Series 7 STC Municipal Bonds (Ch. 7)

Question 1

Which of the following could lower the credit rating of a general obligation municipal bond?

Increasing population

Increasing home foreclosures

Lower unemployment

Rising property values

Answer 1

Increasing home foreclosures

General obligation bonds are paid by taxes. Municipalities with increasing populations, lower unemployment (i.e., more jobs), and increasing property values would have higher tax revenues and higher credit ratings as a result. Municipalities with increasing home foreclosures will have difficulty collecting property taxes and, as a result, their credit ratings would fall.

Question 2

Which of the following are municipal securities:

I. RANs (Revenue anticipation notes)
II. TIPS
III. 529 Plans
IV. LGIPs (Local government investment pools)

Answer 2

I, III, IV (RANs, 529 Plans, LGIPs)

Treasury Inflation-Protected Securities (TIPS) are issued by the U.S. Treasury. Revenue anticipation notes (RANs), 529 plans, and local government investment pools (LGIPs) are all types of municipal securities. RANs are short-term notes that are issued by municipalities and paid by revenues from a project. Section 529 plans are created by state governments and allow individuals to save for educational expenses. Local Government Investment Pools (LGIPs) are a pooled investments that allow municipal governments to save some of their excess cash.

Question 3

A customer has a federal tax rate of 35% and a state tax rate of 7%. Which of the following investments will provide her with the BEST after-tax yield?

A 6.40% in-state municipal bond

A 7.10% out-of-state municipal bond

A 10.95% investment-grade corporate bond

A 11.50% mortgage bond

Answer 3

A 11.50% mortgage bond

Municipal Bond Yield / (100% - Investor’s Tax Bracket) = Taxable Equivalent Yield

For the in-state municipal bond, the taxable equivalent yield is 11.03%.

[Municipal Bond Yield of 6.40% / (100% - 42%), which is 6.40% / 58% = 11.03%.

For the out-of-state municipal bond, the taxable equivalent yield is 10.92%.

[Municipal Bond Yield of 7.10% / (100% - 35%), which is 7.10% / 65% = 10.92%]. In this question, the mortgage bond has the best (highest) after-tax yield.

Question 4

A municipal bond was purchased at 105 and it has five years to maturity. If the investor sold the bond four years later at 103, what’s the result for tax purposes?

The investor has a $20 long-term capital loss.

The investor has no gain or loss.

The investor has a $20 gain that’s taxed at the investor’s ordinary income rate.

The investor has a $20 long-term capital gain.

Answer 4

The investor has a $20 long-term capital gain.

Municipal bonds that are purchased at a premium must be amortized (reduced) to bring their cost basis down to par value at their maturity. In this example, the bond is purchased at a $50 premium and it has five years to maturity. This means that the bond’s basis will be amortized by $10 per year ($50 premium ÷ 5 years). After four years, the bond’s basis will have been reduced by $40 ($10 amortization x 4 years) to bring the adjusted cost basis to $1,010 ($1,050 - $40). When the bond is sold for $1,030, the customer will realize a $20 long-term capital gain ($1,030 - $1,010).

Question 5

An issuer of a revenue bond has gross revenue of $46 million, operating and maintenance expenses of $33 million, interest expense of $2 million, and principal expense of $4 million. If net revenue is pledged, how much money is available to pay the debt service?

$11 million

$13 million

$9 million

$7 million

Answer 5

$13 million

The formula for calculating the funds that are available to pay the debt service on a net revenue pledge bond is gross revenue minus operating and maintenance expenses. In this question, $46 million minus $33 million equals $13 million. Although the total amount of interest and principal expense is necessary to calculate the debt service coverage ratio, it’s not needed to determine the amount of revenue that’s available to pay debt service.

Question 6

An investor is in the 28% tax bracket. Which of the following investments will provide him with the BEST after-tax yield?

A 5% municipal bond

A 5 3/4% corporate bond

A 6 1/2% Yankee bond

A 6 3/4% convertible bond

Answer 6

A 5% municipal bond

The 5% municipal bond will offer the best after-tax yield because the interest income is completely free from federal income taxes. The other investments are types of corporate debt and are subject to federal income taxes, which means that 28% of the income received will be taxable. The taxable equivalent yield of the 5% municipal bond is 6.94%, which is calculated as follows:
Municipal Bond Yield / (100% - Tax Bracket %), or 5% / 72% = 6.94%.

None of the other choices provide a yield that exceeds 6.94%.

Question 6

All of the following sources of income are used by a municipality to meet its debt service for general obligation bonds, EXCEPT:

License fees

Uncollected taxes

Property or ad valorem taxes

Fees from a special tax bond

Answer 6

Fees from a special tax bond

General obligation bonds are backed by the full faith and credit, as well as the taxing power of the municipality that issues the bonds. The income that’s used to pay debt service on these bonds is derived from taxes and other general revenues. These include license fees, uncollected taxes, fines, property taxes, income taxes, sales taxes, and school taxes. A special tax bond is a type of municipal revenue bond.

Question 6

A customer has a federal tax rate of 35% and a state tax rate of 7%. Which of the following investments will provide him with the BEST after-tax yield?

A 6.25% in-state municipal bond

A 6.25% out-of-state municipal bond

A 9.95% investment-grade corporate bond

A 10.25% mortgage bond

Answer 6

A 6.25% in-state municipal bond

For most investors, the major advantage of municipal bonds is that the interest received from the bond is exempt from federal taxes. In addition, most states also exempt their bond’s interest from both state and local taxes if they’re purchased by state residents. However, if a state resident earns interest from an out-of-state municipal security, that interest is typically subject to state and local taxation. If an investor in a particular tax bracket wants to compare the benefit of tax-free interest income from a municipal bond to after-tax income of a taxable bond, it’s necessary to find the equivalent taxable yield. The interest on any corporate bond (which includes a mortgage bond) is fully taxable. Since the investor could purchase either an in-state municipal bond or out-of-state municipal bond, the in-state municipal bond will allow him to exclude both federal and state taxes. In this case, the investor will use the combined tax rate of 42% (35% + 7%) for computation purposes. The taxable equivalent yield is calculated as follows:
Municipal Bond Yield / (100% - Investor’s Tax Bracket)

The 6.25% in-state municipal bonds taxable equivalent yield is: 6.25% / (100% - 42%), or 6.25% / 58% = 10.78%.

The out-of-state municipal bond has the same coupon, but the equivalent taxable yield is 9.62% (6.25% / 65%). Ultimately, the in-state municipal bond has the best or highest after-tax yield.

Question 7

An investor purchased a municipal bond that was originally issued at a discount, but later sold it a premium before the maturity date. The investor’s profit on the transaction is taxed as:

A capital gain

Ordinary income

Tax-deferred interest

A tax-deferred capital gain

Answer 7

A capital gain

Question 7

The State Department of Motor Vehicles has a facility that’s constructed to house its operations. The facility is financed through a new bond issue. The DMV makes its lease payments, which are sufficient to pay the debt service. The bonds are called:

Special tax bonds

Lease rental revenue bonds

Overlapping issues bonds

Direct debit bonds

Answer 7

Lease rental revenue bonds

State and local building authorities may utilize a leasing concept to acquire, construct, or rent office space for their agencies (e.g., social welfare, taxation, motor vehicles). These bonds are not treated as general obligations. State legislatures may need to appropriate funds to pay off the debt service.

Question 7

A retired investor who’s seeking current income and preservation of capital will MOST LIKELY invest in:

A municipal general obligation bond with an A+ rating and that matures in eight years

A tax-free money-market fund

A municipal fund security

A municipal general obligation bond with a BBB rating and that matures in five years

Answer 7

A tax-free money-market fund

Of the choices listed, the tax-free money-market fund will provide the best investment for an investor who wants both preservation of capital and current income. In addition, the money-market fund will provide diversification compared to the purchase of a specific bond which exposes the investor to credit risk. The two G.O. municipal bonds offer current income; however, if interest rates rise prior to maturity, the value of the bonds will fall and the investor could experience a loss of capital.

Question 11

All of the following are types of overlapping debt, EXCEPT:

A bond that’s issued by two towns to finance the building of a gymnasium

A bond that’s issued by two cities to finance the building of a library

A bond that’s issued by two states to finance the building of a bridge

A bond that’s issued by two counties to run their general operations

Answer 11

A bond that’s issued by two states to finance the building of a bridge

Debt that’s issued between two states is not considered overlapping debt. Overlapping debt is general obligation debt of other governmental units for which residents of a particular municipality are responsible. In other words, it’s the debt that’s shared by residents of a municipality for services or facilities provided by several municipalities. Examples of overlapping debt include debt of adjoining cities, road district or school district, or debt issued between two counties.

Question 11

Overlapping includes which of the following:

I: Debt of adjoining cities
II: Debt of road district
III: Debt of school district
IV: Debt of two states

Answer 11

I, II, III

NOT IV

Question 12

Interest earned on which of the following bonds is added to income when calculating the alternative minimum tax?

Limited tax bonds

School bonds

Qualified private activity bonds

Public housing bonds

Answer 12

Qualified private activity bonds

The computation of the alternative minimum tax (AMT) involves adding tax preference items back to a taxpayer’s income. In some cases, interest earned on a qualified private activity bond may be considered a tax preference item. A qualified private activity bond (also referred to as an AMT bond) is a municipal bond that has been publicly approved and has more than 10% of its generated proceeds going to a project that’s financed by a private entity (e.g., a corporation).

Question 12

What document attest to the validity and tax-exempt status of a municipal bond?

Notice of sale

Official statement

Legal opinion

Feasibility study

Answer 12

Legal opinion

The legal opinion is written by a recognized bond counsel that’s hired by the issuer to attest to the validity and tax-exempt status of the bond issue. Essentially, the legal opinion assures investors that the issuer has the legal right to issue the bonds. Since municipal bonds are exempt from registration with the SEC, the legal opinion gives investors some assurance they’re not being defrauded.

Question 13

State governments receive the LEAST amount of revenues from:

Sales taxes

Corporate income taxes

Ad valorem tax

Individual income tax

Answer 13

Ad valorem tax (Property)

State governments receive the least amount of revenues from ad valorem or property taxes. States raise money primarily from corporate and individual income taxes, sales taxes, excise taxes, and license fees. On the other hand, local municipalities raise most of their funds from ad valorem taxes.

Question 14

Which of the following statements is TRUE of municipal bond insurance?

It’s mandatory for non-investment grade bonds.

It must include a letter of credit.

The insurance increases a bond’s rating.

Evidence of insurance is not required to be disclosed on a customer confirmation.

Answer 14

The insurance increases a bond’s rating.

Insured bonds receive higher ratings than uninsured bonds. The issuer or the underwriters may choose to pay the premium necessary to insure the bonds if they believe it will make the bonds more marketable. MSRB rules require disclosure on the customer’s confirmation of “the name of any company or other person, in addition to the issuer, that’s obligated, directly or indirectly, with respect to debt service.” This includes municipal bond insurers.

Question 14

An investor who’s currently in the 15% tax bracket receives a promotion that puts her in the 33% tax bracket. If an RR offers to sell her a 3.75% tax-free municipal bond, what yield would the investor need in a taxable bond to receive the same after-tax yield as the municipal bond?

2.51%

4.41%

5.60%

11.36%

Answer 14

5.60%

Municipal Bond Yield / (100% - Investor’s Tax Bracket)

Since the customer is now in the 33% tax bracket, the 15% rate is no longer relevant. The taxable equivalent yield of a 3.75% municipal bond is 5.60% (3.75% / [100% - 33%]), or 3.75% / 67% = 5.60%.

Question 14

Which type of bond is backed by revenues of a project and, if projected revenues are insufficient to meet the bond’s debt service, potentially the taxing authority of the state?

Tax anticipation note

Special tax bond

Special assessment bond

Moral obligation bonds

Answer 14

Moral obligation bonds

Moral obligation bonds are first secured by the revenues of a project; however, if revenues are insufficient to pay debt service requirements, the state (or a state agency) is morally obligated (but not legally required) to provide the needed funds. Prior to issuing the bonds as moral obligation bonds, legislative approval of the state government must be obtained.

Question 14

A municipality’s debt limit is the maximum amount of:

Interest that a municipality may pay out in one year

Bonds that a municipality may redeem in one year

Debt that a municipality may incur

Debt that was issued based on the revenue derived from a municipal project

Answer 14

Debt that a municipality may incur

A municipality’s debt limit is the maximum amount of debt that a municipality may incur and is important in the credit analysis of a general obligation bond. The debt that was issued based on the revenue derived from a municipal project is only relevant for a revenue bond.

Question 14

A woman will be retiring in 2030 and is interested in income and having her principal available at retirement. Which of the following municipal bonds should be recommended?

A highly rated GO bond that matures in 2025

A highly rated GO bond that matures in 2034, but is callable in 2023 at 105

A highly rated revenue bond that matures in 2030

A non-investment-grade revenue bond that matures in 2030

Answer 14

A highly rated revenue bond that matures in 2030

Since the woman wants her principal available at retirement, a bond that matures in 2030 (the year of her retirement) is the best choice. Because the revenue bond is highly rated, there’s a higher probability that the issuer will be able to pay off the principal at maturity compared to the non-investment-grade revenue bond.

Question 15

Factors that are examined when analyzing airport revenue bonds will NOT include which of the following choices? Whether the airport serves as a major domestic hub for an airline Volume and trends of fees that are paid by restaurants, shops, and newsstands Whether the airport is dependent on tourism The demographics of the county in which the airport is located

Answer 15

The demographics of the country in which the airport is located Any factors that relate to the amount and reliability of revenues that are generated by the operation of the airport are relevant. Since the bonds are supported only by airport revenues, a negative evaluation of one of these factors could result in a lower rating for the bonds. Demographic concerns regarding the county in which the airport is located are relevant to analyzing a general obligation bond, but not a revenue bond.

Question 16

What type of municipal bond will be impacted by overlapping debt? Revenue bonds Housing bonds General obligation bonds Moral obligation bonds

Answer 16

General obligation bonds Overlapping debt is the result of multiple governments having the ability to tax the same constituents. For example, a person who lives in Los Angeles is taxed by the State of California, Los Angeles County, and the City of Los Angeles. The amount of overlapping debt impacts the credit rating of general obligation bonds since the debt service is paid by the taxing authority of the municipality.

Question 17

How often may assets in a 529 plan be rolled over? Once per quarter Only if the beneficiary moves to another state Once every 12 months Never

Answer 17

Once every 12 months

Question 17

Which of the following statements about municipal revenue bonds is NOT TRUE? There's no debt limitation set by the issuing municipality. The maturity of revenue bonds typically coincides with the useful life of the facility being built. They may be issued by states, political subdivisions, interstate authorities, and intrastate authorities. The interest and principal are paid from the revenue received from the facility.

Answer 17

The maturity of revenue bonds typically coincides with the useful life of the facility being built. Municipal revenue bonds don't have maturity schedules that coincide with the usefulness of the facility being built. Instead, they should mature well before the useful life of the facility. Unlike general obligation bonds, municipal revenue bonds don't have debt limitations. A debt limitation is the statutory or constitutional maximum debt that an issuer may legally incur. Revenue bonds can be issued by states, political subdivisions (e.g., counties or townships), interstate authorities, and intrastate authorities. The interest and principal are paid from the revenue received from the facility.

Question 18

T/F. Both GO and municipal revenue bonds have debt limitations

Answer 18

False ; Municipal Revenue Bonds don't have debt limitations

Question 19

An investor is in the 28% tax bracket. Which of the following investments provides her with the BEST tax advantage? A 5% municipal bond A 5 3/4% corporate bond A 6 1/2% preferred stock A 6 3/4% convertible bond

Answer 19

A 5% municipal bond The 5% municipal bond offers the best tax advantage because the interest income is completely free from federal taxes. However, the income received on the other investments is subject to federal taxes at the 28% tax rate. The taxable equivalent yield of the 5% municipal bond is 6.94%, which is calculated as follows: Municipal Bond Yield / (100% - Tax Bracket %), or 5% / 72% = 6.94%. None of the other choices provides a yield that exceeds 6.94%.

Question 19

An investor bought two municipal bonds at 105 and they mature in 10 years. After holding the bonds for four years, the investor sold them for 102. What's the capital gain or loss for tax purposes? QID: 5050714Mark For Review $30 gain $60 gain $10 loss $20 loss

Answer 19

$20 loss Municipal bonds that are purchased at a premium (e.g., 105) must be amortized to bring the cost basis down to par value at maturity. In this question, the bonds have a 5-point premium (105 purchase price - 100 par) and will be amortized by 0.5 points per year (5 point premium ÷ 10 years = 0.5 points per year). After four years, the bond's cost basis is 103 (0.5 amortization per year x 4 years = 2 points amortization; 105 purchase price - 2 points amortization = 103 cost basis)). Since the bond is sold at 102, the investor will have a 1 point or $10 loss per bond ($1,020 sales proceeds - $1,030 cost basis = $10). However, since the investor bought two bonds, the total capital loss is $20 ($10 loss x 2 bonds).

Question 20

What type of municipal bond is subject to the issuer's debt ceiling? Industrial development bond Revenue bond Transportation bond General obligation bonds

Answer 20

General obligation bonds General obligation bonds are backed by taxes and are limited by a municipality's debt ceiling. Revenue bonds, which include transportation and industrial development bonds, are backed by revenues of a project. As a result, revenue bonds are not limited by a municipality's debt limit.

Question 20

What's the net direct debt of a municipal issuer? All of the revenue and general obligation bonds issued by a municipality Only bonds that are supported by revenues of municipality's projects Long and short-term revenue bonds that are issued by a municipality All of the bonds that are issued by the municipality, less any self-supported revenue bonds

Answer 20

All of the bonds that are issued by the municipality, less any self-supported revenue bonds Net direct debt is ONLY THE GENERAL OBLIGATION BONDS OF A MUNICIPAILITY. To find the net direct debt, investors can take all of the bonds that are issued by a municipality and subtract the revenue (i.e., self-supporting) bonds of the issuer (Net Direct Debt = All Bonds - Revenue Bonds).

Question 20

An investor lives in the state of California. The investor wants to supplement her retirement income, but also wants to minimize her income tax liability. What type of bond is the MOST suitable? 10-year, 3% bond issued by the Commonwealth of Puerto Rico 10-year, 3.2% ABC Corporation debenture 10-year T-Note with a yield of 2.87% Nine-year, 3.3% revenue bond that's backed by the fees generated from a toll road in Colorado

Answer 20

10-year, 3% bond issued by the Commonwealth of Puerto Rico Bonds that are issued by U.S. territories and possessions (e.g., Puerto Rico) have a triple tax exemption. Interest from these bonds is not taxed on the federal, state, or local level. In many cases, investors with an income objective who want to minimize their taxes should buy bonds that are issued by a U.S. territory or possession. Corporate bonds are taxable at both the state and federal level. Treasuries are only federally taxable. Out-of-state municipal bonds are only taxable at the state and local level.

Question 21

All of the following statements are TRUE concerning private activity bonds, EXCEPT: The interest on these bonds may not be tax-exempt for some investors. The interest on these bonds may be subject to the alternative minimum tax. The possibility that the bonds may be subject to taxation is reflected in the yield at which the bonds trade. These types of municipal bonds are generally general obligations.

Answer 21

These types of municipal bonds are generally general obligations. Private activity bonds are issued to finance the construction of a facility that will be used by a private corporation. Interest earned on these bonds is often subject to the alternative minimum tax (AMT). The AMT is an alternative method of calculating federal income tax liability. Taxpayers must pay the larger of the AMT or the result of the regular (Form 1040) income tax calculation. In theory, this is true for all taxpayers but, in reality, the AMT is only an issue for higher income taxpayers or those with special tax preference items on their returns. When calculating the alternative minimum tax, certain items may need to be included in taxable income that are typically excluded. One of these items is the interest on many private activity bonds. Therefore, a taxpayer who's subject to the AMT may lose the tax exemption on these bonds. Since this is a disadvantage, these bonds generally trade with higher yields than regular municipal bonds to reflect the fact that the interest received may be taxable. Keep in mind, private activity bonds are generally revenue bonds, not general obligation bonds.

Question 21

An investor is in the 35% tax bracket. Which of the following investments will provide her with the BEST after-tax yield? A 3.50% general obligation bond A 4.10% Treasury bond A 5.25% investment-grade corporate bond A 5.75% non-investment-grade corporate bond

Answer 21

A 5.75% non-investment-grade corporate bond The 3.50% general obligation bond (municipal bond) is exempt from federal income taxes. However, because the other investments are subject to federal income taxes, 35% of the income received would be taxable. The taxable equivalent yield of the 3.50% municipal bond is 5.38%. The formula for calculating the taxable equivalent yield of a municipal bond is: Municipal Bond Yield / (100% - Investor's Tax Bracket) In this case, 3.5% G.O. Bond Yield / (100% - 35%) = 5.38%. Therefore, the highest yield (best after-tax yield) is provided by the 5.75% non-investment-grade corporate bond.