funds. The RR also has a duty to disclose to clients any material facts relating to the specific features of the auction rate securities and the customer’s need for liquid investments when recommending this type of product.
Variable Rate Demand Obligations (VRDOs
Another type of long-term security which is marketed as a short-term investment is a VRDO. A variable rate demand obligation (VRDO) will adjust its interest rate at specified intervals (daily, weekly, monthly) and, in many cases, allows the owner to sell or put the security back to the issuer or a third party on the date that a new rate is established. The investor will receive the par value plus accrued interest.
VRDO vs. Auction Rate Securities
It’s important to understand the difference between a VRDO and auction rate municipal securities. Although they are both long-term securities with short-term trading features only VRDOs have a put feature that permits the holder to sell the securities back to the issuer or third party. Auction rate securities (ARS) don’t have this feature and if the auction fails the investor may not have immediate access to their funds. In addition, ARS use an auction process to reset the interest rate on the securities whereas the reset interest rate on a VRDO is set by the dealer at a rate that allows the security to be sold at par value.
Ratings for Municipal Notes
Moodies
The first three ratings are considered Moody’s Investment Grade (MIG) ratings, with the fourth considered a speculative grade. VRDOs receive ratings based on a variation of the MIG scale—the Variable Municipal Investment Grade (VMIG) system.
MIG 1 (VMIG 1): Superior credit quality
MIG 2 (VMIG 2): Strong credit quality MIG 3 (VMIG 3): Acceptable credit quality SG: Speculative grade credit quality
Ratings for Municipal Notes
Standards and Poors
Standard and Poor’s has the following four rating categories for municipal notes:
SP-1+: Very strong capacity to pay principal and interest
SP-1: Strong capacity to pay principal and interest
SP-2: Satisfactory capacity to pay principal and interest
SP-3: Speculative capacity to pay principal and interest
