Investments & Securities Chapter 8 Municipal Securities Summary Municipal Securities Are Issued State And Local

CHAPTER 8

MUNICIPAL SECURITIES

CHAPTER SUMMARY

Municipal securities are issued by state and local governments and by entities that they establish.

All states issue municipal securities. Local governments include cities and counties. Political

subdivisions of municipalities that issue securities include school districts and special districts

for fire prevention, water, sewer, and other purposes. Municipalities issue long-term bonds as the

principal means for financing both (1) long-term capital projects such as the construction of

schools, bridges, roads, and airports; and (2) long-term budget deficits that arise from current

TYPES AND FEATURES OF MUNICIPAL SECURITIES

There are basically two different types of municipal bond security structures: tax-backed bonds

and revenue bonds. There are also securities that share characteristics of both tax-backed and

revenue bonds.

Tax-Backed Debt

making up shortfalls in the issuing entity’s obligation. However, the state’s pledge is not binding.

Debt obligations with this nonbinding pledge of tax revenue are called moral obligation bonds.

Revenue Bonds

The second basic type of security structure is found in a revenue bond. Such bonds are issued for

either project or enterprise financings in which the bond issuers pledge to the bondholders the

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revenues generated by the operating projects financed. For a revenue bond, the revenue of the

enterprise is pledged to service the debt of the issue. The details of how revenue received by the

enterprise will be disbursed are set forth in the trust indenture.

There are various restrictive covenants included in the trust indenture for a revenue bond to

protect the bondholders. A rate, or user charge, covenant dictates how charges will be set on the

product or service sold by the enterprise. An additional bonds’ covenant indicates whether

additional bonds with the same lien may be issued. Other covenants specify that the facility may

not be sold, the amount of insurance to be maintained, requirements for recordkeeping and for

the auditing of the enterprise’s financial statements by an independent accounting firm, and

requirements for maintaining the facilities in good order.

Hybrid and Special Bond Securities

Some municipal bonds that have the basic characteristics of general obligation bonds and

revenue bonds have more issue-specific structures as well. Some examples are insured bonds,

bank-backed municipal bonds, refunded bonds structured/asset-backed securities and “troubled

city” bailout bonds.

of credit is a liquidity-type credit facility that provides a source of liquidity for payment of

maturing debt in the event that no other funds of the issuer are currently available.

Although originally issued as either revenue or general obligation bonds, municipals are

sometimes refunded. A refunding usually occurs when the original bonds are escrowed or

collateralized by direct obligations guaranteed by the U.S. government. The escrow fund for a

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to the issuer by paying existing bondholders a lower interest rate and using the proceeds to create

a portfolio of U.S. government securities paying a higher interest rate.

MUNICIPAL MONEY MARKET PRODUCTS

Tax-exempt money market products include notes, commercial paper, variable-rate demand

obligations, and a hybrid of the last two products.

Municipal notes include tax anticipation notes (TANs), revenue anticipation notes (RANs),

The put price is par plus accrued interest.

Floaters / Inverse Floaters

A common type of derivative security in the municipal bond market is one in which two classes

of securities, a floating-rate security and an inverse-floating-rate bond, are created from

a fixed-rate bond. The coupon rate on the floating-rate security is reset based on the results of a

Dutch auction.

CREDIT RISK

Municipal bonds are viewed as having little default risk. The default record as reported

byMoody’s indicates that for the issues it rated between 1970 and 2006, there were only

41defaults. This was not always the case. Between 1939 and 1969, 6,195 municipal defaults

were recorded.

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As with corporate bonds, some institutional investors in the municipal bond market rely on their

own in-house municipal credit analysts for determining the credit worthiness of a municipal

issue; other investors rely on the nationally recognized rating companies. The two leading rating

companies are Moody’s and Standard & Poor’s, and the assigned rating system is essentially the

same as that used for corporate bonds.

RISKS ASSOCIATED WITH INVESTING IN MUNICIPAL SECURITIES

YIELDS ON MUNICIPAL BONDS

A common yield measure used to compare the yield on a tax-exempt municipal bond with a

comparable taxable bond is the equivalent taxable yield. The equivalent taxable yield is

computed as follows:

(1 marginal tax rate)−

Yield Spreads

Because of the tax-exempt feature of municipal bonds, the yield on municipal bonds is less than

that on Treasuries with the same maturity. The yield on municipal bonds is compared to the yield

yield on same maturity Treasury bond

Yield spreads within the municipal bond market are attributable to differences between credit

MUNICIPAL BOND MARKET

Primary Market

A substantial number of municipal obligations are brought to market each week. A state or local

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competitive bidding, but generally this is not required for revenue bonds.

An official statement describing the issue and the issuer is prepared for new offerings.

Municipal bonds have legal opinions that are summarized in the official statement.

Secondary Market

Municipal bonds are traded in the over-the-counter market supported by municipal bond dealers

across the country. Markets are maintained on smaller issuers (referred to as local general

The convention for both corporate and Treasury bonds is to quote prices as a percentage of par

value with 100 equal to par. Municipal bonds, however, generally are traded and quoted in terms

bonds that are investment grade. Barclays also publishes a High–Yield Municipal Index and

enhanced state-specific indexes.

THE TAXABLE MUNICIPAL BOND MARKET

Taxable municipal bonds are bonds whose interested is taxed at the federal income tax level.

Because there is no tax advantage, an issuer must offer a higher yield than for another

tax-exempt municipal bond.

taxable bond rather than a tax-exempt bond in the form of a payment from the U.S. Department

of the Treasury.

KEY POINTS

• Municipal securities are issued by state and local governments and their authorities, with the

interest on most issues exempt from federal income taxes. Tax-exempt and taxable municipal

securities are available. “Tax exempt” means that interest on a municipal security is exempt

from federal income taxation.

• Revenue bonds are issued for enterprise financings secured by the revenues generated by the

completed projects themselves or for general public-purpose financings in which the issuers

pledge to the bondholders the tax and revenue resources that were previously part of the

general fund.

structured so that the bonds are to be called at the first possible call date or a subsequent call

date established in the original bond indenture.

• Municipal securities structured as asset-backed securities are backed by “dedicated” revenues

such as sales taxes and tobacco settlement payments.

• Municipal notes and variable-rate demand obligations are tax-exempt money market products

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• A tax risk associated with investing in municipal bonds is that the highest marginal tax rate

will be reduced, resulting in a decline in the value of municipal bonds. Another tax risk

associated with investing in municipal bonds is that a tax-exempt issue may be eventually

declared by the Internal Revenue Service to be taxable.

• Because of the tax-exempt feature, yields on municipal securities are lower than those on

comparably rated taxable securities. Within the municipal bond market, there are credit

spreads and maturity spreads. Typically, the municipal yield curve is upward sloping.

Moreover, there are yield spreads related to differences between in-state issues and general

market issues.

• While the municipal bond market is dominated by tax-exempt municipal bonds, there are

ANSWERS TO QUESTIONS FOR CHAPTER 8

(Questions are in bold print followed by answers.)

1. Answer the below questions.

(a) Explain why you agree or disagree with the following statement: “All municipal bonds

are exempt from federal income taxes.”

One would disagree with the statement: “All municipal bonds are exempt from federal income

taxes.” The argument and clarification are given below.

(b) Explain why you agree or disagree with the following statement: “All municipal bonds

are exempt from state and local taxes.”

One would disagree with the statement that all municipal bonds are exempt from state and local

2. If Congress changes the tax law so as to decrease marginal tax rates, what will happen to

the price of tax-exempt municipal bonds?

A decrease in the maximum marginal tax rate for individuals will decrease the attractiveness of

municipal securities. This was seen with the Tax Reform Act of 1986 where the maximum

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effect on the price of municipal securities as demand will increase. An increase in price is needed

to restore the desired returns.

The lower the marginal tax rate, the smaller the value of the tax exemption features. As the

marginal tax rate declines, the price of a tax-exempt municipal security also declines.

3. What is the difference between a tax-backed bond and a revenue bond?

The two basic security structures are tax-backed debt and revenue bonds. The former are secured

by the issuer’s generally taxing power. Revenue bonds are used to finance specific projects and

The broadest type of tax-backed debt is general obligation debt. There are two types of general

obligation pledges: unlimited and limited. An unlimited tax general obligation debt is the

4. Which type of municipal bond would an investor analyze using an approach similar to

that for analyzing a corporate bond?

Investors use a similar approach to analyze both municipal bonds and corporate bonds. As with

corporate bonds, some institutional investors in the municipal bond market rely on their own in–

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determine the overall debt burden. The second category relates to the issuer’s ability and political

discipline to maintain sound budgetary policy. The focus of attention here usually is on the

issuer’s general operating funds and whether it has maintained at least balanced budgets over

three to five years. The third category involves determining the specific local taxes and

intergovernmental revenues available to the issuer as well as obtaining historical information

both on tax collection rates, which are important when looking at property tax levies, and on the

dependence of local budgets on specific revenue sources. The fourth and last category of

information necessary to the credit analysis is an assessment of the issuer’s overall

socioeconomic environment. The determinations that have to be made here include trends of

local employment distribution and composition, population growth, real estate property

valuation, and personal income, among other economic factors.

5. In a revenue bond, which fund has priority when funds are disbursed from the reserve

fund, the operation and maintenance fund or the debt service reserve fund?

For a revenue bond, the revenue of the enterprise is pledged to service the debt of the issue. The

details of how revenue received by the enterprise will be disbursed are set forth in the trust

6. “An insured municipal bond is safer than an uninsured municipal bond.” Indicate whether

you agree or disagree with this statement.

Everything else being equal, an insured municipal bond is safer. However, generally speaking,

municipal bonds that are insured are riskier than those not insured especially if they are of

7. Who are the parties to a letter-of-credit–backed municipal bond, and what are their

responsibilities?

A letter-of-credit (LOC) agreement is the strongest type of support available from a

The LOC provider `is the bank that issues the LOC and is required to advance funds to the

trustee if one of any specified events occurs. The municipal issuer is the municipality that is

8. Answer the below questions.

a. What are the three different types of letter-of-credit in a municipal bond, and how do

they differ?

A direct-pay LOC grants the trustee the right to request that the LOC provider provide principal

and/or interest for the LOC-backed municipal bond if there is a specified event or default or an

inability of the municipal issuer to meet a contractual interest payment or principal at the

The distinction between a standby LOC and a confirming LOC (also called a LOC wrap)is

that there are small community banks that are unrated by any of the rating agencies but

b. Which of letter-of-credit bond provides the greatest protection for investors?

9. Answer the below questions.

a. What is a prerefunded bond?

b. Why does a properly structured prerefunded municipal bond have no credit risk?

10. Give two reasons why an issuing municipality would want to refund an outstanding

bond issue.

There are three reasons why a municipal issuer may refund an issue by creating an escrow fund.

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First, many refunded issues were originally issued as revenue bonds. Included in revenue issues

are restrictive-bond covenants. The municipality may wish to eliminate these restrictions. The

creation of an escrow fund to pay the bondholders legally eliminates any restrictive-bond

covenants. This is the motivation for the escrowed–to-maturity bonds. Second, some issues are

refunded in order to alter the maturity schedule of the obligation. Third, when interest rates have

declined after a municipal security has been issued, there is a tax arbitrage opportunity available

to the issuer by paying existing bondholders a lower interest rate and using the proceeds to create

a portfolio of U.S. government securities paying a higher interest rate. This is the motivation for

the prerefunded bonds.

11.The following statement appeared in a publication by the Idaho State Treasurer’s

Office:

“Each year since 1982 the Idaho State Treasurer has issued a State of Idaho Tax Anticipation

Note ‘TAN’. These notes are municipal securities that are one-year, interest-bearing debt

Why is a TAN issued by a municipality?

12. What are the revenues supporting an asset-backed security issued by a municipality?

13. The four largest tobacco companies in the United States reached a settlement with 46

state attorneys general to pay a total of $206 billion over the following 25 years. Answer the

below questions.

a. States and municipalities, New York City being the first, sold bonds backed by the future

payments of the tobacco companies. What are these bonds called?

One example is the bonds backed by tobacco settlement payments. In 1998, the four largest

tobacco companies (Philip Morris, R. J. Reynolds, Brown & Williamson, and Lorillard) reached

b. What is the credit risk associated with these bonds?

14. Answer the below questions.

(a) Explain how an inverse-floating-rate municipal bond can be created.

A common type of derivative security in the municipal bond market is one in which two classes of

securities, a floating-rate security and an inverse-floating-rate bond, are created from a fixed-rate

(b) Who determines the leverage of an inverse floater?

The dealer determines the leverage of an inverse floater by choosing the ratio of floaters to

inverse floaters. For example, an investment banking firm may purchase $100 million of the

(c) What is the duration of an inverse floater?

15. Historically, what have been the causes of municipal bankruptcies?

Municipal bonds are viewed as having little default risk. Moreover, cumulative default rates and

recovery rates for investment-grade municipal bonds are better than for comparably rated

Economic conditions: Defaults caused by downturns in the economy and high interest rates.

Nonessential services: Revenue bonds issued for services whose service was no longer needed.

16. Credit default swaps, a derivative instrument described in Chapter 30, allow investors

to buy and sell protection against the default of a municipal issuer. Why do you think it is

difficult to find investors who are willing to buy protection against default of a municipal

issuer but a large number of investors are willing to sell such protection?

Municipal bonds are viewed as having little default risk thus indicating no need to buy default

protection. For example, according to Moody’s, over the period of 1970 to 2005, the 10-year

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more would want to sell protection on a low risk municipal issuer as opposed to buying

protection.

17. In a revenue bond, what is a catastrophe call provision?

In revenue bonds there is a catastrophe call provision that requires the issuer to call the entire

issue if the facility is destroyed. More information on the retirement structure of municipal bonds

including call provisions are given below.

18. What risk would be associated with investing in a municipal bond but not a corporate

bond?

The investor in municipal securities is exposed to the same risks affecting corporate bonds plus

an additional one that may be labeled tax risk. There are two types of tax risk to which tax-

exempt municipal securities buyers are exposed.

19. Answer the following questions.

(a) What is the equivalent taxable yield for an investor facing a 35% marginal tax rate, and

who can purchase a tax-exempt municipal bond with a yield of 6.2%?

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equivalent taxable yield =

tax-exempt

(1 marginal tax rate)

yield

−

.

In our problem, we assume that an investor in the 35% marginal tax bracket is considering the

acquisition of a tax-exempt municipal bond that offers a yield of 6.2%. Inserting our values into

our equation gives:

)35.01(

−

(b) What are the limitations of using the equivalent taxable yield as a measure of relative

value of a tax-exempt bond versus a taxable bond?

When computing the equivalent taxable yield, the traditionally computed yield to maturity is not

the tax-exempt yield if the issue is selling at a discount because only the coupon interest is

20) “The municipal yield curve must indicate that short-term bonds have lower yields than

long-term bonds.” Indicate whether you agree or disagree with this statement.

One would disagree with the statement that in the Treasury and corporate bond markets, it is not

unusual to find at different times either upward, downward or flat shapes for the yield curve. In

21. How does the steepness of the Treasury yield curve compare with that of the municipal

yield curve?

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the municipal bond market. For example, if longer term municipal bonds are in shorter supply

compared to Treasury bonds, then this factor could lead to greater yields for longer term

maturities for municipal bonds. Consequently, a steeper upward sloping yield curve for

municipal bonds would result. Similarly, if longer term municipal bonds are seen as increasing

more rapidly in terms of credit risk with longer maturities, then the upward slope for yield curves

for municipal bonds would be steeper. Finally, investing in municipal securities exposes

investors to the same qualitative risks as investing in corporate bonds, with the additional risk

that a change in the tax law may affect the price of municipal securities adversely. Since the

impact can be greater for longer term maturities, this could cause yield curve for municipal

bonds to be steeper.

22. Explain why the market for taxable municipal bonds competes for investors with the

corporate bond market.

Like the corporate bond market, taxable municipal bonds are bonds whose interested is taxed at

23. What is the yield ratio and why is it typically less than 1?

Because of the tax-exempt feature of municipal bonds, the yield on municipal bonds should be

less than that on Treasuries with the same maturity. Thus, we should typically get a number less

24. Answer the below questions.

(a) What is a Build America Bond?

Despite the excellent performance of the municipal bond sector in terms of credit risk, in 2008

state and local governments and their agencies faced financial difficulties. To provide assistance

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a taxable bond rather than a tax-exempt bond in the form of a payment from the U.S. Department

of the Treasury.

(b) What is the current status of the federal government program authorizing the issuance

of such bonds?

From the time of the program’s inception in April 2009, through the end of the program at the

end of 2010, a total of $181 billion of Build America Bonds were issued. Under this program, the