Unit 1-Municipal Securities Flashcards
1
Q
How often are MSRB members audited?
A
At least once every 4 years (once every two if the institution is a bank acting as a municipal securities dealer
2
Q
Enterprise Fund
A
Debt issued by a govt subgroup (sewage and electric). Interest and principal is gathered in the form of utility fees assessed on those who directly benefit from the utility
- Also known as essential service revenue bond
- While they are a revenue bond, they rated as if they were GOs
3
Q
Par and interest accrual on municipal bonds
A
Typically issued at a par value of $5000. Interest accrues daily and is paid (typically) in semi annual installments
4
Q
Duration
A
Measure of a fixed income security’s potential sensitivity to interest rate changes. Used when evaluating the role of fixed income within a portfolio
5
Q
Laddering
A
A system by which to take advantage of the entire yield curve by investing in multiple munis at different maturities. Shorter maturities can be reinvested into longer maturities when rates are rising. Longer maturities provide stable income during times of falling interest rates.
6
Q
Term Bond (Dollar Bonds)
A
An entire issue that matures at one time (or at least a vast majority of it does)
- Usually requires issuers to establishing a sinking fund to address impending outflow of cash
- Issues without a sinking fund will need to advertise a higher interest rate to attract investors due to uncertainty
- Also called “dollar bonds” they are quoted by price
7
Q
Pull to Par
A
The tendency of bonds to move to their par price as maturity date approaches (or call date)
8
Q
Sinking Fund
A
-Generally not implemented by highly-rated issuers. Is often a necessity for lower-rated or NR issuers to attract investors
9
Q
Calling Bonds
A
- May be whole issue or partial. Partial bonds are chosen by lottery
- Issuers will typically call bonds at a premium (call premium). However, this is not always the case.
10
Q
What is call premium?
A
Difference between call price and par (face value)
11
Q
Reasons to call bonds
A
1) Take advantage of falling interest rates
2) Eliminate outstanding debt
3) Replace short term issues will long (vice versa)
4) Can use call to force conversion into shares (corporate issuers)
12
Q
Call Protection/Call Risk
A
If a bond is called when rates are falling, the investor has reinvestment risk.
-Many munis have a non-callable period (5-10 yrs) in which its bonds cannot be called.
13
Q
What are options when your bond is called (call is announced by issuer)?
A
- Sell in the open market to get money sooner but usually at a discount
- Wait until the call date to get full payment from issuer
14
Q
Serial Bonds
A
An issue with varying maturities (unlike term). May have leveled principal across all maturities or back loaded (balloon)
-Most munis are issued to mature serially
15
Q
Balloon Maturity
A
A type of serial bond in which a disproportionate level of principal is paid at the final maturity date. (e.g., a $100 million issue over 5 years with $50 million due at the end of year 5).
16
Q
Series of Bonds
A
Multiple issues sold by the municipality at different times. Perhaps the municipality doesn’t need all the money up front and wants to spread out issues in order to take advantage of different interest rates
NOTE: Each issue in a series may have different features (taxable or non-taxable, fixed rate or variable, serial, term, or both)
17
Q
Bond Safety
A
The safety of any muni issues is based on the financial viability of the municipality itself, the community at large, and any credit enhancements such as bond insurance and bank letters of credit
18
Q
Cost/Benefit of Credit Enhancement
A
While getting bond insurance or bank line of credit may result in a higher cost when a muni is issued, it allows the issuer to lower interest rates (as the issuer is considered safe). This reduction in interest almost always covers the initial enhancement costs
19
Q
Bond Insurance
A
- Covers principal and interest in case of issuer default
- Does not protect against market risk
- When it comes to insured bonds, both the issuer and insurer need to be examined for creditworthiness. The higher of the 2 ratings is what determines bond rating.
20
Q
Unenhanced
A
A bond that relies solely on its own rating (not that of an insurance company)
21
Q
Advanced Refunding
A
A new issue whose proceeds are then parked into short-term money markets to pay off the remaining interest and eventual principal of a soon-to-mature older issue. Once there is enough funds to pay off the old issue, the bonds are considered “defeased” meaning they no longer count towards a municipality’s statutory debt limit (as there is not question that the municipality will be able to pay them off)
- Advance refunded bonds are very highly rated due to their intrinsically low risk.
- Money set aside for Prerefunding is often parked into State and Local Govt Securities (SLGS)
22
Q
NRSROs
A
Nationally Recognized Statistical Ratings Organizations
- Moody’s
- Standard and Poor’s
- NRSROs are registered with the SEC
- It is important that investors do not focus wholly on bond ratings
23
Q
EMMA
A
Electronic Municipal Market Access
- Repository for ratings information (especially downgrades), disclosure documents, official statements, etc.
- Investors can set up alerts for munis that pertain to them
NOTE: NRMSIR is just the old name for EMMA
24
Q
Customer
A
- A natural person or entity that is not a BD or muni securities dealer acting in its capacity as such
- An issuer is not a customer when it is involved in the sale of its own securities
- However, a municipality may be deemed to be customer if it is buying securities for its own trading account
25
Bond Publications
Tax-exempt bonds are listed in:
- The Bond Buyer
- WSJ
- Bloomberg
26
Who dictates what kind of securities a commercial bank can purchase?
Depends. The Office of Comptroller of Currency, Federal Reserve, the FDIC, or relevant state banking authority
- Banks can invest in munis if they believe there is a low chance of default and payments will be timely
- Banks that invest in munis cannot rely on ratings alone. It must do its own regular due diligence surrounding securities in its portfolio
27
What issues get rated?
Typically issuers who pay to have an agency rate them or an a large enough issue that can garner a lot of investor interest (rating agencies are for-profit)
-A NR muni does not mean it is of poor quality. Smaller issuers may not elect to pay to have a rating
28
High-Yield Bonds (Junk)
Lower cost, higher interest bonds
| -Carry a speculative rating an are typically only appropriate for aggressive investors who understand risk
29
What can issuers do to address a downgrade?
- Downgrades will soften price of outstanding munis, driving rates higher
- Issuers can work with credit agencies to take steps to improve creditworthiness.
30
Legislative Risk and Sequestration
The federal government has increasingly sought to curtail municipal issues. Sequestration is forced budget cuts that reduce a municipality's ability to issue debt.
-Affects Build America Bonds and Qualified Zone Academy Bonds
31
Intergovernmental Tax Immunity/Doctrine of Mutual Reciprocity
At a high level, the idea that the federal government cannot tax the states and the states cannot tax the federal government
-As mentioned in Legislative Risk, the federal government has, over the years, imposed some backdoor restrictions. However, the overall tenant still holds
32
Calculating Tax-Equivalent Yield (TEY)
In some cases, like those for low income earners, a corporate bond may be more appropriate that a muni.
-NOTE: when calculating TEY, the corporate rate will always be higher than the muni rate
33
Given a muni, find equivalent corporate rate
[Given Interest Rate] ÷ (1-Individual Tax Rate)=Corp
34
Given a corp, find equivalent muni bond
[Given Interest Rate] x (1-Individual Tax Rate)=Muni
35
Non-deductible items
- Interest on loans used to purchase munis (margin) is not tax deductible
- Capital gains from selling in the secondary market cannot be exempted
- You may not have to pay taxes (fed or state) if you purchase a muni issued by a municipality of your state. However, you may have to pay your state taxes for issues that are outside of your state
36
Bank Qualified Bonds
A caveat for banks that purchase certain GO issues
-The bank can deduct 80% of interest paid, but cannot exceed a $10 million face.
-E.g., A 1,000,000 issue at 3%. The bank deduct:
1,000,000 (.003)(.8)=$24,000
-Designed to assist smaller municipalities that may not be able to afford expensive underwriting process
37
Arbitrage and its shutdown
The Treasury no longer allows munis to issue bonds and then use proceeds to purchase higher yielding investments (such as treasuries).
-This was deemed to be circumventing the idea of interest exemption
38
Bond Counsel
Lawyers who specialize in municipal debt who evaluate and instruct munis on how to issue debt that is indeed exempt from federal taxation
- Unqualified opinion is best option
- Qualified opinion mean the IRS may challenge tax-exempt status of a bond (this happens more frequently than you may think)
39
Qualified Zone Academy Bonds (QZABs)
Allows municipalities to borrow at zero (or nearly zero) rates in order to help underprivileged communities improve schools
- Similar is Clean Renewable Energy bonds
- Similar borrowing advantages are common in areas that have impacted by a natural disaster
40
Alternative Minimum Tax (AMT)
Passed by Congress to inhibit rich from avoiding paying taxes. Essentially, if you are subject to AMT, you will need to pay taxes on interest earned from muni issues that are for non-essential, private purpose issues
41
General Obligation Bonds (GOs)
Non-revenue generating projects that benefit entire community
- Interest and principal is gathered by the municipality's authority to tax
- Because of tax-backing, these are considered full faith and credit issues
42
Source of funds (GO Bonds)
State GOs: Income tax, licensing fees, and sales tax
City/County GOs: Property tax (ad valorem), license fees, and fines
NOTE: States do not assess property tax. Cities/towns do
43
Statutory Debt Limit
Limits the amount of debt a municipality can issue
- Protects residents from excessive taxes
- Makes existing bonds safer since it limits the municipality's borrowing ability and default risk
- NOTE: A municipality can exceed its statutory debt limit for GOs if it approved in a voter referendum.
44
Limited Tax GO
A GO bond backed by taxes, but limited in regards to what taxes can be used (property, income, etc).
-This limitation makes these munis slightly riskier than those backed by unlimited tax pledge
45
Unlimited Tax GO
A GO in which the municipality can levy taxes to cover all its debt
- Typically needs voter approval
- Higher safety but lower yield (thus limiting expense to taxpayer)
46
Overlapping/Coterminous Debt
When different taxing authorities tap the same taxpayers. For instance:
-Richmond, Indiana can tax to pay for its GOs
-Wayne County can tax to pay for its GOs
NOTE: Coterminous debt usually has to do with property taxes. Look for city and county, but not state
47
Double-Barreled Bonds (Alternate Bonds)
Usually enterprise bonds where interest and principal is primarily paid through utility fees. However, they are also backed by the taxing authority of the local government or state.
- Rated and traded as GOs
- Sometimes called Alternate Bonds due to the alternate sources of revenue that can be used to service debt
NOTE: Double-Barreled bonds are technically revenue bonds
48
Calculating Mils on GOs
- One mil is represented as .001 (7 would be .007)
1) Take the home's assessed property value (not market value)
2) Multiply by mil rate
EX. A 400K home is assesses a tax value of 200K with 7 mils
$200,000 x .007=$1400
49
General Facts: Revenue Bonds
Principal and income is paid through user fees, admission, tolls, etc.
- Higher interest than GO Bonds as they do not have the same wide ranging tax backing
- Not subject to statutory debt limits or voter approval as community tax dollars are not going into the project
- Considered self-sustaining debt
50
Feasibility Study
The process by which an issuer consults with various lawyers, financial professionals, and engineers to identify the profitability and legal implications if the project is undertaken
- A Request For Qualification (RFQ) may be posted by a city who is seeking to consult with said professions
- A Request for Proposal (RFP) may go out to urban design firms who can assist with the project
51
Sources of Revenue (Revenue Bonds)
- Utilities (water, sewage, electric)
- Housing
- Transportation (toll roads, airports)
- Education (R&B, enrollment fees)
- Health clinics and hospitals
- Sports Facilities (stadiums)
52
Special Tax Bond (sin taxes)
A revenue bond that is funded by taxes on cigarettes, alcohol, motels, etc.
- Typically have one or two designated sources of revenue
- Does not include ad valorem taxes
53
Development Revenue Bonds
When a municipal authority issues Industrial Revenue Bonds (IDRs or IDBs), the money is used to build a facility or buy equipment that is subsequently leased out to a corporation.
-As such, the ultimate creditworthiness of the bond is that of the corporation leasing.
54
Lease-Rental Bonds
A municipality builds and office building or school for the benefit of its community which it then leases. E.g., a new school subsequently leased to the school board.
55
Certificate of Participation (COPs)
A type of lease revenue agreement (not a bond) in which investors buy a share of the future revenue of a new project.
-Essentially an IPO for a municipal project. Proceeds are used for construction, land acquisition, etc. Once completed, the revenues generated are paid to initial investors.
NOTE: COPs are not viewed as debt of the municipality, thus can be a nice way for a municipality to avoid hitting its statutory debt limit.
-Theoretically, in the event of a default, the investors could foreclose on the property, facility, equipment.
56
Special Assessment Bond (Special District Bonds)
Issued to finance public improvements (repave roads/sidewalks, or install water purification facility)
-Interest and principal is paid through taxes, but is only assessed on those who have a geographic benefit to the project or facility. ,
57
Mortgage Revenue Bond
Issued by a state or local housing authority, these bonds are backed by a lien on the monthly payments of a large pool of mortgages
58
Housing Authority Bonds
Used to expand housing to low income individuals
- While backed by rental income, they also fully backed by the U.S. Government along with other credit enhancements
- No cap on the amount of proceeds that can be collected to by land and existing buildings
- May be 501 (c)(3) or Public Activity Bond (PAB)
- 501(c)(3) states that the owning entity of the housing must be a govt. entity or have non-profit status
59
Moral Obligation Bonds
A revenue bond with a special provision in which, should revenues or taxes not be enough to cover interest and principal, the state legislature may step in to support the debt
- Moral obligation...not legal requirement
- The additional backing by the state tends to make these bonds more marketable
- Often issued in times of financial distress or increased credit risk by the issuer
- As they are revenue bonds, holders cannot force the municipality to raise taxes. In the event of default, the only way to get paid is if the state steps in
60
Municipal Notes
- Usually mature in less than a year-but can be anywhere from 3 months to 3 years
- Often issued to "hold over" a municipality in anticipation for more revenue down the road
61
Tax Anticipation Notes (TANs)
Used to fund a local government in between tax seasons
62
Revenue Anticipation Notes (RANs)
Used to finance municipality while a project is being completed. Afterwards, the revenues of the project will help fund the govt and repay investors
63
Tax and Revenue Anticipation Notes (TRANs)
A combo of anticipated tax and revenue in the future
64
Bond Anticipation Notes (BAN)
Issued as short term financing as a new long term debt issue is being prepared
65
Commercial Paper (CPs)
A very short term (30, 60, 90...up to 270 day) discounted debt instrument often issued by municipals as an alternative to BANs
- Often used to subsidize payroll expenses
- New CPs are often issued on a rolling basis to provide longer term funding, but also allowing municipalities to take advantage of the short end of yield curve (as opposed to issuing longer-term, higher interest debt)
66
Construction Loan Notes (CLNs)
Issued to provide financing to housing construction projects
67
Grant Anticipation Notes (GANs)
Financing in anticipation of the receipt of a Federal Govt. Grant
68
Variable Rate Demand Notes/Obligations (VDRO)
Essentially shares of a money market that the municipality has set up.
- Typically long term
- Gets to collect funds but pay low interest rate
- As the name implied, investors can demand their money at any time (just like a money market) through put option
- Often backed by a Letter of Credit (LOC) or Bond Purchase Agreement (BPA) set up with a local bank
- Price is stable as interest rate is periodically adjusted to market rates by rate remarking age
69
Floating Rate Note
A cheaper VDRO that does not require rate remarking agent or bank liquidity provider
70
Auction Rate Securities (ARS)
- Issued by municipality, hospital, housing authority, and universities
- Long term bonds regularly adjusted to short term interest rates by Dutch auction
- Lowest bid rate at which all bonds can be sold is new "reset or "clearing rate"
- Resets happen every 7, 28, or 35 days
- Those who bid higher do not receive bonds
- Interest for the current period is based on the interest rate of the prior auction
71
Failed Dutch Auctions (ARS)
- Lack of demand needed to reset the rate
- Underwriting BDs can submit a tentative clearing bid but are not required to
- Failed auctions may result in downgrade of issuer
- Do not have Put feature and can be called by the issuer at any time
72
Short Term Obligation Rate Transparency (SHORT)
System in which dealers of ARS or VDRO submit info to the MSRB about auction marketing, procedure, and methods by which interest rate is set
73
Put Bonds (tender option bonds)
Floating rate securities which allow the holder to put the bond back to the issuer (or tender agent) at par
- Put windows may be daily, weekly, or monthly
- Once put is initiated, exercise will occur on the next reset date
74
Advance & Current Refunding
Typically done when a municipality wants to refinance to lower rate, but existing bonds either cannot be called or are still in call protection. The municipality will simply issue new debt at a lower rate to defease old issues
- If new debt is issued to cover old debt that was not set to mature for 90+ days, it is called "advance refunding"
- If old bonds are set to mature within 90 days of the new refunded bonds, it is called "current refunding
75
Crossover Refunding
When the revenue (taxes, tolls, etc) is used to service the interest and principal on refunded bonds until they can be called or mature. At that time, the revenues are then shifted to service the newly issued debt at a lower interest rate
76
Gross Refunding (full cash refunding)
When the proceeds of a new, lower-interest rate issue are enough to fully refund older debt. In other words, the proceeds do not need to be invested in money markets or other short term instruments to service old debt until maturity or call
77
Market Price Rule
Coded in IRS arbitrage regulations. States that securities purchased by newly issued municipal debt revenue to buy securities to service older (higher interest debt), must be purchased at fair market value.
78
Yield Burning
When a municipality buys short term debt instruments (typically Treasuries) to service refunded bonds in escrow. The municipality cannot pay higher than fair market. Doing so would artificially decrease the yield on the instruments and allow the municipality to "manufacture" its own arbitrage situation.
- Practice is illegal
- By law, securities used to service escrowed debt cannot exceed the yield of the newly issued debt
79
Build America Bonds (BABs)
Created during the 08-09 crash to help municipalities lure more investors than would typically buy munis
- Interest is taxable, but investors receive a tax credit
- Lured lower income earners, IRA investors, and retirement plans, pensions, and foreign investors
- Program expired at the end of 2010, but may be reinstated at some point in the future
80
Tax Credit BABs
Allows investors to claim tax credit on 35% of interest they receive each year from the BAB
-If tax liability is not enough, credit can be carried forward
81
Direct Payment BAB
No tax credit is given to bondholder, but the municipality receives payments from the Treasury equal to 35% of interest it must pay to bondholders
82
Amortizing Bonds Purchased at Premium
Amortization (straight line) reduces cost basis and reported interest over time.
EX. An investor buys a bond at 108 with 8 years to maturity. Each year, the investor must reduce reported cost by 1 pt. If held to maturity, there will no capital loss as the premium has been amortized to par
-If sold before maturity, the G/L is the the difference between the sale price and whatever the adjusted cost basis was at the time of the sale
83
Accretion of Bonds Purchased at Discount
Discounted bonds may be acquired in the secondary market, or issued at an Original Issue Discount (OID) to par
EX. An investor buys a 5% bond with 10 yrs to maturity at 90. Each year, he must increase the reported cost basis by 1 pt. At maturity, there is no G/L
-Like amortization, if sold before maturity, the G/L is the difference between sale price received and whatever the accreted cost basis is
84
Zeros
Debt obligation that does not pay regular interest. Instead, the issue is sold at a deep discount to face value. At maturity, the investor receives face value, the difference between that and purchase price is accreted interest
-Offered bu municipality, the federal govt, and corporations
85
Advantages of Zeros
- Sold at deep discount ($1500-$2000) and mature at $5000.
| - Allow investors to speculate on interest rate moves
86
Disadvantage of Zeros
- Extremely volatile. Since there are no regular interest payments (cash flows), any change in interest rates will cause zeros to fluctuate in price much more than a traditional bond
- Since there are no cash flows during the life of the Zero, the ultimate yield is realized only at maturity
87
Taxation of Zeros
Investors must accrete interest each year (even though interest is not received until maturity). Just like regular bonds purchased at a discount, the annual accretion rate per year is discounted amount to par ÷ years until maturity
88
Capital Appreciate Bonds (CABs)
- Like Zeros, sold at deep discount in increments of $5000
- Issued by a municipality to support small businesses in the community
- Interest received at maturity is considered compounded interest and is not accreted each year to par
- The municipality only has to count the initial principal towards its statutory debt limit, not the total par of the issue
89
Bond Contract
Agreement a municipality enters with an underwriter
- Includes various legal documents such as bond resolution, covenants, trust indenture (if applicable), references to state and federal laws
- Issuer agreed to abide by the covenants and other statutes contained in bond contract
- May require an Additional Bond Test (ABT) to determine if the revenues of the project can generate enough revenue to cover the new issue and any outstanding issues
90
Bond Resolution
- Document that a municipality issues authorizing the issue and sale of new securities (these may be split into 2 docs: an authorizing resolution and award resolution)
- Describes issuers obligations and duties to its bondholders
91
Tust Indenture (Bond Indenture)
An optional document spelling out a terms of a contract between the issuing municipality and a trustee (typically a major bank), who acts as the fiduciary to bondholders enforces covenants, and supervises the overall compliance of the issuer to the bond contract as a whole
NOTE: The indenture is usually too long to be sent to every investor, but must be made available to any investor upon request
92
Protective Covenants
Essentially promises the issuer makes to bondholders that are spelled out in the Trust Indenture
93
Rate Covenant
The issuer must charge rates, fees, ticket sales at a rate high enough to cover operational costs of the facility and to service debt
94
Maintenance Covenant
The issuer agreed to maintain the facility/equipment
95
Insurance Covenant
The facility or equipment must be insured to such an extent that bondholders can be paid in the event of a major destructive event
96
Non-Discrimination Covenant
The issuer must charge everyone who uses the facility/equipment equally and without exception
97
Additional Bond Test (ABT)
If the issuer would like to issue more debt later (using the same project's revenue), it must make sure the revenue of new and existing debt can be serviced by the project
-Under a closed end indenture, any new bonds are subordinate to existing ones (harder to make new issues)
98
Sinking Fund
Account by which the issuer will deposit revenues to service debt
-Often used for lower rated issuers
99
Catastrophe Clause
The issuer agrees to redeem bonds if the facility is damaged or destroyed
100
Outside Audit Clause
The issuer will provide books and records regarding the project to an outside auditor for inspection. The auditor will additionally review the issuer's overall financial situation
101
Call Features
Spells out if/how bonds are to be redeemed before maturity
102
Flow of Funds (net revenue vs. gross)
Net Revenue: Facility operations and maintenance are paid before debt servicing
Gross Revenue: Debt service comes first, maintenance second
103
Official Statement (OS)
The prospectus of a municipal issue
-Prepared by and signed off by an officer of an issuer, the OS spells out all fair, balances, and material information an investor would need to make a decision about investing
-Explains purpose of issue, the financial status of issuer, and how the interest and principal will be repaid
-Discloses interest rate an offering price
FUN FACT: Municipal issuers are not required to prepare an OS. However, the vast majority of BDs are not able to offer municipal securities without one
NOTE: All municipal securities dealers must deliver a final OS to all investors by settlement
104
Preliminary Official Statement (POS)
Very similar to OS, but without interest rate and offering price
-Used by underwriters to gauge investor and issuer interest
105
Municipal Fund Securities
A mutual fund of various municipal securities issued by a municipality and professionally managed
-Like individual municipal issues, municipal fund securities are exempt from registration under the SEC Act of '33 as well as the Investment Company Act of 1940
IMPORTANT NOTE: Since municipal funds are composed of 100% municipal securities, the fund itself is deemed a municipal security, hence the exemption
106
Municipal Fund Securities Exemptions
-Act of '33 and '40 (registration with SEC)
-Preparing a prospectus or statement of additional info (SAI)
-Daily calculation of NAV
-Establishing a Board of Directors (BoD)
IMPORTANT NOTE: Since municipal funds are composed of 100% municipal securities, the fund itself is deemed a municipal security, hence the exemption
107
Types of Municipal Fund Securities
-Local Government Investment Pools (LGIPs)
-529 plans
NOTE: You may also see 529A, which supports ABLE programs
108
Local Government Investment Pools (LGIPs)
Municipal fund securities that are formed by the state , or public sector association for the investment of public funds
- Essentially a money market for state and local govts to invest excess cash.
- Objective is safekeeping, liquidity, and disbursements as requested by the local government
- Individuals can invest directly or through BD
- Assets typically managed by IB firm (but can be state treasurer)
- The state's dept of Treasury oversees administration of LGIPs
- LGIPs are exempt from registration under Act of '40
- BDs who market LGIPs are also exempt from Act of '40, but still must adhere to applicable MSRB rules
109
Investments of LGIPs
Short term debt instruments that quickly mature or can be liquidated with ease
-Some LGIPs mandate securities need to be backed by full faith and credit by US Govt
-Liquidity (as well as the target $1 NAV) are typical, but never guaranteed
Breaking the buck (falling below $1) is extremely rare. Funds least likely to do so are rated AAAm by S&P
110
Buying LGIPs through a BD
- BD must comply with all SEC and MSRB Rules
- Prior to advertising an LGIPs, the BD must review the OS (sometimes called an information statement for LGIPs)
- If a BD sells shares of an LGIP, it must deliver the OS buy settlement. Additionally, any PIPs will require a new OS to be sent by 1st class mail if there are any changes, amendments, stickers, etc.
- All BD commissions must also be fully disclosed
- Like mutual funds, buys may be entitled to breakpoints
- Breakpoint Sales are prohibited
111
529 Plans
College savings plans administered by the states to assist families with college expenses. Two types:
- Prepaid Tuition Plans (not a muni, not subject to MSRB)
- College Savings Plans
112
Owner/Beneficiary Dynamics
Unlike UTMA accounts, the owner of 529 maintains ownership of account and assets (even when bene reaches legal age)
-Owner can change bene at any time (within limits)
-Owner controls all investments and decides when withdrawals are taken
NOTE: While the owner of the plan maintains control of the investments, once monies are deposited, they are no longer considered part of the owner's estate
113
Beneficiaries (and subsequent)
- There is no familial relationship required when naming the initial beneficiary of a 529. However, any subsequent beneficiary designated must have a relationship with the initial beneficiary:
- Spouse
- Children (and their descendants), step-children
- Brother/Sister and steps
- Parents (and their parents)
- Step parents
- Aunt/Uncle/Niece/Nephew
- In Laws: Mother, Father, Brother, Sister
- Spouse of any of the above
- First cousin of the original beneficiary
114
Prepaid College Tuition Plan
-Not a municipal security and not subject to MSRB
-Can be established by the state of private university
-Owner or Beneficiary must reside in the state that is sponsoring the plan (when plan is established)
-Allows for owners to pay FV college expenses by buying PV credits
-Typically applies only to tuition and fees (not R&B)
-Many state plans are back by full faith of the state itself
NOTE: Prepaid plans do not allow owner to chose investments. However, the state usually hires a professional money manager to maximize returns and make sure underlying trust grows with the rate of inflation and tuition increases
NOTE 2: Since pre-paid plans typically grow at the rate of tuition increases, there is little to no investment or inflation risk
115
529 Contributions
- No income limits regarding who can contribute
- Contributions grow tax free. Withdrawals are tax free so long as they go to qualified higher education costs (prepaid is more strict on what "qualified" means)
- Anyone can contribute, not just account owner
116
Types of 529 Prepaid Plans
- Prepaid Unit Plan
| - Contract Plan
117
Prepaid Unit Plan
- Owners of these plans can buy units which represent a fixed percentage of a year's tuition (e.g., 1 unit=1% of year's tuition)
- There is not limit to how many units can be purchased at any one time
- Unit prices are fixed throughout the year, but tend to rise YoY
118
Prepaid Contract Plans
More rigid than the unit plan model. Owners buy contracts in year(s) increments.
- Payments can be in installments or lump sum
- Age can play a role in contract prices. An investment for a toddler may be lower than for a teen as the state will have more time to invest and reinvest money
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Advantages/Disadvantages for Prepaid Plans
Advantage: Essentially a guarantee against inflation and/or dramatic increases in tuition as PV is locked in
Disadvantage: Prepaid plans are seen as a resource for the beneficiary. As such, any applicable student aid is reduced by the amount of money in plan
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What happens when a prepaid plan beneficiary goes to a school out of state?
The state will still pay expenses to the college of the student's choice (public, private, out of state). However the amount paid will be limited to what would have been for an in-state school.
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Economic Growth and Tax Relief Act of 2001 (EGTRA)
Allows wider flexibility for prepaid plans established by private colleges and universities. In order for plans to receive same tax advantage as a state plan:
- Funds must be maintained in a qualified trust for the benefit of the student
- The private institution must receive approval that it meets applicable rules and regulation
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529 College Savings Plans
-Only state sponsored (no private schools)
-Funds can be invested at owners discretion, based on available options (mutual funds)
-Plans can be managed by state treasurer, major bank, investment company
-While composed of mutual funds, college savings plans are exempt from Act of 1940
-Considered muni security and subject to MSRB rules
-State may impose administrative fee (usually low)
-All states and DC have a 529 savings plan option
NOTE: State residency is not a requirement for 529 college savings plans, which means investors need to carefully analyze which plan is most appropriate given the wide array of options
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Investments in a 529 College Savings Plan
Usually an array of mutual funds. Owner can choose risk model (conservative, mod, aggressive).
-Many contain target date funds based on when bene is expected to start college
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Who can contribute to 529 Savings Plan and what are the limits?
-Anyone can contribute, regardless of income
-Each state sets limits on how much can be contributed. This limit is based on what are "reasonable" higher education costs (undergrad and graduate)
-Can range from 140K to 290K
NOTE: While the state's chose their own limits as to what is "reasonable", the Federal government mandates the contribution rule
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Impacts on Taxes and Financial Aid
- Assets in a 529 savings plan are not deemed a resource of the beneficiary. As such, being a beneficiary of one does not affect potential financial aid/scholarships
- Most states will offer some form of tax deduction to residents who contribute to a 529 savings plan of the state
- Contributions grow tax free. Withdrawals are tax free (state and federal) so long as they go to qualified higher education costs
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Things to look for when choosing a 529 savings plan
- Wide array of investment options and professional management
- Low Fees
- Client Service
- State tax deduction eligibility
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Advantages/Disadvantages of 529 Savings Plan
- Only offered by states
- Subject to inflation and investment risk
- Potential for higher growth than prepaid plans
- Assets do not reduce financial aid
- Contributors can open a plan in any state and bene can attend a school in any state
- Contributions subject to state limits
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Contributions and Tax Implications for Contributors (All 529s)
-All 529 contributions must be made in cash
-Contributions are not eligible for federal tax deduction, but many states offer some kind of state tax deduction for investment in that state's plan (some even have match programs)
-While there is no limit to how much someone can contribute in a year, in order to avoid tripping the gift tax, individuals are limited to $15,000/yr ($30,000 if married filing jointly) assuming no other financial gift was made to the same beneficiary in the same year
-For those wanting to maximize TVM, a contribution of $75,000 ($150,000 married, joint) can be made and prorated over the subsequent 5 years without hitting gift tax (so long as no other gift is made in the period)
NOTE: If the IRS determines a 529 was set up without the intention of higher education expenses, it can shut down plan and recoup any tax benefit received
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Contribution Minimums to 529
- May be regular or infrequent
- Initial minimums and subsequent can vary widely depending on the state
- Some states will offer lower initial minimums for in-state contributors
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529 Distributions: Qualified Higher Education Expenses
- Qualified distributions are exempt from federal taxation.
| - States may impose as tax on earnings on an individual's income tax (particularly if the plan is out of state)
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List of Qualified Expenses
- Tuition and enrollment fees
- Books
- Equipment and supplies
- Expenses allowed for special needs students
- Room and Board (see caveats)
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Qualified Room and Board Rules
- If student is living at home, R&B is defined by the amount the institution sets
- If living in student housing, the amount is the average allowance most student's pay (okay if slightly higher, so long as can be documented)
- Off Campus housing, can deduct those expenses deemed as reasonable for R&B (rent)
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Reporting Distributions
- The sponsors of 529 plans must report to the IRS all earnings, contributions, and distributions made during the calendar year and the name and address of the distributee
- A summary of these reports must be furnished to the distributee no later than Jan 31st of the following year.
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Non-Qualified Distributions
NOTE: A 529 holder can withdrawal any amount from a 529 at any time for any purpose
-Non-qualified distributions are subject to ordinary income tax on earning's only (contributions were already taxed) as well as a 10% penalty
-The taxation on a distribution is not FIFO. Rather, the amount of the distribution will be taxed on the proportionate composition of the account as a whole (principal and earnings)
EX. A $1000 distribution from a $10,000 account that is 75% principal and 25% earning will be taxed on $250 of that distribution
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Avoiding the 10% non-qualified distribution penalty
-Death of beneficiary
-Disability
-Receipt of scholarship or other allowance
NOTE: In the case of a scholarship, the 10% penalty is limited to the amount of the scholarship.
NOTE 2: While certain circumstances will negate the 10% penalty, earnings will still be taxed at the ordinary income level
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Estate Consideration of 529 (death of owner)
-If owner of plan dies before funds are distributed, they are not considered part of the owner's estate
EXCEPTION: Any amount in excess of annual limit is considered part of owners estate (e.g, owner dies in year 3 of 5 year prorated funding, 2 years would need to be reported to estate)
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Death of Beneficiary Options
1) Funds distributed to beneficiary's estate (typically subject to estate tax-depending on state)
2) Distribution to the contributor (does not carry 10% penalty)
3) Plan rolled over to new beneficiary related to the original
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529 Rollover Rules
-529 owners are free to rollover from one plan to another without taxation so long as completed within 60 days. These may be done for several reasons:
-The contributor wants to change plan type (prepaid to college savings)
-The contributor wants more investment options offered by a different plan
-The 529 is being rolled over to a relative of the initial beneficiary
NOTE: Rollovers from one plan to another for the same beneficiary are limited to 1 every rolling 12 months. There is no limit to how many rollovers can be done to relatives of the initial beneficiary
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Coverdell Education Savings Accounts (CESA)
- A non-revocable (bene owns assets), self-managed account for education purposes
- Similar to a Roth, contributions are not deductible, but earnings and withdrawals are tax exempt so long as used for qualifying expenses.
- Contributions limited to $2000/student/year
- Can be applied for K-12 and college (including graduate)
- Subject to income limits for high earners (like Roth)
- If kid hits 30 and there is still money in the account without any remaining education expenses, remaining funds must be disbursed subject to income tax and 10%
- Penalty can be avoided if remaining balance rolled into a new education IRA for a family member of original bene
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Lifetime Learning Credit
A tax credit of up to 20% on first $10K of out-of-pocket tuition expenses that can be claimed by parents of kids in college
-Can be claimed each year, but is a fixed amount (does not matter how many kids are in college)
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College Expense Tax Deductions
A deduction of $4,000 for higher education that can be claimed by taxpayers within certain income ranges
- Cannot be claimed in the same year as Hope Credit or Lifetime Learning Credit
- Can not be claimed if the qualifying expenses were already covered by 529 funds
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Recommending 529 Plans
Each BD must gather the following at or prior to recommending a municipal fund security:
-Overall financial status and tax status
-Customer's Investment Objective
-Any information the BD deems necessary to make a fair recommendation
A SP should then evaluate information provided by client and information provided by issuer in order to make sure recommendation is suitable
NOTE: The SP must also have assurances that the customer is fully away of applicable 529 fees and potential state tax implications
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Analyzing GO Bonds
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Things to look at:
-Property Values and Retail Sales
-Local bank deposits
-Diversity of community businesses
-Population Growth/Decline
NOTE: While a quantitative analyst may access the above list, a qualitative analyst may be hired to study:
-General attitude towards taxes and communal debt
-Population and property value trends
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Statutory Debt Considerations (GO Bonds)
- Each OS should stipulate how the new issue affects the municipality's statutory debt limit
- State constitutions may limit for what reasons a municipality issues debt
- Municipalities often stipulate that any new bonds issued to finance a project must mature during the expected lifetime of that project
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Sources of Municipal Debt Financing
State: Income and sales tax
County/School District: Property Tax
City: Fines, Licensing fees, Sales Tax, Utility Tax, City Income Tax, Personal Property Tax
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Ad Valorem Tax
- Determined by county assessor based on recent home prices, income streams, and replacement costs
- Ad Valorem taxes are a lien on the property, meaning the home can be seized if it is not paid
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GO Debt Red Flags
The municipality may have to issue more debt if:
-Annual income is not enough to support existing issues
-Principal payments are scheduled to close together
-Sinking fund is inadequate
-Pension funds are not adequately funded
-It has contracted more future capital improvements
NOTE: These very likely can lead to credit downgrade
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The Debt Statement
A summary of municipality's debt that includes:
- Total value of property
- Assessed Value of Property
- Assessment Percetage
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Municipal Debt Structure (Finding Net Total Debt)
1) Start with total debt
2) Subtract self-supporting debt and sinking funds
3) =Net Direct Debt (debt the municipality itself owes)
4) Add any overlapping debt the municipality owes to the county or state
5) =Net Total Debt
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Analyzing Revenue Bonds
Based on the facility's ability to generate enough revenue to cover maintenance and debt service. Considerations:
- Economic Feasibility
- Proximity to competing facilities
- Dependability of revenue sources
- Ability to call (will lower rate offset call premiums?)
- Efficient flow of funds (are there seasonal slumps?)
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Net Revenue Pledge Structure
1) Operations and Maintenance
2) Current Debt (within a year) principal and interest
3) Surplus (sinking) fund
NOTE: Net Revenue is far more common than Gross
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Municipal Debt Ratios
All mention of ratios should be associated with GO bonds with the exception of "Debt Service Coverage Ratio," which deals with revenues
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Private Purpose Bond
- Includes IDR and IBRs
- Issued by municipalities for non-essential projects (shopping mall)
- Interest may be federally tax exempt but is subject to AMT. As such, rates are more comparable to corporate issues
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Offering Circular
Disseminated by BDs to provide info to potential investors on existing munis, or those new issues that are not yet available
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Obligated Person
Any entity (usually the issuer) that is liable to support the payment (in whole or part) of an issued muni
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Original Issue Discount Bonds (OID)
Simply bonds that are issued at a discount to their stated par
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Market Discount Bonds
Bonds purchased in the secondary at a discount to their original price plus any accreted OID
NOTE: OIDs and Market Discount Bonds are subject to different federal taxation rules
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Buying a LGIP direct
Most retail investors can buy LGIP shares directly and without going through a BD
-These are usually state employees
NOTE: Since the MSRB has no jurisdiction over issuers, those non-BD personnel facilitating the purchase of a LGIP (directly) by an individual investor do not have to adhere to MSRB rules (e.g., delivering OS, disclosing fees)
