Municipal Securities Flashcards
This deck focuses on municipal securities characteristics, taxation, and regulation by the MSRB.
What are the two main types of munis typically issued?
- Revenue bonds - backed by a revenue producing facility
- General obligation (GO) - backed the taxing power of the issuing municipality
What are the key obligations of a bond counsel in a municipal bond issuance?
- Provide a legal opinion of the issue and make sure the issue is consistent with securities law
- Confirm the issue’s tax-exempt status
- Confirm the municipality’s legal authority to issue the bonds
What are the two types of legal opinions for muni securities?
Qualified and Unqualified
- Qualified - This means that there are concerns or qualifications regarding the legality of the issuance; this puts the deal at risk
- Unqualified - means there are no concerns or qualifications regarding the legality of the issuance; this is preferred
What are the three types of bond maturity?
- Balloon maturity: Borrower pays off a small portion of the principal prior to maturity and pays off the remaining portion at maturity
- Serial maturity: A portion of the notional amount is set to mature at regular intervals, usually years, and each interval has a different coupon rate
- Term maturity: The entire bond matures at the same time; this is the most common type
For what types of projects do municipals use general obligation bonds?
Non-revenue projects
GOs are supported by the taxing authority of the municipality issuing the bond. They are used for projects that produce no revenue and will be paid for via taxes. These include basic service projects like public schools, public parks, and public buildings.
What are ad valorem taxes?
Ad valorem taxes, also referred property taxes, help to support GO bonds that are issued by cities and counties. Property taxes are based on the assessed value of the property, which is taxed in mils. An investor will pay $1 of taxes for every $1,000 of assessed value.
What are the key factors in analyzing the credit quality of a municipal general obligation bond?
- Existing direct debt of the municipality
- Debt per capita
- Assessing the tax base of the issuer: average income, age, local industries, etc.
- Covenants
- Overlapping debt; sometimes a municipality shares the debt load with another because they will both use the service (e.g. a public ferry in between the two cities).
Who is entitled to collect property taxes?
Only the local city or county government
States are not allowed to collect property taxes so general obligations issued by the state depend on income, sales, and excise taxes.
What is the primary protection for the investor in municipal general obligation issues?
Constitutional Debt Limits
Some states limit the amount of debt any municipality can take on and most municipalities require a vote before issuing debt. Both of these protect investors. The city and county have a legal right to raise property taxes to pay the bondholders. This makes the GOs the safest investment for the investor. However, a limited-tax bond is less safe for an investor because it caps the degree that a city or county can raise taxes and limits their ability to pay bond holders.
What is the combination of a general obligation and revenue bond called?
Double-barrel bond
In a double-barrel bond, if the revenue is not sufficient, there is a legal obligation by the municipality to make up the shortfall from taxes.
From where can a revenue bond draw income to pay bondholders?
Almost any project that individuals will pay additional monies to use. Airports, colleges, tolls, stadiums, and utilities are all examples of projects that could be supported by the fees and income generated from the completed project.
What are examples of types of analysis should be performed on revenue bonds?
- Feasibility studies - revenue bonds rely on income that isn’t guranteed so they are naturally riskier than GOs. Is the supporting project feasible?
- User charges - are the fees for use of the project high enough to sustain debt payments based on the expected number of users?
- Demographics - are there enough users in the area?
- Covenants - protections in place that details the rights of the bondholders and obligations of the issuer
Where are the covenants of a revenue bond listed?
The Trust Indenture
This will contain all the obligations of the issuer as well as outlining specific protections that protect the investor. The indenture will also specify a trustee who will ensure compliance with the indenture.
What are two of the most common types of covenants?
- Insurance covenant - the commitment to ensure anything built with the revenue bonds
- Rate covenant - an assurance that usage rates will be kept high enough to maintain the project after completion.
Note: as much as the indenture is used by municipal issues, it isn’t required, as bonds are covered under the Trust Indenture Act of 1939, which does not require indentures. Because of their use in corporate debt, it has become common for municipal securities to follow suit.
What are the two different orderings of cash flows found in the flow of funds statement for a revenue bond?
Gross Revenue vs. Net Revenue
In a net revenue pledge, all operations and maintenance are paid first. This is assumed unless a gross revenue arrangement is stated in the indenture. In the indenture, an issuer can specify a reserve fund that funds a few years of payments to investors as a buffer. In a gross revenue pledge, investors are paid first, then maintenance, then the reserve fund.
What is an industrial development revenue bond?
IDRBs are issued by a municipality to construct industrial facilities or factories that will in turn be leased to an occupant to start a business and create jobs. Their cash flow comes from the company making lease payments. Since the company makes payments, which in turn the municipality pays to bondholders, the industrial development bond will have the same credit rating as the corporation.
What is the name for revenue bonds that are also backed by a non-binding pledge of the legislature?
Moral Obligation Bonds
These bonds are backed by a revenue producing facility and non-binding pldege of the legislature. If the revenue is not sufficient, the lawmakers, at their discretion, can make up the shortfall from taxes.
What are variable rate munis?
These bonds are issued with some floating interest rate that changes periodically based on a benchmark rate such as the rate on Treasury bills. Because their interest rate changes with the market, their price tends to remain relatively stable.
What is short-term muni debt called?
Muni Notes
These are issued with maturities of a year or less and are typically issued with the expectation of future anticipated tax or non-tax revenues that the issuer will use to pay off the debt.
What are the types of muni notes typically issued?
- Tax anticipation note (TAN) - used when future tax revenue is anticipated for but the state needs the funds now
- Revenue anticipation note (RAN) - used when future non-tax revenue is anticipated but the state needs the funds now
- Tax and revenue anticipation (TRAN) - has two streams of income supporting the note (taxes and future revenues)
For municipal securities, what is the analog to the prospectus required for stocks and bonds under the Act of ‘33?
Official Statement
Recall that municipal securities are exempt from the Securities Act of 1933 so they are not required to issue a prospectus. However, they have a similar disclosure document called an official statement ithat is very similar to a prospectus. None of the official statement is reviewed by, nor on file with, the SEC.
What purpose does the official statement serve?
- Primary disclosure document for munis
- The official statement discloses material information to potential investors.
What are the two types of underwritings for muni securities?
Negotiated and Competitive Offering
What are the characteristics of a negotiated muni offering?
In a negotiated underwriting, the municipality appoints an underwriter based on a myriad of factors, including sector expertise, price, and relationship with the issuer.
What determines the winner of a competitve offering?
Lowest net cost to issuer
In a competitive underwriting, the underwriter that will cost the municipality the lowest amount of interest over the life of the bonds will be awarded the deal. In this case, best price wins, relationship with the issuer makes no difference.
What is the notice of sale?
The notice of sale is the document released by the issuer to invite bids in a competitive sale.
What forms the syndicate in a muni underwriting?
Syndicate Agreement
The investment bank will have its own capital on the line and after seeing the ad appear will evaluate their ability to sell the issue and determine how much capital to risk, if they have other orders, etc. Once they decide to pursue the underwriting they sign a syndicate agreement with other members to spread the risk.
What details are usually found in the syndicate agreement?
- Amount of capital commited by each member
- The identity of the lead manager of the syndicate
- How long the syndicate agreement will be in effect
- The fee for the elected manager and the spread paid to other members of the syndicate
- Outline of who shares liability for unsold bonds and in what proportion
What is the distinction between an Eastern and Western muni underwriting?
- An Eastern underwriting is an undivided account, where all underwriters share liability for any unsold bonds.
- A Western underwriting is an divided account, where all underwriters are only responsible for their own allotment of bonds.
During a primary issue of municipal securities, what is the order of allocation of sales?
During the primary offering, just as in a stock IPO, the offering can be oversubscribed. In this event, there is a particular order in which the syndicate will award shares:
- Presale Orders
- Group Orders
- Designated Orders
- Member Orders
What type of bonds are purchased “when issued?”
Bonds that are legally authorized but not yet issued
The term “when issued” is not specific to munis, and simply means the bond has been sold and will be ready for issue soon.
Why are municipal securities not typically sold short?
Because of the lack of liquidity in the muni market, it is challenging for investors to cover a short that requires the purchase of that exact bond.
How are munis quoted?
Munis trade on a yield basis instead of by price. The yield typically quoted is the yield to maturity.
What are the three types of muni quotes in the secondary market?
- Subject quote - information or indication only
- Firm - can trade at that price or yield right now
- Working indication - bond not in inventory but broker can get it for around this price. Has to source the issue somewhere else.
What are the markup or markdown rules for munis?
Only when a broker-dealer is making a transaction as a principal is a markup or markdown taken. When the broker is purely acting in an agency between buyer and seller, they charge a commission. If the broker-dealer is selling to a customer they markup and if they are buying they mark down.
What is the anti-reciprocal rule?
Prohibits a dealer from making a deal with institutional customer that states if the institution buys munis from the dealer, then the dealer will sell more of that institutions’ products.
What is the taxable equivalent yield of a municipal security?
Since municipal securities pay interest that is tax-free, in order to compare a tax-free income to a taxable interest paying instrument, the taxable equivalent yield must be calculated, This is done by dividing the tax-free yield by (100% minus the investor’s tax bracket).
Define:
accretion of bond discount
Accretion is the annual adjustment of the cost basis of a discount bond towards par. For an original issue discount (OID) municipal bond, the annual accretion is not taxed. For any other discount bond, the annual accretion is taxed each year as ordinary income.
Define:
accrued interest
The interest that is paid by the buyer of a bond to the seller of a bond when a bond is traded between coupon dates. It is calculated from the prior coupon date, including that date, up to, but not including the settlement date.
What are the settlement rules for corporate, municipal and treasury securities?
Corporate and municipal bonds now settle one business day after the trade date (T+1) - called regular way settlement - and US Government bonds settle in one business day after.
Interest begins to accrue on the date of settlement, not the trade date.
A 3% corporate bond pays interest on February 1st and August 1st. The trade date is Monday, June 12th. What is the number of days of accrued interest?
To calculate the number of days of accrued interest, go from the prior interest payment date (including that date), up to, but not including the settlement date. In this case, go from February 1st up to, but not including the settlement date of June 13th (T+1 settlement). Calculate on a month-by-month basis, remembering that for corporates, each full month has 30 days.
- Feb: 30 days
- Mar: 30 days
- April: 30 days
- May: 30 days
- June: 12 days (up to, but not including, June 13th)
Total Accrued Days = 132 days
What is the importance of the dated date?
This is when the buyer begins to accrue interest and it continues to accrue up to the settlement date. The day of settle is the first day the buyer will receive interest accruals.
For accrued interest calculations, how many days are in a month or year for corporate, municipal, and treasury bonds?
The only instrument that uses the actual days in each month is US Government bonds. For those, accrued interest is calculated by using actual day count.
For corporates and munis, we assume every month has 30 days for the calculation.
Define:
additional takedown
The compensation earned by the syndicate manager or syndicate member for taking on risk for a bond. It is based on each firm’s allocations.
Define:
advance refunding
The act of issuing new bonds at a low rate call away more expensive bonds, that are not yet callable, at a later date.
Define:
balloon maturity
A bond maturity schedule where some debt matures each year, but the bulk of the bonds matures at once.
Define:
bond interest coverage ratio
Also referred to as the coverage ratio, it is a comparison of the annual revenues generated by a facility to the annual debt service owed to bondholders. It is used in the analysis of revenue bonds.
Define:
bond swap
The simultaneous buying and selling of two different issues with different maturities.
Define:
catastrophe call
A call where the municipality redeems the debt prior to maturity due to some catastrophe occuring.
Define:
coterminous
Services within the same community that share the same geographic boundary but that may issue bonds seperately. For example, school bonds and bonds for a water plant. This is important because they will be backed by the revenues from the same group of people. Multiple coterminous projects could increase the tax burden on a small population and therefore limit its ability to pay.
Define:
covenant
The part of an indenture that specifically outlines bondholder rights and protections. This is relevant for revenue bonds.
Define:
debt per capita
A measure of muni risk that divides the total outstanding debt and coterminous debt by the number of tax payers in that district. This is relevant for GO bond analysis.
Define:
Doctrine of Mutual Reciprocity
This is the agreement between the state and federal government that allows municipal securities to be federally tax-exempt. The federal government doesn’t tax state and local coupon payments as income to the shareholder and the state doesn’t tax income tax from income gained from US Treasuries.
Define:
double-barreled bond
A muni backed by both revenue and taxing authority. This is a feature that protects the bond holder so all else being equal, this type of security will trade at lower yields.
Define:
Eastern account
A style of underwriting where the syndicate members will be responsible for a pro-rata portion of unsold shares if another member of the syndicate is unable to sell all of theirs.
Define:
general obligation bond
A municipal bond issed for the benefit of a non-revenue producing facility. It is backed by the taxes of the issuing municipality.
Define:
gross revenue pledge
This is a covenant that protects bondholders by stipulating that all interest and principal payments are made first before operating and maintenance costs are paid. This is found in the flow of funds statement for revenue bonds.
Define:
industrial development revenue bond
A muni security that is issued to finance building something that private companies will use. These bonds are backed by lease payments made by the corporation to the municipality and therefore the credit risk is that of the corporation not the municipality.
Define:
limited-tax bond
A muni GO where there has been a limit placed on how much the issuer can raise taxes to make interest payments. This works against the bondholder in the event that taxes at the cap aren’t sufficient to meet interest payments.
Define:
market discount bond
A municipal bond purchased in the secondary market for a discount. Because the discount is market driven the annual accretion becomes taxable.
Define:
market premium bond
A municipal bond purchased in the secondary market for a premium. The premium must be amortized (or reduced) each year.
Define:
mill rate
This is the rate that municipalities are able to charge on the assessed value of property. It equals .001%. Put differently, an investor will pay one dollar of tax for every $1,000 of assessed value.
Define:
moral obligation bond
A municipal bond backed by a revenue producing facility and a non-bind pledge of the legislature. If the revenue is not sufficient, the lawmakers, at thier discretion, can make up the shortfall from taxes.
Define:
MSRB
A self-regulatory organization, that is empowered by and accountable the SEC, that helps to regulate municipal securities firms and professionals. Take note, the MSRB does not regulate the issuers of munis.
Define:
net overall debt
A figure that helps to analyze GO bonds. It is calulated as the total debt of the municipality minus any self-supporting debt (e.g. revenue bonds) plus the municipality’s share of any overlapping debt.
Define:
net revenue pledge
Found in the flow of funds statement for revenue bonds and indicates that the municipality will pay operating and maintenance first before any debt service.
Define:
official notice of sale
A document released by the issuer to invite bids in a municipal bond competitive sale.
Define:
official statement
A disclosure document that takes the place of a prospectus for new issue municipal securities.
Define:
preliminary official statement
The document used in a municipal underwriting to solicit indication of interest. Similar to the red-herring in a corporate offering.
Define:
qualified legal opinion
A legal opinion that expresses some concerns about the legalility of a new municipal bond issuance. Often times, a qualified opinion will kill the deal.
Define:
revenue anticipation note
A short-term municipal note issued by a municipality in anticipation of receiving future non-tax revenue.
Define:
revenue bond
A type of municipal security whose interest and principal will be paid by the revenue generated from the project that is built with the funds raised.
Define:
revenue pledge
This pledge will be written in the indenture of a revenue bond describing in what order the investors will be paid. There are two types: gross revenue pledge and net revenue pledge.
Define:
special assessment bond
A municipal bonds that are backed by an assessment on those who directly benefit from the improvements the bonds fund.
Define:
special revenue bond
Municipal bonds that are backed by a tax on a complimentary product. For example, a tax on gasoline might help to support the maintenace of roads in a city.
Define:
tax and revenue anticipation note
A short-term municipal note issued by a municipality in anticipation of receiving future tax and non-tax revenue.
Define:
tax-equivalent yield
The yield that would effectively be earned by the investor if the issuer were taxable. Tax-free issues trade at lower yields because of the tax-free benefit; in order to evaluate relative value, a tax-equivalent yield calculation is necessary. It is calculated as the (tax-free yield)/(1-tax rate).
Define:
total takedown
The amount a syndicate member receives if they both take on risk for bonds and sell the bonds themselves.
Define:
unlimited tax bond
A general obligation bond where there is no limitation on the municipality’s taxing power to redeem the bonds.
Define:
unqualified legal opinion
A legal opinion where there are no concerns regarding the municipality’s authority to issue the debt. This the preferred type of legal opinion.
Required when a representative receives a written customer complaint
Inform supervisor or principal
Use a 360-day year in the calculation of accrued interest
Municipal and corporate bonds
Use a 365-day year in the calculation of accrued interest
U.S. Government bonds and notes
Of YTC, YTM and CY, the yield that is highest when a bond is trading at a premium and is callable
Current Yield (CY)
Of YTM, YTC and CY, the yield that is highest when a bond is trading at a discount and is callable
Yield to Call (YTC)
Of YTM, YTC and CY, the yield that is lowest when a bond is trading at a discount
Current Yield (CY)
Of YTM, YTC and CY, the yield that is lowest when a bond is trading at a premium and is callable
Yield to call (YTC)
Interest payment varies based on performance of an index
Variable rate or adjustable rate bonds
Special account in which Issuer funds are set aside in advance of a call
Sinking fund
Allows bonds to be called before maturity if certain specified events like natural disasters occur
Catastrophe clause
An issuer with outstanding bonds that have a 5% coupon issues similar new bonds with a 6% coupon. The outstanding bonds will trade at a
Discount
An issuer with outstanding bonds that have a 5% coupon issues similar new bonds with a 4% coupon. The outstanding bonds will trade at a
Premium
An investor buys a 6% bond trading at a 6.5% basis. The bond is purchased at a
Discount
An investor buys a 6% bond trading at a 5.5% basis. The bond is purchased at a
Premium