Chapter 3- Municipal Securities 30-40 questions Flashcards
Municipal Bonds
Securities issued either by state or local government or by US teritiories, authorities and special districts
Purpose of public works and construction projects
Second in safety of principal only to Us gov
Generally pay lower interest due to tax adv.
Should take into account when evaluating against a corporation
Municipal bond taxation
Interest is Not generally taxed by the federal government (origin from Doctrine of Reciprocal Immunity which states level of gov can tax only interest of own issues)
US territories are not taxed at any level
Capital gains are still taxed, may not be subject to tax if municipal is in state
Buying low and selling high results in capital gains
If living in a different state then the bond may be taxed
Issues of Municipals
Territorial possessions of the US
State Government
Legally constituted tax authorities (counties, agencies etc)
Maturity Structures of Municipals
Maturity ranges from less than a year to more than 30
3 different types of maturity:
1. Term Maturity- All matures at single date, quoted by price, called dollar bond
- Serial Maturity- Mature on different dates to a predetermined schedule. Quoted based on yield to maturity. Most common
- Balloon Maturity- Pay partial amount, but largest portion is paid off at maturity. Type of serial maturity
General Obligation Bonds
Municipal bonds issued for capital improvements that benefit entire community
Paid by taxes collected by municipal issuer such as property tax (ad valorem), license fees
Known as full faith and credit issues
Municipalities may have debt limits to protect taxpayers
Voter approval is required if wanting to go over limit
Property taxes are usually limited to a certain percentage and expressed in mills
One Mill equals $1 per 1000 or .001
Limited tax GO- secured by specific tax, more risk associated
Overlapping debt (coterminous debt)- several different municipal authorities taxing same person. Only occurs with property tax
Double Barreled Bonds- Revenue bond that also has the backing of taxation
Revenue Bonds
Used to finance municipal facility that generates sufficient income
Additional Bonds test may be issued before a subsequent issue with an equal Lien can be completed
Feasibility study on economic feasibility and need is issued before project is taken on
Interest and principal paid from: Utilities, housing, transportation, education, health, industrial and sports
Not backed by taxes
A trust indenture (referred to on face) protects bondholders by making sure the facility is in compliance… usually issued but not required
Common bond covenants
Rate covenant- promise to maintain rates sufficient to pay expenses and debt services
Maintenance- maintain equip and facility
Insurance covenant
Additional Bonds test- all debt after is subordinated unless needed for completion
Sinking fund
Catastrophe clause
Flow of funds/ priority of disbursing funds
Industrial Development Revenue Bonds
Issued to construct facilities or purchase equipment that is later leased to a corporation
Carries corporation debt rating
Payment of the issue is ultimately the responsibility of the corporation
Tax Reform Act of 1986 causes most of these to be taxed under the alternative minimum tax but not to those not filling under ATM
Lease rental bonds
Issued to finance office construction for itself or its state or its community
Example: building a school which is paid back by tuition
Basically a lease back agreement (make to lease)
Certificate of Participation
Form of lease revenue bond that permits investors to participate in revenue from lease, installment or loan payments
On specific equipment or land of municipal
Certificate holders could technically foreclose on the asset
Special tax bonds
Secured by one or more designated tax outside of property (ad valorem) tax
Does not have to be directly related to projects purpose
Special Assessment Bonds
Issued to finance the construction of public improvements such as streets sidewalks sewers
Property tax only on those benefiting
New housing authority bond
Sometimes called Public Housing Authority bonds or Section 8 bonds
Funds used to improve low income housing backed by US gov
Most secure of all municipal bonds
Backed by rental income of the houses
Not a double barreled because it’s second revenue source is US gov
Moral Obligation Bonds
State, local or agency issued bond
State legislature can appropriate funds to make payments, but not established by law
Revenue Bonds only
Issuer Default
Bondholders have right to sue if a GO bond goes into default
Moral Obligation Bonds would have to receive a legislative apportionment
Municipal Anticipation Notes
Issued for municipality that expects other revenue soon
Ones that aren’t exactly how they seem:
1. Bond anticipation notes- interim financing that will turn into long term funding
- Variable rate demand notes- fluctuating interest rate with a put options
Variable Rate Municipals
Offers interest tied to another specified interest rate
Price remains relatively stable throughout life
Usually reset to Market every 6 months
Auction Rate Securities
Tied to short term interest rates
Long term maturities of 20 to 30 years
Rate is determined by a Dutch auction at short term intervals at 7, 28, or 35 days
Typically issued by hospitals, utilities, nonprofit housing, university
Failed auctions are hazard as no demand may be found and may effect rating
State and Local Government Securities Series
US treasury securities directly issued to municipal issuers only in connection with pre refunding
Immediately invests in state or local gov securities
Directly issued by US Government
Build America Bonds
Taxable obligations but generally tax credits are given in lieu
Assist in reducing costs to issuing municipalities and to stimulate economy
Two types:
1. Tax Credit BABs- fed income tax credit equal to 35% of interest paid on bond during year, may be carried forward
- Direct Payment BABs- Provide municipal issuer with payment of 35% of interest
Currently not instated
Bond Contract
Collection of legal documents that includes a bond resolution, applicable law, and other legal docs pertaining to the issue or issuer
Bond Resolution
Municipality authorizes issue and sale of securities through this
Most include the indenture to increase marketability
Not required by law
Serves as a contract between issuer and trustee
Flow of funds statement is normally included and establishes the priority of payments from a facilities revenues
Official statement
Prospectus for a municipal
Includes a feasibility statement and any material information needed to be known
Must be given to investor before settlement date
May follow a preliminary official statement
Bond Counsel
An attorney specializing in tax exempt bonds
Either issues their legal opinion as a:
Qualified opinion- may be a legal uncertainty
Or
Unqualified opinion- unconditional
Some smaller issuers may not obtain a legal opinion and are marked ex legal
Ex legal mark allows bond to be issued in good delivery
Legal opinion is in regards to both the legality and tax exempt status of the issue
Negotiated underwriting
Investment banker underwrites and helps establish interest rate and offering price
Can be either a public offering or private placement
Competitive Bidding
Municipality posts an invitation to bid
Investment bankers respond requesting info and then bid, with lowest net interest cost winning
An official notice of sale is usually published in The Bond Buyer and local newspapers
Official notice of sale includes all information needed to make a bid including the amount of good faith deposit required to submit the bid
Bonds rating and underwriter name are not included because they haven’t been determined
All bonds are issued in fully registered or Book entry form
The Bond Buyer
Published every business day and offers info on primary bond market
Shows 30 day visible supply (total dollar volume in next 30 days expected)
Small supply means interest rates likely to fall
Placement/acceptance ratio indexes- percentage of total dollar value of sold over offered for sale
Also includes
40 bond index- daily price index, 20yr mature, includes 40 GO and Revenue bonds
20 bond- weekly, 20yr GO, A of better
11 bond- 11 of 20 20bond, AA or better
revdex 25- 25 rev bonds, 30yr mature, A or better
Yields for Revdex higher due to more risk in rev bonds
Thomson Muni Market Monitor
Offers current news items pertaining to secondary municipal market and current offerings
Secondary market
Real Time Transaction Reporting System
Provides information generated from the National Securities Clearing Corp to the public within 15 minutes
New Issue Worksheet
Presented by the Bond Buyer
Shows all information used in the official notice of sale
Schedule of year by year maturities
Bond years are the number of 1k bonds being sold by number of years outstanding
1000 bonds 2 yrs maturity= 20,000 bond years
Bond Years
Years to Maturity x # of bonds
Used to calculate the average life of an issue
Total bond years / total bonds
Syndicate letter
Sent out to each underwriter two weeks before issue is awarded to be signed
Includes: level of participation Priority order of allocation Duration of syndicate Appointment of managers as agent Fees and breakdown of spread Other obligations
Not legally binding till submission of bid
Syndicate account types
Establishes the liability of each underwriter
2 types
Western account- Each underwriter is responsible for their own allocation
Eastern Account- Undivided, each underwriter is allocated a portion of the issue. Given a proportionate share of what is written
West is divided, east is united
If issues not sold, west is responsible for their share, east everyone takes their share
Writing the scale
Process by which a syndicate will establish the reoffering yield (price)
Must determine what yield is necessary to sell the bond and then adding the premium to get to the bid
Firm commitment
All competitive bids are submitted as firm commitments
No profit guaranteed
Will buy the whole issue no matter what
Two possible reasons to award an issue
Lowest Net Interest Cost or the lowest True interest cost
NIC- combines proceeds with total coupon interest
TIC- combines same principals but also factors in TVM
A deposit is usually put down during the bidding process, around 1-2% of par
Syndicate Account
Developed when the issue is awarded
Syndicate manager handles the books
All proceeds from the sale and expenses siphon out of the account
30 calendar day account
Spread
Difference between the bid and ask
In the case of a syndicate, the purchasing price and the reoffering price
Production refers to the total dollars earned from a municipal issue
Point
Management fees are referred to in points
1 point is equal to $10
Total Takedown
Portion of the spread remaining after subtracting management fee
Syndicate members can either realize their full takedown or give a partial amount to other sellers
The concession is the amount that a seller will make by selling the bond
Reallowance
Usually a syndicate will notify other buyers in the Bond Buyer
Typically, they are offered at a smaller discount typicall half the concession price
Size of each portion of the spread
Small to large
Managers fee
Additional takedown
Concession
Syndicate member would receive total spread of it is the manager and sells the bond
Order priority for Municipals
Must be defined according to the Municipal Security Board
Timeline Established:
- Order period- usually an hour the day after the awarded bid
- Of over-subscribed, order priority is followed. Explained on next card
Order types in order from top to bottom in priority
- Presale order- entered before a syndicate wins the bid. Takedown is split among participants in the order
- Group net order- Placed after the bid is awarded, split between participants
- Designated orders- institutional order, allocates takedown to certain members
- Member and member related orders
Highest priority given to orders that benefit most members
Orders are summarized and sent to each member by syndicate manager
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Municipal bond delivery
On a when-issued basis meaning, the bonds are authorized but not yet issued
Managing underwriter must register with a clearing agency, who is given notice of the coupon and settlement date
Syndicate then gives notice to buyers
Underwriters then send out final confirmations with the purchase price and settlement date
Difference between dated date and settlement date
Dated date is the day in which interest begins to accrue.
Investor must pay interest from dated date up to the settlement date
Criteria used to evaluate GOs or General Obligation Bonds
General Wealth of the community (because GOs are backed by tax revenues)
Quantitative (statistics) and Qualitative (community opinion) analysis
Debt limit and the city charter as they may restrict lending abilities
Municipality income from taxes and fines
Ad Valorem (Property) taxes- States/counties have right to seize land if tax not paid
The Official statement and the underlying financial statements-
look for possible future cash needs, and rating decreases
Also the debt statement, which sheds light on the debt structure (explained next)
Debt Structure
Total debt
- self supporting debt(revenue bs)
- sinking fund accumulations
= net direct debt or GOs and short term notes
+ Overlapping Debt (share of county, school, park, sanitary debts)
= net overall debt
If net, then no self support or sinking fund
Criteria used to evaluate revenue Bonds
Based on facilities potential to generate money to cover operating expenses, principal and interest expenses
Should consider the following: Economic Justification Competing facilities Sources of revenue Call provisions (the higher the premium the better) Flow of funds Debt service coverage
Net revenue pledge (typical flow of funds)
- Operations and Maintenance
- Debt service Account- Used to pay in year interest and principal maturing
- Debt service reserve fund- Can hold one year debt service
- Reserve maintenance fund- supplements general maintenance
- Renewal and replacement fund- reserve fund for major renewal or equipment replacements
- Surplus (sinking) fund
If operations and maintenance is not first, debt repayment is (gross revenue pledge)
Municipal Debt Ratios (more important to understand than calculate)
- Net debt to assessed value: debt per assessed property value, alternate uses estimated (preferred). 5% is reasonable
- Taxes per capita: tax income of city/person
- Debt per capita: city debt per person
- Debt trend: whether ratios are rising or falling
- Collection Ratio: Taxes collected / assessed
- Coverage Ratio: how many times revenue will cover debt service, 2:1 is acceptable
Outside factors effecting both Revenue and GO bonds
Interest Rate comparisons amongst similar bonds (smaller market due to uniqueness)
Municipal Bond Insurance- typically lowers interest yield but offers more safety
Bond Rating- S&P or Moody rating
Moody- MIG 1-4 is good, SG is speculative
S&P- SP-1 through 3
Fitch F-1-3
Quotations of Municipal bonds
Sold in the OTC market
Interest or solicitation by a municipal dealer would be considered a quotation request
Basis quote- Priced on a yield to maturity basis called a basis quote
Some revenue bonds are quoted on a % of par dollar basis and are called dollar bonds
Ex. 104 means 104% of par
Bona Fide Quotation
To be considered bona fide, a dealer must be prepared to sell at the price
The quote must reflect the dealers best judgement and have a reasonable relationship to the fair market value
May reflect firm inventory/expectation of market direction
Quotations are subject to prior sale or change in price
Four types of quotations
- Bona Fide
- Workable indication- bid price at which a dealer will purchase securities from another dealer. Able to be revised.
- Nominal (subject) quotation- Indicate a dealers estimate of a securities market value
- Out firm with recall quote- Good for an hour with a 5 minute recall period (if a firm receives an offer after another one, they can give a 5 minute period where the original buyer has to commit)
Secondary market joint or trading account
Formed by a group of investment bankers to purchase large blacks of bonds from institutions and resell them
Joint account can only issue one quote when reselling bonds
30 calendar days to settle
Report of sales of Municipals
MSRB rules prohibit false reports of trades
Municipal dealers report trades with other dealers to the National Securities Clearing Corp. Must include the names and accrued interest
Round lot for Municipals
100,000 in face
Broker’s Broker
Some only trade with banks and other municipal brokers
Do not disclose ID of customers
Do not maintain an inventory of bonds
Reciprocal dealings (antireciprocal rule)
Cannot solicit trades in Municipals from an investment company in return for sales by dealer of share or units in the investment company
MSRB Rules on Municipal trading
Suitability of client must be tested before a recommendation is made
Should not put Municipals in an IRA or 401k
Best suited for those who want income
Can open the account but not make recommendations if info not available
Cannot guarantee against loss, share in profits, or misuse funds
If a control relationship (the dealer has control in the issuer) additional disclosure is needed in the form of writing to the client usually on the confirmation.
Markups vs Commission
Commissions- When a dealer acts as an agent by buying trades for a customer it charges commission
Markup- When a dealer acts as a principal (buying and selling for its own inventory), it charges a markup when selling to customers and a mark down when buying from customers
Principal Transactions
Executed at a net price including the markup markdown
Factors in the trade include: Best judgement of FMV Expenses of transaction Dealer is entitled to a mark up or down (not disclosed) Total dollar amount Value of exchanged securities
The markup or markdown is not disclosed on the confirmation
Agency Transactions
Executed for a commission
Trading outside of the dealers holdings
Take into consideration: Security's available Expense of execution Value of services provided Amount of other compensation received
Commissions are disclosed to the customer
Confirmation disclosures
Must describe security, list fade date, settlement date, accrued interest, firm info, and whether acting as agent or principal
MSRB rule: When disclosing yield on a callable bond, must state the lower of YTM or YTC.
For discount bonds it is YTM, premium bonds it’s YTC
If there are a number of call dates on premium bonds, then use near term in whole call
Variable Rate Bonds, bonds in default, and bonds sold at par have no yield specified
Required info on confirmations
In agency Transactions, the other party and the amount of commission must be disclosed
The dated date of it affects interest calculation
Whether the securities are fully registered, registered to principal only, book entry form or in bearer form
Whether the security is called or pre refunded
Any special qualification or factor that might affect payment
Whether bond interest is taxable
Broker/dealer acting as an Financial Advisers to municipal securities issuers
Relationship exists when a muni dealer provides advisory or consulting services to an issuer with respect a new issue
Conflict of interest would arise if FA acts as both underwriter and FA and is banned by MSRB
Can still help prepare official statement, and buy from the underwriting for customers (customers must be informed)
Cannot use confidential info to solicit purchases or sales
Tax Reform Act of 1986
Restricted fed income tax exemption for municipal bonds to public purpose bonds
If more than 10% of proceeds go to private parties, it’s considered a private activity bond
Calculation for determining tax benefits of a municipal
Tax free yield/ (100%-tax rate) = yield required
To reverse
Yield of other X (100%-TR) = yield in tax free
Use the Yield to Maturity
Expenses related to the purchasing and holding of the Municipals are non deductible
Exception *- banks purchasing certain issues of GO bonds can deduct 80% of interest
Property taxes
Property taxes are not issued by states and therefore cannot be conterminous
To be double barreled, a bond must be backed by
2 different municipal revenue source
Dated date
No longer used after first interest payment is made
Contra broker
Not necessary as long as it is stated that the name is available upon request
Schools
Financed by GO bonds in general
Hospitals, airports and golf courses are usually financed by revenue Bonds
Moody’s investment Grade Rating are applied to
Municipal notes, not municipal bonds
Bond Placement Ratio
$ value of new issues sold divided by dollar value of the new issues offered
Callable municipal bonds
Call premiums tend to decrease over time
And
Call prices are stated as a percentage of the principal amount to be called
