Module 5 - Municipal Securities

Question 1

MUNICIPAL SECURITIES

Answer 1

MUNICIPAL SECURITIES, also known as MUNICIPALS and MUNIS, are state and local debt issues. Local issues may include those of cities, counties, or other local agencies and authorities. The proceeds from municipal securities are often directed toward financing specific public projects in the municipality or state for which the bond is issued. Such projects may include highways, environmental clean-up efforts, housing projects, or even sports stadiums.

Municipal securities offer a higher degree of security and safety to investors than do corporate bonds. Municipals also tend more to be held to maturity. They are not as susceptible to market fluctuations as stock, but their prices do fluctuate with changes in their risk characteristics or in interest rates.

Question 2

TYPES OF MUNICIPAL SECURITIES

Answer 2

Municipalities issue the following three basic types of securities (listed in order from least risky to most risky):
- Municipal notes
- General obligation bonds
- Revenue bonds
−Remember that all bonds are called FUNDED DEBT

MUNICIPAL NOTES are short-term securities issued in multiples of $1,000, although most are now issued to institutional investors (banks and insurance companies) in multiples of $1 million.

GENERAL OBLIGATION BONDS, or GO BONDS, are long-term debt securities backed by the taxing power of the entity issuing the bond. GO bonds are also issued in multiples of $1,000.

REVENUE BONDS are long-term debt securities issued to generate funds to build public projects. Revenue bonds are backed only by the revenues earned from the facility that was built with the proceeds gained from the bond issue. Revenue bonds are issued in multiples of $1,000.

Question 3

MUNICIPAL NOTES

Answer 3

When a local agency is in need of short-term financing, it can issue short-term notes, called MUNICIPAL NOTES. Municipal notes are the least risky of municipal securities because their time to maturity is short. Thus, there is lower risk of the municipality defaulting on the interest and/or principal.

Question 4

Five different types of municipal notes can be issued, depending on the needs of the issuing entity. They are:

Answer 4

• Construction Loan Notes (CLNs) or Project Notes (PNs) — issued to start a housing project in a low-income area of a city. These can be known as either a CLN or a PN
• Tax Anticipation Notes (TANs) — issued in anticipation of incoming taxes
• Revenue Anticipation Notes (RANs) — issued in anticipation of revenues from a specific project
• Bond Anticipation Notes (BANs) — issued in anticipation of the proceeds from a bond issue
• Grant Anticipation Notes (GANs) — issued in anticipation of receiving money from a grant to the municipality

Question 5

Construction Loan Notes (CLNs)

Answer 5

CLNs, formerly called PNs, are issued for the purchase and construction of property for new, low-income housing projects. They are also issued for the renewal of existing projects or the building of urban housing. They are nothing more than a “construction loan” to get a housing project started. Although municipalities issue the project notes, they are actually backed by the U.S. government. This is because when the project is complete, the Public Housing Authority (PHA), a government agency, issues a PHA BOND, whose proceeds will be used to pay off the construction loan note/project note.
• CLNs are the safest of all municipal securities because they are paid from the proceeds of public housing authority bonds.
• CLNs can be issued for up to three years duration, and usually have very low interest rates due to being tax-free. They are short term, issued at a discount, with the appreciation tax-free.
• The rates for CLNs are the lowest rates for debt securities since they are short-term, tax-free, and backed by a U.S. government agency.

Question 6

TAX ANTICIPATION NOTES (TANs)

Answer 6

TAX ANTICIPATION NOTES (TANs) are issued by a local agency of a municipality to generate temporary money to finance current expenses until taxes are collected. Tax anticipation notes are issued with the understanding that the agency will receive tax revenue in the near future. School districts often use tax anticipation notes because their budgets usuall run from July 1 to June 30, yet they do not receive any tax money until the following December when tax payments are due. Interest payments received on tax anticipation notes are always exempt from federal income tax, and are usually exempt from local and state income tax as well.

Question 7

REVENUE ANTICIPATION NOTES (RANs)

Answer 7

REVENUE ANTICIPATION NOTES (RANs) are issued by municipalities anticipating the receipt of future revenues. These anticipated revenues are in the form of money that will be coming in from the use of a facility. The facility has not brought in sufficient revenues, but they are anticipated to increase in the near term. By issuing revenue anticipation notes, the municipality obtains money to continue operating the facility, wit the knowledge that much of their needed revenues will be received shortly from the users. Interest payments received on revenue anticipation notes are always exempt from federal income tax, and are usually exempt from local and state income tax as well

Question 8

BOND ANTICIPATION NOTES (BANs)

Answer 8

BOND ANTICIPATION NOTES (BANs) are issued by a municipality in anticipation of the issuance of a bond that has been passed for some project in the community. The issuance of these notes allow the project to get started while waiting for the receipt of the funds from the new bond issue.

Since the bonds to be issued are the only source of income to build the project, the bond anticipation notes are only as good as the municipality’s ability to issue and sell those bonds. Therefore, the bond anticipation note is considered the least secure of the municipal notes.

Interest payments received on a bond anticipation note are exempt from federal income tax and are usually exempt from state and local taxes in the state in which they are issued. Interest payments received on the bond that will be issued to pay the bond anticipation note are also exempt from federal income tax and are usually exempt from state and local taxes in the state in which they are issued.

Question 9

GRANT ANTICIPATION NOTES (GANs)

Answer 9

GRANT ANTICIPATION NOTES (GANs) are issued by a municipality for a project that is being funded by a grant. Usually, the grant is by the U.S. government or the state government, but it can also be by a private entity that bestows grants for projects that will benefit a community or other public service. When a grant has been bestowed on a city or county for a project, it requires the project to be finished, or at least in the finishing stages, before the money will be forthcoming. With the issuance of the GANs, the project can be built. When paid, the grant money then pays off the GAN, and the investors are paid their principal and interest.

Keep in mind that with TANs, RANs, BANs, and GANs, their interest payments are usually exempt from state and local taxes in the state in which they are issued. However, if they are purchased by investors outside of the state of issue, their interest payments are subject to state taxes like any other municipal security.

Question 10

MIG ratings measure the risk of an issuer defaulting on the payments of interest and principal for a municipal note, such as BAN, GAN, TAN, or RAN. CLNs or PNs are not rated since they are backed by the issuance of a government-housing bond. MIG stands for MOODY’S INVESTMENT GRADE. This is a system developed by Moody’s Rating Service for rating municipal notes. There are four ratings: MIG 1, MIG 2, MIG 3, MIG 4, with MIG 1 being the highest (best) rating and MIG 4 being the lowest (worst) rating.

Answer 10

Remember for Test

Question 11

GENERAL OBLIGATION BONDS

Answer 11

GENERAL OBLIGATION BONDS (GO Bonds) are municipal bonds that are backed by the “full faith and credit” of the issuer. Principal and interest payments are paid from the tax revenue generated by the issuing state or municipal entity.

GO bonds have a lower risk of default than do revenue bonds; therefore, they usually have lower yields and higher ratings than revenue bonds.

There is a limit on the tax rate a municipality is allowed to charge on assessed property. This limit is set either by voter referendum or by a statutory provision in the charter of the municipality. If the municipality wants to issue any debt (bonds) that will cause it to exceed this debt limit, it must first have a vote of the people.

Taxes imposed to raise money for GO bonds are called AD VALOREM TAXES. “Ad valorem” refers to the “at value” or “assessed value” of the real estate property upon which the tax rate is based.
Most cities and counties have both residential and commercial buildings, and the ad valorem taxes from these properties go to pay the debt service on the bonds.

Municipalities raise most of their revenues from property taxes. Property tax amounts are expressed in MILS PER THOUSAND, where one mil is equal to 1/10th of one cent (or .001 dollars). The ad valorem tax is computed either on the assessed valuation or on the total valuation, depending on the rules of the taxing entity.

Municipalities can also issue a LIMITED TAX BOND that is only backed by a special tax, not the full taxing power of the issuer.

Question 12

REVENUE BONDS

Answer 12

REVENUE BONDS are issued to obtain funds to construct bridges, tunnels, streets and infrastructure, rapid transit, harbors, and parks. Principal and interest for revenue bonds are paid from fees imposed on the users of the facility for which the bond was issued. Property taxes are not used to pay for revenue bonds, with the exception of special assessment bonds, so a vote of the citizens is not required. In fact, there is no effect on the municipality, its revenues, its taxes and tax limits, or any other concern regarding the municipality. A revenue bond stands on its own. A feasibility study is conducted before a revenue bond is issued to determine whether a project is necessary and whether it can pay for itself. In a specific municipality, a revenue bond is more risky than a GO bond and thus has a higher coupon because the only source of payments for principal and interest is the revenues of the facility.

Question 13

Revenue bonds are classified according to the method by which revenue is generated to pay off them off. The classifications are:

Answer 13

• User-fee revenue bonds
• Tolls and fees bonds
• Special tax bonds
• Special assessment bonds
• Industrial development bonds (also known as IDBs and IDR bonds, for industrial development revenue bonds)
• Public housing authority bonds (PHA bonds)
• Double-barreled bonds
• Moral obligation bonds

Fees charged for water and sewer usage pay off USER FEE REVENUE BONDS.

Fees charged for the usage of highways, toll bridges, airports, and other projects pay off TOLLS AND FEES BONDS.

Question 14

SPECIAL TAX BONDS

Answer 14

SPECIAL TAX BONDS are issued for specific purposes, such as building or renewing roads or rapid transit systems. Principal and interest is paid from the revenues generated from a special tax placed on certain items. For example, a highway bond may be paid by a gasoline tax.

Question 15

SPECIAL ASSESSMENT BONDS

Answer 15

SPECIAL ASSESSMENT BONDS are issued to generate money either to purchase specific property or to construct facilities, such as infrastructure in new housing areas, for a specific group of users. Special assessments are imposed only on certain people in the area. Special assessment rates stay the same even if property taxes or interest rates increase. This is because the assessment is based on the original amount needed, not including any cost increases due to inflation.

Question 16

INDUSTRIAL DEVELOPMENT BONDS (IDBs) or INDUSTRIAL DEVELOPMENT REVENUE BONDS (IDRs)

Answer 16

INDUSTRIAL DEVELOPMENT BONDS (IDBs) or INDUSTRIAL DEVELOPMENT REVENUE BONDS (IDRs) are issued by a municipality for a corporation for financing construction of such projects as pollution control facilities, industrial parks, sports stadiums, airports, or educational facilities. The municipality issues the bond to investors as a municipal bond, tax-exempt, and sells the proceeds of the bond to the corporation (usually for $1). The corporation is responsible for paying the interest and the principal. The revenues to pay for the bonds come from the company’s revenues. These bonds are issued for private use, such as for equipment purchases or the construction of buildings, but not for land. The bond receives municipal status, regarding tax-free interest, because the bond is issued for the “best interest of the populace.”

In some cases, the corporation gets laws passed that allow the municipality to issue bonds with municipal status, but most often, the bonds are for stadiums, convention centers, and so forth, The municipality issues the bonds for the corporation, which make the payments. Since these bonds are an obligation of the corporation, they take on the ratings of the corporation and not the rating of the municipality under which the bonds are issued.

Question 17

PUBLIC HOUSING AUTHORITY BONDS (PHA bonds)

Answer 17

PUBLIC HOUSING AUTHORITY BONDS (PHA bonds) are issued by a U.S. government agency for state and local housing finance agencies, and regional redevelopment agencies to build low-income housing. The proceeds of the bonds are used for a variety of reasons, including:
• To pay off PNs/CLNs that have been issued for the construction or renovation of low-income housing projects
• To make loans directly to a developer for housing developments
• To make loans directly to moderate or low-income homebuyers
• To lend money directly to lending institutions for loans to homebuyers

PHA bonds are paid for by rent (or mortgage) payments made by the residents of the housing project built by the bond proceeds. However, if the residents are unable to make rent payments sufficient to make the bonds’ principal and interest payments, the federal government will make the principal and interest payments. Thus, although PHA bonds are issued by state and local housing agencies, the federal government backs them. The federal government guarantees PHA bonds to help encourage the building of low-income homes.

Question 18

DOUBLE-BARRELED BONDS

Answer 18

DOUBLE-BARRELED BONDS are issued to generate funds to pay for a specific facility. A double-barreled bond is both a revenue bond and a general obligation bond. The bond’s interest and principal payment is first paid by the revenues generated by the users of the facility, and if those revenues are insufficient, the bond is subsequently secured by property taxes. Accordingly, the bond is backed by an additional source of revenue, which usually includes the full taxing power of the municipality.

In many large cities, double-barreled bonds were issued to build football and/or baseball stadiums. These bonds were first backed by the revenues generated from the use of the stadium, and then backed by the taxes of the community, if such taxes were needed.

MORAL OBLIGATION BONDS are paid from revenues of a facility, which is built by money from the bonds. These bonds pay for facilities that are needed in a community, state, or other district. The revenues generated from the facilities are expected to be sufficient to make all bond interest and principal payments. If there are not enough revenues from the facility to pay the debt service, the local council (or state legislature) can make an annual appropriation to have the debt service covered. If the local taxing body does not have the money or does not consider the facility a necessity, the issue’s debt service would not be paid at that time.

Question 19

BUILD AMERICA BONDS BABS

Answer 19

Two types of BABs are available — the first version and the second version. Both versions have been oversubscribed at the offerings (more purchasers than bonds available).
• Since institutional investors are not limited to the amount they can purchase (as in most municipal bond offerings), the only way that an individual investor can get them is in the secondary market.
• The BABs are presently being issued with maturities of 30 years.

In the first BAB version, the government subsidizes 35% of the interest that the municipality pays for the bond issue.
• This lowers the cost of the bonds to the municipality, allowing for higher interest rates.
• The higher interest rates make this version more desirable for those purchasers who do not pay income tax, or who pay only a small amount of income tax, and want a long source of steady income.
• These investors are typically older people looking for income and institutional investors not necessarily looking for tax-free income, but wanting the highest yielding issues they can find with a long period to maturity.

Question 20

SERIES BONDS

Answer 20

SERIES BONDS are issued at different times, either at different dates within one year or different dates over a period of years. A series bond can have one common maturity, the term, or each series bond can ahve its own serial maturity period

Series bonds can be issued as serial bonds or as term bonds, or they can even be issued as serial bonds with a term bond at the end. Most municipalities have numerous issues outstanding, and each is considered a series bond since they were issued on different dates.

Question 21

SERIAL BONDS

Answer 21

SERIAL BONDS mature over a number of years and can be easily confused with SERIES BONDS. When a bond is issued so that parts of the bond MATURE in different years, the bond is called a serial bond. It can be a series bond, or it could be the only bond issued by that municipality. Most municipalities issue their bonds in serial form.
The various maturities in a serial bond issue have different prices, expressed not in dollar amounts, but in basis form. This means the price is given as a yield.

Either a BASIS BOOK or a software program is then used to change yields to dollars, or if dollars are given, change dollars to yields. Note: The test previously used questions right out of the basis book, but now only asks questions about the basis book itself. Therefore, simply remember it is used for this conversion.

It is also important to note that since a serial bond has an amount of principal mature each year, the interest cost to the issuer decreases each year.
Serial bonds are issued so the municipality has money coming in over a period of time, either from taxes or from revenues from a facility.

Question 22

TERM BONDS

Answer 22

TERM BONDS, issued by corporations and municipalities, all mature at one time. By having the whole issued bond come due on one date, corporations can either refund (refinance) the bond or they can anticipate having the money to pay it off. Municipalities, on the other hand, tend to issue term bonds only when they do not anticipate having funds available in the early years and but do anticipate having the funds by the time the issue matures. Since they do not have a large amount of funds in the early years, the municipality issues the bond as a term bond. If there would be ample funds in the early years, the municipality would prefer to issue the bond as a serial bond to reduce interest costs.

Question 23

REFUNDING THE BOND

Answer 23

Please note that REFUNDING THE BOND is when one bond is issued to pay off another bond, commonly referred to as refinancing.

• It is called refunding the bond because the municipality has funded the debt over again, or “refunded” its debt
• This is done only if the issuer can reduce its interest cost.

Question 24

PUT BONDS

Answer 24

For any of the previously mentioned notes or bonds the issuer can add a PUT FEATURE that is beneficial to the investor. (Note terms are normally too short to take advantage of a put feature.)

PUT BONDS can be redeemed prior to maturity without being called by the issuer. This is a good feature for investors when interest rates rise, because they can redeem the bonds and then reinvest the money in higher-interest bonds.
Issuers add the put feature to bonds so they can issue them with lower interest rates. There is a limited time period during which the investor can put the bond to the issuer.
• During this PUT PERIOD, the market price of the bonds is never below the PUT price, so the YIELD never exceeds the coupon

Question 25

TYPES OF BOND OWNERSHIP

Answer 25

In the past, municipal bonds have been purchased in any one of three forms of ownership. Within a few years, however, only one predominant form of ownership may be available — book-entry (much like how the U.S. government issues bonds). This is due to the high cost of lost and stolen bonds. However, be familiar with the three forms of ownership for municipal bonds for the exam:
• Bearer
• Fully registered
• Book-entry
All three forms of ownership for municipal bonds are issued in increments of $5,000, although the minimum denomination is $1,000.

Question 26

BEARER BONDS

Answer 26

BEARER BONDS (also known as COUPON BONDS) are owned by the person who holds (or bears) them. With bearer bonds, possession is 100% of the law. Owners of bearer bonds do not have their names registered on the books of the issuer. The holder of the bond is thus the owner. As of January 1, 1983, bearer bonds could no longer be issued. However, some are still in the marketplace, and the occasional question on bearer bonds may appear on your exam. The owner collects interest by cutting off the interest coupons and presenting them to a bank. The owner collects the principal by presenting the bond on or after the maturity date at one of the paying banks. Bearer bonds used to be issued in $1,000 or $5,000 increments. They were most commonly issued in $5,000 increments. If the exam asks for the minimum denomination for a bearer bond, the answer is $1,000.



Question 27

REGISTERED BONDS

Answer 27

With REGISTERED BONDS, the owner is registered with the issuer. All interest payments are sent to the person whose name is registered with the company.
Registered bonds are issued in denominations of $5,000 with increments of $5,000. They are most commonly issued in $5,000 denominations. However, if the test asks for the minimum denomination of registered bonds, the answer is $1,000.

Question 28

BOOK-ENTRY BONDS

Answer 28

BOOK-ENTRY BONDS are bonds whose ownership is registered in electronic form by the issuer or, more often, by the trustee on behalf of the issuer. In these cases, the issuer makes all principal and interest payments to the bondholders via the trustee. The actual owner of the bond never sees a certificate. Book-entry bonds are most commonly sold in denominations of $5,000 with increments of $5,000. However, the minimum denomination may be as high as $100,000 for some issues.


Example
The City of New York issues a $20 million bond. The city does so by issuing one $20-million certificate to a trustee. The underwriter then sells $20 million in bonds to a large number of investors. Once the entire $20 million is sold, the names of the investors are given to the trustee, who then distributes interest and principal on the bonds when due. When investors sell their bonds, the names of the new owners are sent to the trustee to replace the names of the old owners. The new owners now receive interest and principal when due.

The good part about book-entry bonds is that they can never be lost. The bad thing is that investors must keep their confirmation slip to show they have ownership. Some people dislike this form of ownership, because they feel that the broker/dealers may sell the bonds without informing them or that someone could electronically steal the bonds. Some investors simply prefer the feel of the certificate in their hands.

Since 1983, any newly issued bonds must be in fully registered or book- entry form only, with most using the book-entry form of ownership. The Municipal Securities Rulemaking Board (MSRB) rules have changed and now require that, “For good delivery, all bonds must state if delivery of the bond will be in book-entry form.” The type of delivery need not be given if the bonds are in bearer or registered form.

However, because of the number of bonds and the amount of money lost over time, soon only one method of ownership will be available: Book-entry. All U.S. government T-bills, T-bonds, and T-notes are already issued exclusively in book-entry form.

Question 29

THE INDENTURE

Answer 29

The INDENTURE, also called a trust indenture, is a large document outlining all of the requirements of the issuing municipality. Part of the indenture can be found in the official statement, but it is usually a separate document held by the trustee. The indenture outlines all the important features of the bond — maturity dates, interest rates, name of the trustee and trustee bank, and all protective covenants. It does not have the RE-OFFERING YIELDS. RE-OFFERING YIELDS are yields at which the bond is selling in the market, so re-offering cannot be guaranteed.

Question 30

PROTECTIVE COVENANTS

Answer 30

PROTECTIVE COVENANTS are agreements made between the issuer and the purchaser of a revenue bond. Protective covenants are set forth in the indenture. Protective covenants are basically promises made by the issuer to perform certain duties in connection with the bond. The most important protective covenants are:

• Rate covenants
• Insurance covenants
• Maintenance covenants
• Revenues pledge covenants

Question 31

A RATE COVENANT

Answer 31

A RATE COVENANT ensures that the issuer will keep rates high enough to meet operation and maintenance expenses as well as debt service and any other costs that the issuer may incur.

Question 32

An INSURANCE COVENANT

Answer 32

An INSURANCE COVENANT is a promise by the issuer to carry sufficient insurance on the facility to protect the bondholders against destruction or damage to the facility.

Question 33

A MAINTENANCE COVENANT

Answer 33

A MAINTENANCE COVENANT is a promise by the issuer to maintain the facility in good working order and to keep it in good repair so as to maintain revenues.

Question 34

A REVENUES PLEDGE COVENANT

Answer 34

A REVENUES PLEDGE COVENANT is a promise by the issuer on how the money received in revenues is to be paid. The items paid first and second are outlined in the flow of funds, and depend on the type of pledge. The types of pledges are:
• Gross revenues pledges
• Net revenues pledges
Any other monies left over after payments to debt service and maintenance may go to other needs. Money does not have to go to optional call funds or any other optional funds in the covenant.
Most revenue bond indentures allow for PERIODIC REVIEWS or audits of the project books by a consulting engineer or other qualified party.

Question 35

FLOW OF FUNDS

Answer 35

The FLOW OF FUNDS is a term that describes how (and for what purpose) the funds generated by a facility will be spent. The flow of funds is one of the most important bond provisions set forth in the indenture.

The REVENUE FUND is the fund into which all revenues must first be deposited at the time they are received by the issuer.

Depending on the type of pledge in the revenues pledge covenant found in the indenture, money from the revenue fund would go either to the operation and maintenance fund or the debt service fund. (Both funds are defined below.)
If the fund contains a NET REVENUES PLEDGE, payments made from the revenue fund must first be used to meet the ongoing expenses of the project. (These payments are made to the operation and maintenance fund.) Remaining funds will be used to pay debt service on the bond.

If the fund contains a GROSS REVENUES PLEDGE, payments made from the revenue fund must first be used to pay the principal and interest (debt service) on the bond. (These payments are made to the debt service fund.) Remaining funds will be used to pay operation and maintenance costs on the facility.

The OPERATION AND MAINTENANCE FUND is a fund that contains money to be spent only on the operation and maintenance of the facility.

Question 36

A SINKING FUND

Answer 36

A SINKING FUND is a fund that must be set up for term bonds only, and is money the issuer must regularly set aside for eventually redeeming its bonds, as specified in the indenture. This fund assures the bondholders that there will be sufficient dollars available at maturity.
• A sinking fund is set up by the issuer to deposit part of the income, either from taxes or revenues, in an ESCROW ACCOUNT. This money may not be used for anything except to pay for the principal of the issue when it comes due.
• Money must be set aside and deposited into this account every year. The money from the sinking fund must be invested in U.S. government securities for safety (not put into a bank). It is used as an investment to earn a return until the payment is due — whether through a partial call of the bonds, waiting until the bonds mature, or repurchasing the bonds in the open market.
• The money in the sinking fund is used by the municipality to buy its own bonds in the open market if they are at a discount, or to pay off bonds that are called. If part of the bond issue is called AND PAID by this sinking fund, it is known as a SINKING FUND CALL.
• Term bonds usually have a sinking fund since the whole bond comes due at one time and provides money for the issuer at that time.
• Serial bonds do not need a sinking fund since part of the issue comes due every year. However, a sinking fund is usually provided with a serial bond to put excess money in for possible calls as well as for the part of the issue that comes due each year.

Question 37

The DEBT SERVICE FUND

Answer 37

The DEBT SERVICE FUND is a fund that contains additional money to be spent only on the bond’s principal and interest payment (debt service) if, at a certain point, the revenues are temporarily not enough to make these payments.
If any money remains in the revenue fund after debt service and operation and maintenance costs have been paid, it is allocated to the funds listed below, in the following order:
• DEBT SERVICE RESERVE FUND: Serves as a reserve to pay debt service in future years.
• RESERVE MAINTENANCE FUND: Serves as a reserve to pay for unanticipated maintenance costs on the facility.
• RENEWAL AND REPLACEMENT FUND: Serves as a reserve to pay for the replacement of worn-out equipment and to make repairs over the life of the project.
• SURPLUS FUND: Can be used for any lawful purpose, including the redemption of bonds or the reduction of fee payments by users.

Question 38

FEASIBILITY STUDIES AND ENGINEERING REPORTS

Answer 38

Before a revenue bond may be issued, a research analyst is hired to perform a FEASIBILITY STUDY and engineers are hired to draw plans and produce ENGINEERING REPORTS for the project. The feasibility study and the engineering reports are usually requested to determine whether the project is actually needed and/or whether the needed revenue will be available. The engineering report is also issued to show that the facility will stand up to the elements of nature and is a structurally sound facility. A feasibility study and an engineering report are always required on a proposed facility that is being financed by a revenue bond.

Financial Reports and Outside Audits

Municipal issuers of revenue bonds are required to have annual audits performed on their books because financial reports are prepared from these records.

Question 39

LEGAL OPINION

Answer 39

Prior to a municipal bond being issued, a municipality must obtain a LEGAL OPINION from a BOND COUNSEL. A BOND COUNSEL is a lawyer who is knowledgeable in the laws of municipal bonds. The legal opinion by the bond counsel, in effect, states that the bond is a municipal bond as determined by existing local and tax laws and that the interest is exempt from federal and state (if applicable) taxes.
In making its opinion, the bond counsel:
• Researches the state and local laws to check into the
requirements for a bond to have tax-exempt status
• May assist in getting favorable legislation passed in the locality,
if necessary
• Supplies information to the underwriters for the official
statement

Question 40

BOND RATINGS AND RATING ORGANIZATIONS

Answer 40

Just as each consumer has a credit score measuring their creditworthiness, the creditworthiness of municipalities and the bonds they issue is also measured to provide investors with an indication of the issuer’s financial strength and ability to make principal and interest payments. BOND RATINGS are a measure of the chance of default of interest and principal by the issuer. The three major bond-rating organizations are:
• Standard and Poor (S&P)
• Moody’s
• Fitch Investor’s Service.
These agencies rate:
• General obligation bonds and some revenue bonds that are backed by property taxes

This means that the lower the chance of a municipality either missing an interest payment or not making a principal payment, the higher the rating. When a municipality misses interest payments on a bond, the ratings go down, usually to the DEFAULT RATING, which is D for S&P and C for Moody’s.
• If a bond is REFUNDED or PRE-REFUNDED (or ADVANCE-REFUNDED, explained more fully in Section 8.7), the ratings by both S&P and Moody’s go up to AAA and Aaa, respectively.

The ratings for each rating service are shown in the chart below. The more added to the letter, the higher the rating; for example, AA is better than A, and A1 is better than an A rating.

Both Moody’s and Standard & Poor only rate large offerings. Small offerings usually do not get rated because of the high cost of obtaining a rating. In addition, most revenue bonds do not get rated since the facility that the bond is issued for cannot guarantee the revenues will be sufficient for payment of interest and principal. Some revenue bonds, those backed by property taxes on only a few homes in an area, can be rated, but most are not

Question 41

These rating organizations use a number of factors when rating each issue, including any or all of the following:

Answer 41

• The amount of bonds the issuer has outstanding at the time of rating
• The amount of overlapping debt, if any
• The amount of debt of each taxpayer (per capita debt)
• The amount of population, its growth and character
• The method of generating income for payment
• The amount of property and its assessed valuation
• How well the municipality has collected taxes in the past

Question 42

White’s Tax-Exempt Bond Rating Service or White’s Ratings as it is known, is a rating agency that classifies municipal securities based on the market factors of the trading of the bonds. It does not use the credit conditions of the municipality itself, but rather how the public sees the municipality as an investment and how they receive new issues of that municipality in the market. A Baa- or BBB-rated bond by Moody’s or S & P’s for instance, might have an AA rating by White’s because the municipal issuer might be highly respected even if there is a lot of outstanding debt per capita.
In addition to ratings on municipal bonds that give investors an idea of how strong the bonds are, some municipal bonds are also classified as BANK QUALIFIED BONDS. Most of the time these bonds are rated BBB/Baa or higher, but the ability of the bonds to pay is not what makes the bonds BANK QUALIFIED.

A bank-qualified bond is a municipal bond purchased by a bank that allows the bank to deduct 80% of the carrying costs it paid to purchase and hold the bonds.

Carrying costs are the interest expenses incurred to purchase or carry an inventory of securities, including costs for purchasing municipal bonds. The tax code does not allow banks to deduct the interest costs for purchasing and holding municipal bonds, EXCEPT for bank qualified bonds. It is a special benefit so banks can have bonds available for their customers.

Answer 42

REMEMBER FOR TEST

Question 43

MARKETING MUNICIPAL SECURITIES

Answer 43

The MUNICIPAL SECURITIES RULEMAKING BOARD (MSRB) regulates the actions of underwriters, broker/dealers, and the people who sell municipal bonds. MSRB rules do not apply to issuers, they only apply to the people who sell the municipal securities. The voters have the say in the issuance of new municipal issues.
The two markets for municipal bonds are the market for new issues and the secondary market.

Question 44

THE PRIMARY MARKET — NEW ISSUES

Answer 44

Before a municipal issue can come to market, it must be advertised. With general obligation bonds, two advertisements are placed: A NOTICE OF SALE and a TOMBSTONE. With a revenue bond, only one advertisement, the tombstone, is used.
A NOTICE OF SALE is an advertisement by a municipality to prospective underwriters wherein the municipality requests that bids be submitted on the cost of underwriting a new issue. This type of advertisement is only used in connection with a competitive underwriting.

A TOMBSTONE ADVERTISEMENT is an advertisement by the underwriters to prospective buyers. Tombstone advertisements may only include very basic information regarding the new issue, including the following:
• The offering price
• The name of the issuer
• The dated date (i.e., the date that interest starts to accrue)
• The dates on which interest payments are made
• The offering scale, which shows the yield to maturity
• How to obtain an official statement
• The name of the underwriter
• The names of the members of the selling syndicate (and occasionally the selling group)

Tombstone advertisements may not include any inducements to the new issue. They are for informational purposes only. The names of the members of the selling syndicate (and selling group) appear either in order of participation amount or in an order that is otherwise determined by agreement.

Question 45

UNDERWRITING MUNICIPAL BONDS

Answer 45

The two methods of underwriting municipal securities and bringing them to market are:
• Competitive
• Negotiated

Competitive Underwriting

In a COMPETITIVE UNDERWRITING, the issuer advertises for underwriters to submit bids on the cost of underwriting the issue. The issuer chooses the underwriter that has offered the bid that allows the municipality to generate the highest possible amount of proceeds from the underwriting at the lowest possible interest cost. The various broker/dealer firms who wish to compete in the bid to underwrite submit their bids to the issuer after seeing the advertisement called the NOTICE OF SALE.

Negotiated Underwriting

In a NEGOTIATED UNDERWRITING, the issuer asks a broker/dealer with which the issuer has an established working relationship to submit a cost estimate for underwriting the issue. If the cost estimate is too high, the issuer tries to negotiate a lower cost with that broker/dealer. If a lower cost cannot be negotiated, the issuer calls another underwriter. Both negotiated and competitive underwritings are covered in the Underwriting Module.

All municipal bonds, when newly issued, come with an OFFICIAL STATEMENT. The OFFICIAL STATEMENT discloses all the important aspects of the bond, the issuer, and the protections for the buyer. This also includes any call features. The official statement is discussed in greater detail in the Underwriting Module.


Question 46

THE SECONDARY MARKET

Answer 46

All trading of municipal securities in the SECONDARY MARKET (the market consisting of trading between two investors) is done in the over-the-counter market. Bonds that are sold by an investor are considered sold in the secondary market.
Any issue being sold for the second time or more is considered a SECONDARY ISSUE, so the market where it is sold is called the secondary market. Remember, bonds that are sold directly from the issuer are primary issues sold in the primary market.
BOND TRADERS are broker/dealers who buy the bonds from investors wanting to sell and then resell them to investors wanting to buy.
The three major secondary market-trading venues are:
• Interdealer trading
• The retail business, which is trading between individuals
• The institutional investor business (generally consisting of entities
investing millions of dollars)

Question 47

SOURCES OF INFORMATION FOR MUNICIPAL BONDS

Answer 47

For information about new or secondary municipal bond issues, a broker/dealer or a municipal bond dealer can consult any one of several publications.

The BOND BUYER is a publication that is now produced online for underwriters only. Underwriters must know all the information in this daily newspaper. Although the Bond Buyer is shown online daily, it only produces various indexes once a week. The Bond Buyer Revenue Index is composed of 25 revenue bonds with 30 years or more to maturity. There are three general obligation indexes: the GO 11 and the GO 20, and the GO 40 all with bonds maturing in 20 years.
• The GO 11 index has an average rating of AA.
• The GO 20 index has an average rating of A+ (A1).
• The GO 40 index has an average rating of BBB.

The type of information that underwriters must know, including important features and lists, is covered in detail in the Underwriting Module.
The MUNIFACT WIRE is a wire service for secondary trading, with some underwriters watching it.
• The Munifact Wire is run by the Bond Buyer and provides a great deal of information regarding new issues of municipal bonds in both the primary and the secondary markets. It gives information about the issuer, the indenture, and any information for analyzing the ratings and quality of the issues. There are no prices or yields.

The KENNY WIRE and the C-WIRE are wire services for secondary trading.
• The Kenny Wire and the C-Wire provide information about municipal securities. More importantly, these services are known for finding and listing bonds for which dealers are seeking bids in the secondary market.

The Wall Street Journal and local newspapers carry some tombstone advertisements and notices of sale. However, these resources are generally considered secondary to the above-mentioned publications.

Question 48

INTERDEALER TRADING

Answer 48

INTERDEALER TRADING is a term that describes trading between BOND TRADERS. Bond traders are firms that have a municipal department trading in the secondary market. These bond traders make a market in the different municipal bonds that are available, meaning that they buy bonds from investors or other dealers who want to sell the bonds, or they sell bonds to investors or other dealers who want to buy bonds.

When dealers want to purchase certain bonds, they contact other bond traders and request prices on those bonds (if they are available for purchase). If those dealers cannot find any of the bonds they want, they then contact one of the many BROKERS’ BROKERS, and ask this broker to find the bonds they want.

A firm that is a broker’s broker only acts in an assistant role called an AGENCY BASIS. A broker’s broker:
• Never acts as a market maker
• Helps dealers find a particular bond they are looking for
• Helps institutional firms buy and sell bonds
• Helps large buyers and/or sellers remain anonymous
• In general, acts in a broker capacity
• Never acts in a principal transaction even when buying bonds to help municipal firms fill an institution’s order

Bond dealers sometimes wish to remain anonymous when trying to sell certain bonds because they may not want the whole dealer community to know that they are selling a particular bond at a particular price. In these cases, dealers also use a brokers’ broker to help them sell the bonds since the brokers’ broker does not reveal the identity of the selling dealer.

INDIVIDUAL INVESTORS are called HOUSEHOLD INVESTORS in the industry. These investors are usually in the higher tax brackets and are looking for an investment that gives a yield exempt from taxes. These investors contact municipal dealer departments of broker firms to buy or sell the municipal securities for their portfolio. These firms, or dealers, then fill the individual investor’s requests or contact the broker’s broker to find the bonds the investors desire.

INSTITUTIONAL INVESTORS are large investors who purchase large amounts of bonds (or other securities) at one time. Institutional investors consist of commercial banks, insurance companies, and bond mutual funds. These investors buy large quantities of each issue. On occasion, some of them purchase an entire issue.