unit 6 Flashcards
municipal bond
- a debt security issued by a state, municipality, or other subdivision (school, park, etc) to finance its cap ex (highways, public works, school buildings, etc)
- bough and sold OTC
- only recommend to investors in higher tax brackets
muni bond price (basis quotations)
- usually price and offered for sale on yield to maturity/basis quote
basis point
1/100 of 1%
dollar priced bonds
regular %
dollar bond
muni bond quote rules
- bought and sold on OTC
- MSRB created by Securities acts amendments of 1975 to regulate securities professionals in muni securities
- bona fide (firm) quotes
- workable indication quote
- nominal or subjective quote
- holding a quote
- BW/OW
bona fide (firm) quote
- dealer must be prepared to trade the security at the price specified in the quote and under the conditions and restrictions of the quote.
- must reflect the dealer’s best judgement and have a reasonable relationship to FMV
- may reflect firms inventory and expectation of market direction
- dealers cannot misrepresent a quote made by another dealer
- always subject to change
- dealers can offer to sell securities by providing quotes without owning the bonds - must know where to obtain them
workable indication
reflects a bid price at which a dealer will purchase securities from another dealer.
always can revise bid as market conditions change.
nominal or subject quote
indicates a dealer’s estimate of a security’s market value.
provided for information purposes only.
holding a quote/out firm quote
dealer may quote a bond price that is firm for certain time.
Good for an hour (or half hour) with 5 minute recall period.
bid wanted (BW)/ offer wanted (OW)
dealers soliciting bids/offers from marketplace.
considered a quote request.
term maturity
- all principle matures at a single date in the future.
- quoted by price
- called dollar bonds
- might require a sinking fund
sinking fund
account established by an issuing corporation or muni into which money is deposited regularly so that the issuer has the funds to redeem its bonds, debentures or preferred stock
serial maturity
bonds within an issue mature on different dates according to a predetermined schedule.
quoted on YTM (basis)
the longer the maturity, the higher the yield
ballon maturity
issuer pays part of a bond’s maturity before the final maturity date, but the largest portion is paid at maturity.
a type of serial maturity
legal opinion
- printed on the face of every bond certificate (except if stamped Ex-Legal) is a legal opinion written and signed by the bond counsel
- states legally binding on the issuer and conforming to applicable laws.
- either qualified or unqualified
bond counsel
attorney specializing in tax-exempt bond offerings
qualified opinion
there may be legal uncertainity of which the purchasers should be informed
unqualified opinion
issued by the bond counsel unconditionally
issuers want this.
Ex-legal
- allows bond to meet good delivery requirements without an attached legal opinion
- clearly stated on bond certificate
general obligation (GO) bonds
- back by full faith and credit and taxing power of the muni. Ex- income taxes, license fees, sales tax
- when issued by local govt they are most often backed by ad valorem taxes (property tax)
-issued for capital improvements that benefit the entire community - these projects don’t produce revenue so principal and interest are paid by taxes
- commonly use bond resolution
statutory debt limits
-amount of debt a muni may incur is capped by state/local statues to protect taxpayers from excessive taxes
- can make a bond safer for investors
- public referendum is required to increase and voter approval
- tax limits, limited tax on GOs, overlapping debt
tax limits
- some states limit property taxes to a % of the assessed property value or % increase in a single year.
- expressed as mills $1 per $1000 or $.001
limited tax GOs
- a bond secured by a specific tax.
- greater risk
overlapping debt
- several taxing authorities that draw from the same taxpayers
coterminous debt
bonds issued by different muni authorities that tap the same taxpayers.
2+ taxing agencies that share geographic boundaries and issue debt separately
revenue bonds
- back by revenues generate by muni facility the bond issue finances
- not subject to statutory limits and don’t need voter approval
- may be subject to additional bonds test before subsequent bond issues with equal liens on the project’s revenue may be issued. Tests to ensure the adequacy of the revenue streams to pay both old and new debt
-self supporting debt - have trust resolution or trust indenture
feasibility study
- before issuing a RO, issuer will engage various consultants to prepare a report detailing the economic feasibility and need for the project.
- include est. revenues, details operating, economic and engineering aspects
sources of revenue
- RO bonds pay bondholders only from the specific earnings and net lease payments from: utilities, housing, transportation, education, health, industrial and sports
protective covenants
promises meant to protect the bondholder
trust indenture (or bond resolution)
- empowers the trustee to act on behalf of bondholders
- rate covenant: a promise to maintain rates sufficient to pat expenses and debt service
-maintenance covenant: a promise to maintain the equipment and facilities - insurance covenant: a promise to insure any facility build so bondholders can be paid off if the facility is destroyed/inoperable
-additional bonds test
-sinking fund - catastrophe clause: promise to use insurance proceeds to call bonds and repay bondholders if a facility is destroyed
- flow of fund - priority of disbursing the revenues collected
- books and records covenant: require outside audit and financial reports
- call features: call dates and prices
- these are optional but increase marketability
open ended indenture
allowing further issuance of bonds with the same status and equal claims on asset or revenues if permitted by the bond indenture
closed ended indenture
allowing no further issuance of bonds with an equivalent lien on assets or revenue.
new bonds will be subordinated to the original issue
types of revenue bonds
- industrial development revenue bonds
- lease-rental bonds
- double-barreled bonds
- certificates of participation
- special tax bonds
- special assessment bonds
- new housing authority bonds
- moral obligation bonds
industrial development revenue bonds
- issued to construct facilities or purchase equipment which is then leased to a corporation
- corporation is responsible for payment of principal and interest
- bonds carry corporation’s debt rating
- bonds are subject to the alternative min tax
- industrial development bonds are private-purpose bonds, and the interest income could subject the holder to the alternative minimum tax. Thus, the interest income may not be completely tax free.
- Industrial development revenue bonds (IDRs) are municipal bonds generally backed by a lease or similar obligation entered into by a corporation. That is the backing and defines the risk level. The IRS defines interest received from industrial development revenue bonds (IDRs) as a tax preference item. As such, the income received might be subject to taxation under the alternative minimum tax. This tax usually applies to individuals who are in the higher tax brackets and would be an important determinant when evaluating the suitability of the investment.
lease-rental bonds
- issues bonds to finance office construction or itself or it state or community
-lease payments provide backing for the bond. Lease payments come from funds raised through special taxes or appropriations, the lessor’s revenues or the muni’s general fund
double-barreled bonds
- RO bonds that have GO characteristics
- principal and interest are paid from a specified facility’s earnings.
- bonds are also backed by the taxing power of the state or muni.
- rated and traded as GOs
certificates of participation
- a form of lease revenue bond that permits the investor to participate in a stream of revenue from lease, installment, or loan payments related ti the acquisition of land or construction of specific equipment or facilities by the muni.
- tied to annual appropriation so not legal viewed as muni debt
special tax bonds (designated tax bonds)
- secured by 1+ designated taxes other than ad valorem
special assessment bonds
- issued to finance the construction of public improvements (streets, sidewalks, sewers)
- issuer assess a tax only on the property that benefits
new housing authority bonds (public housing authority bonds/Section 8)
- to develop and improve low income housing
- back by full faith and credit of US govt
-most secure of all muni bonds - backed by rental income and govt makes up any shortfall
moral obligation bonds
if the revenue or tax collection is not enough the state legislature has the authority to appropriate funds to make payments.
if goes into default the only way bondholders can be repaid is through legislative apportionment.
muni notes
- short term securities that generate funds for a muni that expects other revenues soon.
- less than 12 month maturity is common but can be 3 months to 3 years
- interest and principal is paid at maturity, so they are issued at a discount
tax anticipation notes (TANs)
to finance current ops in anticipate of future tax receipts. helps even out cash flows between tax periods
revenue anticipation notes (RANs)
offered periodically to finance current ops in anticipate of future revenues from revenue producing projects or facilities
tax and revenue anticipation notes
combination of TANs and RANs
bond anticipation notes (BANs)
sold as interim financing that will eventually be converted to long term funding through a sale of bonds
tax exempt commercial paper
often used in place of BANs and TANs for up to 270 days - maturities are most often 30, 60 and 90 days
build America bonds
-issued at par
- no longer issued
construction loan notes (CLNs)
issued to provide interim financing for construction or housing projects
grant anticipation notes
issued with the expectation of getting federal grant money
Variable rate muni securities
- have interest rates that fluctuate with current market interest rate changes
- VRDOs, ARS
variable rate demand obligations (VRDOs)
- floating rate obligations that typically have a nominal long term maturity of 20-30 yrs but have an interest rate that resets periodically
- price stays relative stable
- investor ability to demand issuer repurchase the bonds at par value (like a put option)
-sometimes considered money market instruments
auction rate securities (ARS)
- interest rates are reset through Dutch auctions, typically every 7, 14, 28 or 35 days
- generally structured as bond with long term maturities (20-30 yrs)
- no new issue since 2007
GO bond analysis
- income of the muni
- general wealth of community
- characteristics of the issuer
- debt limits
- ad valorem taxes
- official statement: future financial needs, debt statement, calculating the muni’s net total debt
primary source of muni income
- income and sales tax are major sources of state income
- real property taxes are primary income for counties
- school districts are the largest source of city income
- city income includes: fines, fees, assessments, sales tax, hotel taxes, city income taxes, utility taxes and city personal property tax
general wealth of community
- property values
- retail sales per capita
- local bank deposits
- diversity of industry
- population growth or decline
quantitative analysis
objective information on a muni’s population, property values, per capita income
qualitative analysis
subjective factor that affect a muni’s securities - attitudes on taxes and debts, trends in population and property value
debt limits
- to protect taxpayers from excessive taxes
- limit on overal debt a muni can have
- bond’s official statement discloses how close total outstanding debt, including the new issue, comes to the limit
- state constitution or charter can also limit the purposes for which a city can issue bonds
ad valorem (per value) taxes
- property taxes are based on a property’s assessed value
- the tax is a lien on the property which means the property can be seized if taxes aren’t paid
- property taxes are based on millage rate (1 mill = $0.001)
official statement
- muni bonds must provide a form of prospectus called an official statement
- used to determined financial condition at present and in future
future financial needs
must review future debt requirements.
muni might need to issue more debt if:
- annual income isn’t sufficient to make payments on short term or floating debt
- principal repayment schedules are too close together
- sinking funds are inadequate
- pension liabilities are unfunded
- capital improvement plans
debt statement
includes full valuation of taxable property, the est assessed value of property and the assessment %.
overlapping debt with muni’s proportionate share is disclosed
total debt
the sum of all bonds issued by the muni - self supporting debt = net direct debt
net direct debt
includes GOs and short term notes
net total debt/net overall debt
overlapping debt + net direct debt
revenue bond analysis
- rated by facilities potential to generate sufficient money to cover op expenses, principal and interest payments
- not subject to limits
- self supporting
- bondholder, not taxpayers, bear the risk
-factors: economic justification, competing facilities, sources of revenue, call provisions, flow on funds
flow of funds
issuer pledges to pay expenses in a specific order
commonly a net revenue pledge is used - ops and maintenance expenses are paid first. remaining funds go to debt service and other obligations.
gross revenue pledge - if the issuers has not pledged to pay ops and maintenance first, debt service (principal and interest due + sinking fund obligations) is the priority
flow of fund in net revenue pledge
- ops and maintenance
- debt service
- debt service reserve fund
- reserve maintenance fund
- renewal and replacement fund
- surplus (sinking) fund
debt coverage ratio
available revenue/debt service requirement
higher ratio is better
muni bond marketability factors
- rating: higher the rating, the more marketable the bond. Many institutional investors are limited to investment grade debt - as the # of investors increases so does marketability
- maturity: shorter time to maturity is more marketable
- coupon: higher coupons are more marketable
- block size: typically size is $100,000. smaller sizes aren’t marketable
- call feature: the longer the call the protection, the more marketable. Noncallableable bonds are the most marketable
- dollar price: lower dollar price is more marketable
- refunding
- insurance
refunding
- like refinancing - when rates fall, muni issues new bond at lower rate and use proceeds to pay off older higher interest debt
- two types: advance and current refunding
- increases quality, making them more marketable
advance refunding/prerefunding
- refinancing an existing muni bond issue before its maturity or call date by using money from the sale of a new bond issue.
- proceeds are used to buy special govt securities- $ goes to escrow that immediately invests in state and local govt securities (issued from Treasury to munis only in connection with perefundings, SLGS)
current refunding
- old bonds will be redeemed within 90 days or less from the date of the issuance of the refunding bonds
muni bond insurance
- buying insurance increases marketability
- insured bonds are issued with lower coupons rates (due to added safety)
- cost of insurance may lesson yield muni issuer is willing to pay
- MSRB requires certificates have evidence of insurance if they are insured
- insurer takes on liability
- interest and principal will be paid as schedule over the life of the bond
fair prices/ MSRB rule G-30
- markups or markdowns or commissions that muni securities dealers charge must be fair and reasonable and listed on customer confirmation, taking into account: FMV, total dollar amt, special difficulty with trade, dealer is entitled to profit.
- the more marketable the security the less profitable to the dealer
broker’s broker
- assist other firms find buyers and sellers
- primary and secondary markets
- deal mostly with other muni securities firms
- muni market is thin
- anonymity - broker’s broker doesn’t disclose buyer/seller
accrued interest
- increase the bond cost to buyer and proceeds to the seller.
- calculated from the last interest payment date up to but NOT including the settlement date (T+2), meaning the interest starting from that day belongs to the buyer and the previous 6 months interest is a credit to the seller.
- ALL MONTHS COUNT AS 30 DAYS and A YEAR IS 360
- first payment is called a long coupon
dated date
- the date from which interest accrual begins for a new bond issue
trading flat
no accrued interest is included in the transaction
muni bonds bought at a premium
- buyer must amortize the premium on a straight line basis over the remaining life of the bond.
- if the bond is sold before maturity, gain or loss is the difference between sales price and the adjusted cost basis
straight line amortization
an equal Amt of the premium will be amortized each year the bond is held
amortization
- the paying off of debt in regular intervals over a period of time
- also, the ratable deduction of certain capitalized expenditures over a specified period of time
- reduces costs basis and reported interest income
muni bonds bought at a discount
- discount is accreted
- tax effect of accretion depends on whether the bond was purchased as an original issue discount (OID) - new issue being offered at a discount or as an issue purchased at a discount in the second market
accretion
the process of adjusting the cost basis back up to par
- increases cost basis and reported interest income
interest payments
- interest on a muni security is exempt from federal income tax in almost all cases - tax exempt or tax free investments
- muni issuers are able to borrow at lower interest cost and is usually lower than on a US govt bond
tax reform action 1986
- restricted federal income tac exemption of interest for muni bonds to public purpose bonds
public purpose bonds
- bonds issued to finance projects that benefit citizens in general rather than particular private interests
- if the bond directs more than 10% of its proceeds to private parties it is considered a private activity bond and is not autmatically granted tax exemption
calculating tax benefits
- if the investor resides in the issuer’s state , it is generally free of state income tax in addition to free from federal tax.
- tax equivalent yield for a muni bond issued by an entity within a state with a state income tax will have a higher tax equivalent yield to a resident of that state because of double tax exemption.
tax equivalent yield
tax equivalent yield = (muni bond coupon/(100% - investor’d tax bracket))
- tax equivalent yield is ALWAYS higher than the muni coupon
Original issue discount (OID) bonds
- accretion is taxable income
- IRS considers the discount of OID bonds to be a part of the issuer’s payment of interest, therefore accretion on OID is tax free
alternative minimum tax (AMT)
- private activity bonds might be subject to AMT
- congress enacted AMT in 1969 to make certain that high income taxpayers don’t escape paying taxes.
- certain items get favorable tax treatment and muse be added back onto taxable income for the AMT
- IRC says taxpayers must add the excess of the AMT over the regular tax to determine total tax liability.
tax preference items
- tax exempt interest on private purpose, nonessential govt service muni bonds
- certain costs associated with direct participation programs (DPP) - R&D costs and excess intangible drilling costs
- local taxes (state income and property) and interest on investments that do not generate income
- accelerated depreciation on investment property
build america bonds (BABs)
- taxable muni bonds
- created under Economic recovery and reinvestment act of 2009 to help with reducing costs to issuing munis and stimulating the economy.
- bondholders pay tax on interest received from the BAB
- tax credits are provided instead of tax exempt status.
- expanded the pool of investors
- expired on 12/31/2010
tax credit BABs
- provide bondholder federal income tax credit of 35% of the interest paid on the bond in each tax year
- excess can be carried forward
direct payment BABs
- price the muni issuer with payments from the US treasury equal to 35% of the interest paid by the issuer
muni fund securities
- 529 plans
- achieving a better life experience (ABLE) plans
- local govt investment pools (LGIPS)
section 529 plans - qualified tuition program (QTP)
- tax advantaged saving plans offering benefits to those saving for future edu costs
- funded with after tax dollar
- earnings grow tax deferred
- withdraws for edu expenses are tax free
- if the money is used for any other costs the earnings will be taxable a on federal (and maybe state) income tax return in the yr of distribution. +10% tax penalty on the earnings portion of distribution
prepaid tuition plans
allow donors to lock in future tuition rates at today’s prices
inflation protection
education savings plan
- allows donor to invest lump sum or periodic payments
- invest in target date funds
- starting in 2017, up to 10,000 per yr can be used for k-12 edu
achieving a better life experience (ABLE) plans
- tax advantaged savings accounts for individuals with disabilities and their families.
- limits eligibility to individuals with significant disabilities where the age of onset occurred before turning 26.
- contributions are after tax dollars and not tax deductible for federal income taxes.
local govt investment pools (LGIPS)
- state establish LGIPS to provide other govt entities (city, county, school districts, etc) with a short term investment vehicle to investment funds
- formed as a trust in which munis can purchase share or units in the LGIPS portfolio
- not required to register with the SEC and not subject to SEC oversight
- do have disclosure docs which include info statements, investment policy and operating procedures
muni securities rulemaking board (MSRB)
- rules and regs applicable to all firms and individuals that deal with muni securities are written by MSRB
- established by the securities act amendments of 1975 as a independent self regulatory org.
- governs the issuance and trading of muni securities
- protect investors interests, ethical in offering advice, responses to complaints
and disputes - doesn’t regulate issuers
- no authority to enforce its rules - enforced by FINRA with SEC oversight. Except for deal/commercial banks - enforced by agencies: office of the comptroller of the currency, federal reserve board, FDIC
records of associated persons (rule G-7_
- muni securities dealer must obtain and keep on file specific info about its associated persons (anyone with securities registration)
- employment history, disciplinary actions, residence, personal data
- contained in U-4 and U-5 forms
- any material change must be updated within 30 days
- records must be kept for a min of 3 yrs after the termination of the AP
Books and record keeping requirements (Rules G-8 and G-9)
- G-8: lists records to be made
- G-9: states retention requirements (lifetime, 6 yrs and 4 yrs)
lifetime records
- articles of incorporation
- minutes of board or partnership meetings
- records of stock certificates
6 yr records
- blotters (record of original entry)
- general ledger
- customer ledger
- customer accounts records
- written customer complaints (FINRA only requires 4 yrs of retention)
- principal designation record (must be readily available for 2 yrs
MSRB RULE G-15
- requires members to provide customers with written confirmation of transactions
- yield or dollar price computed and she shall be computed to the lower of call or nominal maturity date
- only in whole calls are included
MSRB RULE G-17
don’t cheat, steal or lie
MSRB RULE G-21 advertising
- any material designed for use in the public media
- kept on file for 4 yrs
MSRB RULE G-22 control relationships
- a muni securities form that has a control relationship with respect to a muni security is subject to additional disclosure requirements
- Ex: an officer of a muni dealer sits on BOD of an issuer.
- control relationship must be disclosed in writing at or before the transaction’s completion
MSRB RULE G-37 political contributions
- prohibits muni firms from engaging in muni securities business with an issuer for 2 yrs after any political contribution is made to an official of that issuer
- de minimis contributions of up to 250 are allowed as long as individuals are eligible to vote for the official.
muni finance professional (MFP)
AP of a broker dealer who is primarily engaged in muni securities actives other than retail sales
financial advisors
when a muni dealer provides financial advisory services to an issuer with respect to a new issue for a fee or other compensation
basis of compensation
financial advisory relationship must be documented in writing before, upon or promptly after inception.
this establishes the basis of compensation
conflicts of interest
- firm acts as a ember of the underwriting syndicate and financial advisor of the same issue
- BD typically cannot participate in underwriting if they are acting as financial advisor
- customers must be informed that an advisory relationship exists at or before confirmation of the sale
bond resolution
- The bond resolution, which is also referred to as the bond contract, contains the requirement for the municipality to properly keep the facilities books, reporting requirements regarding revenues collected, conditions of the maintenance covenant, and terms of the rate covenant.
underwriting agreement
underwriting agreement is between the municipality and underwriters, and it spells out the terms agreed to for the underwriting of a new issue.
