Unit 6: Municipal Bonds

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The call premium on a municipal bond trading above par is best described as the difference between A) par and the call price. B) the market price and the call price. C) the amortized premium and the annual interest. D) the market price and par.

A) Explanation The call premium represents the difference between the call price and par. The farther away a call date, the lower the call premium. LO 6.c

Investor information about the financial condition of a municipal issuer is most likely found in A) the official notice of sale. B) the official statement. C) the legal opinion. D) The Bond Buyer.

B) Explanation The official statement, which is the disclosure document used in new municipal offerings, will describe the issue's financial condition in detail. LO 6.a

A customer purchases a municipal bond in the secondary market at 84, and he holds the bond to maturity. Because the customer must accrete the discount, what are the tax consequences at maturity? A) Capital gain of $160 B) No capital gain or loss C) Capital loss of $16 D) Capital gain of $16

B) Explanation When a municipal bond is purchased in the secondary market at a discount, the discount must be accreted for cost-basis purposes. Note that the accretion on a discount municipal bond purchased in the secondary market is taxable as ordinary income. At maturity, the customer's cost basis has been accreted to par. Therefore, there is no reported gain or loss on redemption. LO 6.e

A bank doing which of the following would not be required to register as a municipal broker-dealer with FINRA? A) Engaging in transactions to purchase or sell municipal securities for public customers B) Underwriting municipal securities for municipal issuers C) Holding municipal securities as custodian for public customers D) Providing investment research regarding municipal securities to public investors

C) Explanation A bank simply holding municipal securities as custodian for public customers need not register as a municipal securities broker-dealer with FINRA. LO 6.h

A broker's broker does all of the following except A) conceals the identity of the principals. B) acts as agent for dealers. C) makes a market in securities. D) assists in placing securities.

C) Explanation A broker's broker acts as the agent in transactions by facilitating the movement of blocks of bonds. The broker's broker is allowed to conceal the identities of the contra-parties, thus protecting investment strategies. A broker's broker does not make a market in securities. LO 6.d

Which of the following statements about municipal brokers' brokers is not true? A) They perform specialized trades for institutions. B) They do not maintain inventories. C) They perform trades on a principal basis only. D) They do not perform retail trades with individual investors.

C) Explanation A broker's broker does not maintain an inventory of bonds. Therefore, they do not act as principals; they act as agents only in trades between dealers or institutions. They do not do retail business. LO 6.d

A calamity (catastrophe) call may be made by a municipal issuer if A) a building constructed with revenue bond financing has been condemned. B) the issuer must call outstanding bonds on a predetermined schedule as outlined in the bond contract. C) interest rates have fallen. D) the issuer has accumulated excess money in its surplus account.

A) Explanation A calamity call is also known as a catastrophe call. If a facility built with revenue bond financing is destroyed or condemned, the issuer must call the bonds with the bulk of the funds provided by insurance proceeds. LO 6.b

An investor receiving a quote of 102 for a municipal security is probably interested in A) a term bond. B) a general obligation bond. C) a serial bond. D) a bond anticipation note.

A) Explanation A quote of 102 is referred to as a dollar quote ($1,020) rather than a yield quote. The most common dollar bonds are those with a term maturity. The other choices are most often quoted on a yield basis rather than a price basis. LO 6.a

Long-term securities issued by municipalities that use a Dutch auction method to reset short-term interest rates known as clearing rates are A) auction rate securities (ARS). B) American depositary receipts (ADRs). C) real estate investment trusts (REITs). D) collateralized mortgage obligations (CMOs).

A) Explanation ARS are long-term securities issued by municipalities that use a Dutch auction to reset interest rates at short-term intervals. The reset rate is known as the clearing rate and establishes the rate paid during the period following the auction. LO 6.b

An investor purchased a corporate bond with a 6% coupon at a net price of 101. The bond had accrued interest for 45 days. Which of the following statements regarding the confirmation of this trade is correct? A) The total amount due on the purchaser's confirmation will appear as $1,017.50. B) The total amount due on the purchaser's confirmation will appear as $1,010. C) The total amount received on the seller's confirmation will appear as $1,002.50. D) The total amount due on the purchaser's confirmation will appear as $1,025.

A) Explanation Accrued interest is always added to the price of a bond. When you buy the bond, you pay that accrued interest, and when you sell a bond, you receive that accrued interest. The principal value is 101, or $1,010. Forty-five days of accrued interest is ⅛ of a 360-day year, or ¼ of a 180-day semiannual interest payment. With a 6% coupon, the bond pays $30 every 6 months. One quarter of that is $7.50 so the total cost to the purchaser is the $1,010 plus the $7.50, or $1,017.50. LO 6.e

TANs, RANs, GANs, and BANs are issued by municipalities seeking A) short-term financing. B) financing for low-cost housing. C) bond insurance. D) special tax assessments for general obligation bonds.

A) Explanation Municipal short-term notes (tax anticipation notes, revenue anticipation notes, grant anticipation notes, and bond anticipation notes) are used as interim financing until a permanent long-term issue is floated or until tax receipts increase or revenue flows in. LO 6.b

Which of the following details would not be found on the bond resolution for a revenue bond? A) The insurance covenant B) The rate covenant C) The maintenance covenant D) The tax covenant

D) Explanation Unless something in the question refers to special taxes, revenue bonds do not have tax backing. The other items are included in the bond resolution (or trust indenture). The rate covenant is a promise to maintain rates sufficient to pay expenses and debt service. The maintenance covenant is a promise to maintain the equipment and facility/facilities. The insurance covenant is a promise to insure any facility. LO 6.b

Of the following callable bonds, which confirmation must show yield to call? A) 6% municipal, basis 5.5%, due 2028 B) 6% municipal, basis 6.5%, due 2028 C) 6% municipal, basis 7%, due 2038 D) 6% municipal, par, due 2038

A) Explanation The only bond priced at a premium is 6% municipal, basis 5.5%, due 2028. On a premium bond, the yield to call will be lower than the yield to maturity. LO 6.h

Of the following callable bonds, which confirmation must show yield to call? A) 6% municipal, basis 5.5%, due 2028 B) 6% municipal, par, due 2038 C) 6% municipal, basis 7%, due 2038 D) 6% municipal, basis 6.5%, due 2028

A) Explanation The only bond priced at a premium is 6% municipal, basis 5.5%, due 2028. On a premium bond, the yield to call will be lower than the yield to maturity. LO 6.h

All of the following terms are associated with general obligation (GO) bonds except A) protective covenants. B) coterminous debt. C) voter referendum. D) limited tax bond.

A) Explanation The protective covenants are found in the trust indenture of a revenue bond. Among the more common protective covenants are the rate covenant and the maintenance covenant. The former is a promise to maintain rates sufficient to pay expenses and debt service. The latter is a promise to maintain the equipment and facility/facilities. Coterminous debt, or overlapping debt, exists when a single property is taxed by more than one taxing authority (e.g., when property is taxed by both a school district and a county). Certain GOs may have limitations imposed on increasing any of the taxes that back them and are called limited tax bonds. GO bonds require voter approval. LO 6.b

If your customer bought an original issue discount bond from the Mount Vernon Port Authority, how is the discount on this bond taxed? A) Accreted during the life of the bond and not taxed B) As ordinary income C) Amortized during the life of the bond and not taxed D) As capital gains

A) Explanation Under IRS rules, an owner of an original issue municipal discount bond must adjust the bond's cost basis by accreting the discount over the life of the bond. The accretion is not taxed. LO 6.f

All of the following are characteristics of 529 plans except A) donor income limits apply. B) the assets can be transferred to a family member if not used by the original beneficiary. C) there is no age limit on the beneficiary. D) an official statement (OS) must be provided to any prospective purchaser.

A) Explanation Unlike the Coverdell ESA, there are no donor income limits with a 529 plan. All of the other statements are true as to 529 plans.

A J & J Treasury bond with a 5% coupon due July 1, 2019, is purchased in a cash transaction on February 24. What is the number of days of accrued interest? A) 63 B) 54 C) 53 D) 55

B) Explanation A bond begins accruing interest on the prior interest payment date (January 1) and accrues up to, but not including, the settlement date (February 24). Did you notice that this was a cash transaction? That means the settlement date is the same day as the trade (February 24). Normally, Treasury securities settle T+1. If this was a regular-way trade, the accrued interest would be 55 days because settelment would have been February 25. Be careful reading the question; it is easy to skip over critical information. Because accrued interest on government bonds is computed actual days, actual year, 31 days for January plus 23 days for February, it equals 54 days. LO 6.e

The function of a broker's broker in the municipal bond business is to do which of the following? Help sell municipal bonds that a syndicate has been unable to sell Protect the identity of the firm on whose behalf the broker's broker is acting Help prepare bids for an underwriting syndicate Serve as a wholesaler, offering bonds at a discount from the current bid and offer A) III and IV B) I and II C) II and III D) I and IV

B) Explanation A broker's broker helps sell the bonds a syndicate has left and does not disclose the identity of the firm on whose behalf it is acting. Brokers' brokers do not charge fees for quoting a security, do not maintain inventory, and act solely as agents earning a commission for their services. LO 6.d

Under Municipal Securities Rulemaking Board rules, which of the following would indicate a control relationship between a municipal dealer and an issuer? A) The dealer is engaged as an underwriter for the issuer B) A dealer's officer sits on the issuer's board of trustees C) The dealer was an underwriter of the municipality's last issue D) The principal of the dealer lives within the municipality

B) Explanation A control relationship exists if someone represents both an issuer and municipal securities dealer. LO 6.h

A customer purchases an XYZ municipal bond at 108. It is scheduled to mature in 16 years. After owning the bond for 10 years, she sells the bond at 102. What capital gain or loss must she report for tax purposes at the time of the sale? A) $20 gain B) $10 loss C) $60 loss D) $10 gain

B) Explanation If a municipal bond is purchased at a premium, the premium must be amortized over the time until maturity. An $80 premium on a 16-year municipal bond indicates that $5 will be amortized each year ($80 / 16 = $5). Ten years at $5 per year is $50 of amortization. Therefore, after 10 years, the tax basis would be $1,080 minus $50, or $1,030 (103). Because the sale was for 102 ($1,020), the customer has a $10 loss on one bond. LO 6.e

When a municipal bond has a net revenue pledge, what is the first item that gets paid from the revenue received? A) The debt service account B) The debt service reserve account C) The surplus fund D) The operations and maintenance fund.

D) Explanation Under a net revenue pledge, operations and maintenance expenses are paid before all debt service. Payments are made in the following order: operating and maintenance expenses, debt service, debt service reserve, and surplus. LO 6.c

In the analysis of a general obligation bond issued by a county, negative factors would include I) an increase in assessed property values. II) an increase in the county's unemployment rate. III) an increase in the percentage of tax payment delinquencies. IV) an increase in the number of office buildings being rehabilitated. A) I and IV B) II and III C) I and II D) III and IV

B) Explanation Because general obligation bonds are backed by taxes, an increase in tax delinquencies is negative. When unemployment rates increase, it could lead to an inability of the residents to keep current with their taxes. LO 6.b

A 3% bond with 20 years to maturity is being issued by a syndicate with a reoffering yield of 4%. What is the term used to describe this bond? A) Original issue premium B) Original issue discount C) High-yield bond D) Secondary market discount

B) Explanation Because the bond is being issued by a syndicate, it is a new issue (i.e., an original issue). Because the yield (4%) is higher than the coupon (3%), it is an original issue discount. LO 6.f

Municipal securities broker's brokers A) share the names of their clients with the executing dealers. B) execute trades for other municipal securities broker-dealers. C) bid on negotiated underwritings. D) participate in selling groups on new municipal issues.

B) Explanation Broker's brokers are what the term implies. They represent other firms and use their connections to facilitate trades, usually with institutions. They never take an inventory position or get involved with underwriting new issues. One of their key roles is preserving the anonymity of their clients. LO 6.d

If industrial development bonds are called because of condemnation, this would be covered under which of the following clauses in the bond indenture? A) Defeasance B) Catastrophe C) Refunding D) Refinancing

B) Explanation Condemnation is considered a catastrophe and only applies to revenue bonds. LO 6.b

Which of the following is the computation for the coverage ratio for a municipal revenue bond issue? A) Revenues collected divided by annual interest expense B) Net revenue divided by annual interest and principal expense C) Revenues collected divided by annual principal expense D) Annual interest and principal expense divided by revenues collected

B) Explanation Debt service coverage measures the amount of money available for debt service compared to the annual debt service requirements. Annual debt service includes both interest and principal expense. LO 6.b

One of your customers calls you to say that he received a letter saying that his local water works revenue bonds were being defeased. How would that affect the customer? A) The customer will need to file a claim with the appropriate court to receive payment for the bonds. B) The customer would be receiving payment of the principal plus any accrued interest after the defeasance is completed. C) The maturity date is being automatically extended as called for in the official statement. D) Because of failure to generate sufficient revenue, interest payments are suspended temporarily.

B) Explanation Defeasance occurs when an outstanding bond issue is paid off prior to maturity through a refunding. Once the creditors (the bondholders) have received their funds, any liens on assets or revenues are terminated. **This question deals with material not covered in your LEM, but it relates to recent rule changes and/or student feedback. LO 6.d

The interest from which of the following bonds is subject to federal income tax? State of Nebraska City of Duluth Treasury notes Federal National Mortgage Association (FNMA) A) I and III B) III and IV C) I and II D) II and IV

B) Explanation Direct federal debt, such as a Treasury note, is subject to federal income tax but exempt from state tax. FNMA bonds are subject to federal, state, and local taxes. State and city bonds, being municipals, are exempt from federal income tax. LO 6.f

An example of overlapping debt would be a school district and A) a local utility power plant. B) county general debt. C) a water pollution control facility. D) corporate debt of the county's largest employer.

B) Explanation Do not combine revenue bonds with GOs to determine overlapping debt. Overlapping debt occurs in real estate taxing situations. Only GOs are backed by real estate taxes. LO 6.b

Which of the following ratios is normally considered adequate coverage of interest and principal charges for a municipal revenue bond? A) 3:1 B) 2:1 C) 7.5:1 D) 1:1

B) Explanation Generally, a sound debt service (interest and principal) coverage ratio for municipal revenue bonds is 2:1. In other words, $2 of revenue is collected for every $1 of debt service. LO 6.b

Which of the following details would not be found on the bond resolution for a revenue bond? A) The rate covenant B) The maintenance covenant C) The insurance covenant D) The tax covenant

All of the following statements regarding Section 529 plans are true except A) states impose very high overall contribution limits. B) contributions to a 529 plan may be subject to gift taxation. C) the assets in the account are controlled by the account owner, not the child. D) the income level of the contributor can affect the annual contribution amount.

D) Explanation Unlike Coverdell ESAs, the income level of the contributor will not affect annual contributions under a Section 529 plan. LO 6.g

All of the following are characteristics of 529 plans except A) an official statement (OS) must be provided to any prospective purchaser. B) the assets can be transferred to a family member if not used by the original beneficiary. C) there is no age limit on the beneficiary. D) donor income limits apply.

D) Explanation Unlike the Coverdell ESA, there are no donor income limits with a 529 plan. All of the other statements are true as to 529 plans. LO 6.g

Voter approval may be required for new bond issues for construction of which of the following? I) Airports II) Turnpikes III) State prisons IV) Public high schools A) I and II B) II and IV C) I and III D) III and IV

D) Explanation Voter approval may be required for new issues of GO bonds. State prisons and public high schools are among the facilities for the public good that are built and supported by GO issues. User fees (like tolls) support revenue bond issues for the construction of facilities such as airports and turnpikes. LO 6.b

If a municipal bond is purchased at a discount, which of the following is true? A) The discount is amortized and increases cost basis each year until maturity. B) The discount is amortized and decreases cost basis each year until maturity. C) The discount is accreted and decreases cost basis each year until maturity. D) The discount is accreted and increases cost basis each year until maturity.

D) Explanation When a municipal bond is purchased at a discount, the amount of the discount is accreted. Accretion is the process of upwardly adjusting the cost basis each year until maturity. At maturity, the cost basis will equal PAR. LO 6.e

A customer buys a municipal bond in the secondary market at 96 that has four years to maturity. Two years later, the customer sells the bond at 99. The tax consequences of this investment are A) three points of capital gain. B) three points of ordinary income. C) two points of capital gain and one point of ordinary income. D) two points of ordinary income and one point of capital gain.

D) Explanation When a municipal bond is purchased in the secondary market at a discount, the annual accretion is taxed as ordinary income. The annual accretion is one point per year (four points divided by four years to maturity). Therefore, when the bond is sold two years later, its cost basis is 98. If the bond is sold at 99, there is a long-term capital gain of one point per bond. Also, there is ordinary income taxation on the accretion of two points. LO 6.f

The official statement for a new revenue bond indicates that the flow of funds is based on a net revenue pledge. This means the first payments go to A) pay the interest and principal maturing in the current year. B) renewal and replacement fund. C) the debt service reserve fund. D) pay current operating and maintenance expenses.

D) Explanation When the flow of funds is described as a net revenue pledge, it means the operating and maintenance expenses are paid first. Following that is the debt service (interest and this year's principal). In a gross revenue pledge, the order is reversed. LO 6.c

A corporate bond pays interest on a J/J 15 schedule. An investor purchasing these bonds on Friday, April 17, would pay accrued interest for A) 96 days. B) 92 days. C) 91 days. D) 95 days.

A) Explanation Accrued interest on a corporate (or municipal) bond is based on each month containing 30 days. As with all bonds, the accrued interest is paid up to, but not including the settlement date. A trade made on Friday settles the following Tuesday (T+2), April 21. That means 3 months at 30 days each (90 days) plus 6 additional days (we don't count the settlement date) for a total of 96 days. One way to set this up is: 4/21 - 1/15 = 3 months and 6 days = 90 + 6. LO 6.e

A municipality has an ad valorem tax rate of 10 mills. A piece of real property is assessed at $100,000 and has a market value of $125,000. The annual taxes paid on the property are A) $1,000. B) $1,250. C) $100. D) $125.

A) Explanation Ad valorem tax rates are based on mills with one mill being equal to $0.001 (1/10th of a cent). The amount of taxes to be paid on the property is determined by multiplying the millage rate—in this case, one cent (10 mils at $0.001 = $0.01)—times the assessed property value ($100,000). The market value is irrelevant. For those who have difficulty determining where the decimal point goes, on any question like this, drop the last three 000s from the assessed value and multiply by the millage rate. In this question, that would be $100 times 10 and that equals the correct answer of $1,000. LO 6.c

An unqualified legal opinion means that A) the bond counsel has rendered an opinion without any qualifying limitations. B) the underwriter has failed to disclose sufficient information to qualify the issue. C) the interest is not exempt from state or local taxes. D) the issue is legal, but certain contingencies may limit the flow of funds in the future.

A) Explanation An unqualified legal opinion means that the bond counsel found no problems with the issue. A qualified opinion means that the issue is legal, but certain contingencies exist. For example, the bond counsel might render a qualified opinion because authority to tax is in question or the issuer does not have clear title to the property. LO 6.a

An investor has purchased a municipal certificate of participation (COP). COPs can be characterized by all of the following except A) they would require voter approval before a municipality could issue them. B) the holder of a COP could foreclose on the asset generating the revenue in the case of default. C) the holder of the COP participates in lease or loan payments from a specific piece of equipment or facility purchased or built by the municipality. D) they are a form of municipal revenue bond.

A) Explanation COPs are considered revenue issues and, therefore, do not require voter approval. They are a form of lease revenue bond that allow the holders of the certificates to participate in some revenue stream (lease or loan payments) associated with land, equipment, or facilities purchased or built by the municipality. They are unique in that in the case of default, the holders of the COPs could foreclose on the asset associated with the certificate. LO 6.b

All of the following statements regarding 529 plans are true except A) contributions are made with pretax dollars at the federal level. B) earnings accumulate tax free if the money is used for qualified educational purposes. C) anyone can make a contribution on behalf of a beneficiary. D) a beneficiary of a 529 plan may also be the beneficiary of a Coverdell Education Savings Account.

A) Explanation Contributions are made with after-tax dollars. Withdrawals are tax free at the federal level if used for qualified higher education expenses. LO 6.g

One of your customers calls you to say that he received a letter saying that his local water works revenue bonds were being defeased. How would that affect the customer? A) The customer would be receiving payment of the principal plus any accrued interest after the defeasance is completed. B) Because of failure to generate sufficient revenue, interest payments are suspended temporarily. C) The maturity date is being automatically extended as called for in the official statement. D) The customer will need to file a claim with the appropriate court to receive payment for the bonds.

A) Explanation Defeasance occurs when an outstanding bond issue is paid off prior to maturity through a refunding. Once the creditors (the bondholders) have received their funds, any liens on assets or revenues are terminated. **This question deals with material not covered in your LEM, but it relates to recent rule changes and/or student feedback. LO 6.d

A representative wishes to execute an order for a customer's discretionary account. The municipal dealer has a control relationship with the issuer of the security to be purchased. Under Municipal Securities Rulemaking Board rules, the representative A) must have specific authorization from the customer. B) may not execute the order. C) may refer the customer to a firm that has no control relationship. D) must wait until the firm terminates the control relationship.

A) Explanation Even in a discretionary account, a registered representative may not exercise discretion when a control relationship exists between the issuer and the dealer without first receiving the customer's permission. LO 6.h

All of the following are useful tools for saving for a child's higher education except A) funding a Roth IRA in the child's name. B) opening an UTMA account. C) using a Section 529 plan. D) starting an education IRA.

A) Explanation Funding of IRAs, traditional or Roth, requires that the owner have earned income. Although the term is rarely used any longer, the original name of the Coverdell ESA was education IRA (and it may appear on the exam). LO 6.g

A municipality that has issued grant anticipation notes (GANs) (short-term municipal notes) does so in expectation that the debt service will be paid by the receipt of funds attained A) via grants from the federal government. B) from both tax and other anticipated revenue. C) through the issue of long-term bonds. D) from future tax revenue.

A) Explanation GANs are short-term municipal notes issued in anticipation of funds via grants that the municipality is expecting from the federal government. LO 6.b

A customer purchased a full faith and credit bond. This bond would be known as A) a general obligation bond. B) a moral obligation bond. C) a sinking or surplus fund bond. D) a revenue bond.

A) Explanation General obligation bonds are also known as full faith and credit bonds. LO 6.b

Which of the following ratios is normally considered adequate coverage of interest and principal charges for a municipal revenue bond? A) 2:1 B) 3:1 C) 1:1 D) 7.5:1

A) Explanation Generally, a sound debt service (interest and principal) coverage ratio for municipal revenue bonds is 2:1. In other words, $2 of revenue is collected for every $1 of debt service. LO 6.b

All of the following characteristics regarding industrial development bonds (IDBs) are true except A) the bonds are normally backed by the full faith and credit of the municipality. B) funds from the lease are used to pay the principal and interest on the bonds. C) the bonds are issued by municipalities or other governmental units. D) the funds are used to construct a facility for a private corporation.

A) Explanation IDBs are issued by a municipality, and the proceeds are used to construct facilities or purchase equipment for a private corporation. The corporation leases the facilities or equipment, and funds from the lease are used to repay investors. In addition to a first mortgage on the property, IDBs are backed by the full faith and credit of the corporation (not the municipality). LO 6.b

Which of the following municipal bonds may be paid by a state's legislative apportionment of funds to service the debt? A) Moral obligation B) Special tax C) Special assessment D) Industrial development revenue

A) Explanation If a moral obligation bond goes into default, bondholders do not have the right to sue to force a tax to pay off the bonds. The only way bondholders can recover the principal is through legislative apportionment. The issuer's legislative body has to appropriate funds to pay off the bonds. With a moral obligation bond, issuers have the moral, but not legal, obligation to service the debt. LO 6.b

If a customer buys a new issue municipal bond at a discount in the primary market, which of the following statements are true? I) The discount must be accreted. II) The discount may not be accreted. III) At maturity, there is a capital gain. IV) At maturity, there is no capital gain. A) I and IV B) I and III C) II and III D) II and IV

A) Explanation If a new issue municipal bond is bought at a discount in the primary market, the discount must be accreted. The accretion is considered interest income, and, as an original issue discount bond, is not taxable. LO 6.f

A project that was funded with a revenue issue has been condemned by the state under an eminent domain proceeding. The outstanding bonds would be subject to which of the following call provisions? A) Catastrophe call B) Defeasance call C) Prerefunding call D) Refunding call

A) Explanation If a revenue project was condemned under eminent domain, the bonds would be subject to a catastrophe call. LO 6.b

An investor purchases five Mount Vernon Port Authority J & J 1 bonds in a regular way transaction on Wednesday, October 18. How many days of accrued interest are added to the bond's price? A) 109 B) 108 C) 114 D) 110

A) Explanation Interest accrues on municipal bonds on a 360-day-year basis, with all months having 30 days. This bond pays interest on January and July 1 (J & J 1). Therefore, July, August, and September each have 30 days of accrued interest, and October has 19 days of accrued interest; this totals 109 days. Settlement date is Friday, October 20. LO 6.e

A municipal A & O bond is issued on October 1, 2010, with a 10-year stated maturity. If a trade in this bond settles on April 1, 2020, how many days' worth of accrued interest will be added to the price of the bond? A) 0 B) 180 C) 90 D) 1

A) Explanation Interest on a municipal bond begins to accrue on the previous payment date and ends the day before settlement date. Always assume a bond pays interest on the first of the month unless told differently. In this case, interest is payable on April 1 and October 1 each year. Whenever a bond trade settles on a payment date, it trades flat (without accrued interest). LO 6.e

The alternative minimum tax (AMT) is designed to present an alternative tax computation that disallows deductions for certain tax preference items and includes certain nontaxable income. Which of the following is not a tax preference item? A) Interest received on corporate bonds B) Local income and property taxes C) Certain costs associated with an oil and gas drilling program D) Tax-exempt interest received on private purpose bonds

A) Explanation Interest on corporate bonds is taxable and included in an investor's adjusted gross income (AGI), but not for the AMT. Tax-exempt interest on private activity bonds and excess intangible drilling costs in an oil and gas DPP are included as tax preferences. In addition, state and local taxes and accelerated depreciation are in the list of preference items. LO 6.f

The interest on which of the following municipal securities may be considered preference income for alternative minimum tax purposes? A) Private purpose bonds B) TANs C) PHAs D) Original issue discount bonds

A) Explanation Interest on private activity municipal bonds is included in the taxable income of an investor who is subject to the alternative minimum tax. LO 6.f

Under Municipal Securities Rulemaking Board (MSRB) rules, a broker-dealer must disclose control relationships A) in all customer transactions. B) never. C) only for secondary market transactions. D) only for new issues.

A) Explanation MSRB rules require disclosure to clients of any control relationship that exists between the broker-dealer and the issuer. The rule applies to all customer transactions, including research reports. LO 6.h

Which of the following statements regarding municipal securities quotations are true? I) A quotation can be an indication of interest. II) A quotation cannot be an indication of interest. III) A quotation can be a one-sided request for a bid or offer (bids wanted and offers wanted). IV) A quotation cannot be a one-sided request for a bid or offer (bids wanted and offers wanted). A) I and III B) II and III C) II and IV D) I and IV

A) Explanation Municipal Securities Rulemaking Board rules pertaining to quotations cover all bona fide bids and offers, including one-sided requests for bids wanted and offers wanted, which are considered indications of interest. LO 6.a

If an investor is in the highest federal income tax bracket and is subject to the alternative minimum tax (AMT), which of the following securities should an agent recommend? A) General obligation (GO) bond B) Corporate bond C) Industrial revenue bond D) Treasury bond

A) Explanation Municipal bonds are suitable for the portfolio of an investor who is in a high tax bracket because the interest is exempt from federal income tax. A GO bond is a better recommendation than an industrial revenue bond because the interest on industrial revenue bonds is likely subject to the AMT. LO 6.f

In safety of principal, general obligation municipal bonds are considered second only to A) U.S. government and agency bonds. B) common stock. C) AAA-rated corporate bonds. D) preferred stock.

A) Explanation Municipal securities are considered second in safety of principal to only U.S. government and agency issues. LO 6.b

You are having a discussion with one of your clients regarding suitable investments. The client is in a high-income tax bracket and has a high net worth as well. During the conversation, your client mentions several investments that she is thinking about that might be beneficial to her now. Of those listed, which would be the best recommendation? A) Municipal bonds B) Noninvestment-grade corporate bonds C) A real estate investment trust (REIT) D) A corporate blue-chip balanced mutual fund

A) Explanation Of the choices listed, only municipal bonds offer a tax consequence suitable for high-income, high-net-worth investors in the form of tax-free interest payments. Corporate bond interest, mutual fund dividends, and income earned from REITs are all taxable. LO 6.b

A new municipal bond issue had a dated date of January 1, 2018. The first coupon was due on August 1, 2018. The customer bought for settlement on September 1, 2018. How many months of accrued interest must he pay at settlement? A) One month B) Six months C) Eight months D) Seven months

A) Explanation On a new bond issue, the issuer sets the dated date. That is the date from which interest first begins to accrue. It is not unusual for the first interest payment date to be more than six months from the dated date. That is known as a long coupon (longer than six months). Therefore, on August 1, 2018, seven months of interest was paid (January through the end of July). The customer did not purchase the bond until late August and owes interest only from the August 1, 2018, coupon payment date up to, but not including, the September 1 settlement date (one month). LO 6.e

Which of the following types of municipal bonds is subject to statutory debt limits? A) General obligation (GO) bonds B) Special tax bonds C) Industrial development revenue (IDR) bonds D) Hospital bonds

A) Explanation Only GO bonds, which are backed by the taxing authority of the issuer, are subject to statutory debt limits. LO 6.b

Which of the following bodies may not incur overlapping debt? A) A state government B) A parks and recreation department C) A county highway department D) A school district

A) Explanation Overlapping debt is debt of another issuing body that is paid by property taxes of residents. School districts, parks and recreation departments, highway departments, and library systems are all paid through real estate taxes (GOs). State debt is least likely to be overlapping, as states do not generally tax real estate. LO 6.b

Which of the following would be considered in analyzing the credit worthiness of a revenue bond issuer? I) Per capita debt II) Debt service coverage III) Management IV) Debt to assessed valuation A) II and III B) I and IV C) I and II D) III and IV

A) Explanation Revenue bonds are paid out of revenues from a particular project or facility, not from tax revenue. Therefore, debt service coverage and the personnel in charge of managing the facility are important. Overall debt of the issuer would be important in analyzing a general obligation bond backed by the issuer's full faith and credit. LO 6.b

Which of the following bonds is issued to finance the construction of subsidized housing and is backed by rents and the taxing authority of the U.S. government? A) Section 8 B) Special assessment C) Moral obligation D) Special tax

A) Explanation Section 8 bonds, also known as Public Housing Authority bonds and New Housing Authority bonds, are used to finance subsidized housing. These bonds are backed by rental income. If this income is insufficient to service the debt, the U.S. government makes up the difference. Essentially, these are revenue bonds backed by the U.S. government, and are therefore AAA rated. LO 6.b

Which of the following statements regarding the suitability of municipal bonds are true? I) The tax-free interest payments make them more suitable for those in higher tax brackets. II) The tax-free interest payments make them more suitable for those in lower tax brackets. III) The tax-free interest is why municipal bonds are not considered suitable investments to be included in one's retirement account, such as an IRA. IV) The tax-free interest is one reason why municipal bonds are considered suitable investments to be included in one's retirement account, such as an IRA. A) I and III B) II and IV C) II and III D) I and IV

A) Explanation Tax-free interest payments are more suitable for those for whom the tax advantage has the most impact. That would be those in higher tax brackets, who would pay more taxes on the interest received if the interest payments were taxable. Additionally, the tax-free interest is why municipal bonds are not suitable for retirement accounts. This is because the earnings in retirement accounts are already tax deferred, and the impact of receiving tax-free interest is lost or diminished. LO 6.f

Which of the following may only be accomplished after applying the additional bonds test for a revenue bond? A) Issuing new bonds with an equal lien on the project's revenues B) Increasing the project's user charges C) Spending revenues already allocated for project expansion D) Prerefunding an outstanding bond issue

A) Explanation The additional bonds test must be met under the provisions of a revenue bond indenture before additional bonds with an equal lien on project revenues can be issued. The conditions under which additional bonds may be issued are specified in the bond indenture. This is an open-end covenant. LO 6.b

An investor purchased 10 GO bonds at a discount of 2 points per bond. The bonds mature in 10 years. After holding the bonds for 5 years, they were sold at par. For tax purposes, the investor has A) a $100 gain. B) a $100 loss. C) no gain and no loss. D) a $50 gain.

A) Explanation The cost per bond is $980. The accretion amount each year is $20. $20 ÷ 10 years = $2 per year. $2 per year × 5 years = $10 per bond accretion, making the adjusted cost basis $990 per bond. When the bonds are sold at par ($1,000), there is a profit of $10 per bond × 10 bonds, which equals a $100 gain. LO 6.e

Which of the following investment vehicles has the highest credit risk? A) Industrial revenue bonds B) New Housing Authority bonds C) Ginnie Mae pass-through certificates D) General obligation bonds

A) Explanation The industrial revenue bonds would have the highest risk because debt service is the responsibility of the corporation leasing the facility rather than the issuing municipality. LO 6.b

Ten municipal bonds were purchased with 9% nominal yield for settlement on February 1, 2015. The maturity date of the bonds is July 1, 2035. What is the number of days of accrued interest on the 10-bond trade? A) 30 B) 31 C) 37 D) 29

A) Explanation The maturity month and day will always match one of the two semiannual coupon dates. Because maturity is July 1, the bond pays interest on January 1 and July 1 of each year. With settlement on February 1, the bond accrued interest from January 1 up to, but not including, settlement (30 days). LO 6.e

Under Municipal Securities Rulemaking Board rules, if a municipal securities dealer has a financial advisory relationship with an issuer, which of the following statements is not true? A) The relationship need not be disclosed in communications with the public pertaining to that issuer's securities. B) The relationship must be disclosed to purchasing customers. C) The contract must be in writing. D) The contract must set forth the basis of compensation.

A) Explanation When a financial advisory relationship exists, it must be disclosed to all buyers of that issuer's securities and in any advertising (communications with the public) relating to that issuer. LO 6.h

A municipal bond is purchased at a discount in the secondary market at 90. The face amount is $10,000, and the bond has 10 years to maturity. If the bond is sold for 97 after five years, what is the taxable gain? A) $200 B) Capital gains not taxable C) $700 D) $300

A) Explanation When a municipal bond is bought at a discount in the secondary market, the discount is accreted and taxable as ordinary income. Accretion increases cost basis. Therefore, five years later, the bond's cost basis is 95. At that point, the customer has a two-point capital gain. Had the bond been bought as an original issue discount, the annual accretion is considered interest income and is not taxable. LO 6.e

If a municipal bond rated BBB is prerefunded, all of the following statements are true except A) the marketability of the issue will decrease. B) funds required to meet debt servicing have been set aside in escrow. C) the rating of the issue will increase. D) the issue is now backed by U.S. government securities.

A) Explanation When funds are escrowed to call in a bond at a predetermined call date, the bond is said to be prerefunded. The money set aside is invested in government securities, which makes the issue very safe and highly marketable. The rating of prerefunded bonds is AAA, as they are now backed by U.S. government securities. LO 6.b

An investor purchases a municipal bond at par to yield 5.5% to maturity. Two years later, if he sells the bonds at a price equivalent to a 5% yield to maturity, the investor incurs A) a capital gain. B) no taxable result at this time. C) a capital loss. D) tax-free income.

A) Explanation Yields fall as bond prices rise. Because the yield to maturity has dropped, the bond is trading at a higher price than when it was purchased. The consequence of the sale is a capital gain because the investor sold the bond that was purchased for par at a premium. LO 6.e

One of your customers is in the 37% federal income tax bracket. The customer prefers purchasing corporate bonds over municipal bonds because the corporation's financials are much easier to understand. On the customer's next purchase, the instructions are to find a corporate bond that will yield the same after-tax return as would be received from a municipal bond with a 3.20 coupon. The bond you suggest must have a coupon of A) 5.08%. B) 3.20%. C) 4.38%. D) 8.65%.

A) This is a tax-equivalent yield question. The interest paid on a corporate bond is taxable, while that of the municipal bond is tax free. The formula is: The coupon of the municipal bond divided by (100% − tax bracket). In our question, that would be 3.20% divided by 63%, or 5.08% LO 6.f == 3.2/(1-0.37) =5.079

The yield to maturity of an outstanding revenue bond has just fallen from 3.8% to 3.4%. All of the following could explain the drop except A) the bond's rating has improved. B) the bond's debt coverage ratio has fallen. C) market interest rates have fallen. D) the bond has added insurance.

B) Explanation A falling debt coverage ratio is bad news because it indicates that the facility is not generating as much revenue as planned. It would be similar to the effect on your credit rating if you took a 20% or so pay cut. When a bond's rating goes up, the added safety means less risk and that will lead to a lower yield to investors. If interest rates in the market drop, the yields of outstanding bonds will reflect that. Adding insurance to a bond always increases the safety and leads to lower yields. LO 6.c

A statutory debt limitation restricts a municipality's authority regarding A) insuring bond issues. B) issuing general obligation (GO) bonds. C) selling revenue bonds. D) raising tax rates.

B) Explanation A municipality may be limited by statute regarding the amount of GO debt it may incur. LO 6.b

Long-term securities issued by municipalities that use a Dutch auction method to reset short-term interest rates known as clearing rates are A) real estate investment trusts (REITs). B) auction rate securities (ARS). C) collateralized mortgage obligations (CMOs). D) American depositary receipts (ADRs).

B) Explanation ARS are long-term securities issued by municipalities that use a Dutch auction to reset interest rates at short-term intervals. The reset rate is known as the clearing rate and establishes the rate paid during the period following the auction. LO 6.b

An investor sold a corporate bond with a 5% coupon at a net price of 101. The bond had accrued interest for 45 days. Which of the following statements regarding the confirmation of this trade is correct? A) The total amount due on the purchaser's confirmation will appear as $1,035.00. B) The total amount due on the purchaser's confirmation will appear as $1,016.25. C) The total amount received on the seller's confirmation will appear as $1,003.75. D) The confirmation will indicate the current yield based on the price of the bond.

B) Explanation Accrued interest is always added to the price of a bond. When you buy the bond, you pay that accrued interest, and when you sell a bond, you receive that accrued interest. The principal value is 101, or $1,010. Forty-five days of accrued interest is ⅛ of a 360-day year, or ¼ of a 180-day semiannual interest payment. With a 5% coupon, the bond pays $25 every 6 months. One-quarter of that is $6.25, so the total proceeds to the seller (and cost to the purchaser) is the $1,010 plus the $6.25, or $1016.25. One of the details included on a bond confirmation is the yield to maturity based on the price of the bond, but not the current yield. LO 6.e

An insured municipal bond is purchased by your client in the secondary market. After the sale, Municipal Securities Rulemaking Board rules would require you to A) send a copy of the official statement. B) make delivery of the certificates accompanied by evidence of insurance, either on the face of the certificates or in a separate document. C) indicate that the bonds are insured on the confirmation because this is the only requirement. D) include a copy of the insurance policy with delivery of the certificates.

B) Explanation Although it is likely that the confirmation would include a statement that the bonds are insured, it is also necessary to provide the client with some proof of that insurance, either on the bond itself or, in the case of book entry delivery, as a separate document. LO 6.d

Municipal bonds—known as dollar bonds—are generally quoted A) net yield. B) as a percentage of par. C) yield to maturity. D) yield to call.

B) Explanation Although municipal bonds are usually quoted on a yield basis, actively traded bonds known as dollar bonds are often quoted as a percentage of par (price). The term dollar bond comes from the quote being made in dollars. Remember that a percentage of par value ($1,000) equals a dollar price. LO 6.a

The term for the annual reduction of a municipal bond's cost basis purchased at a premium is A) compound accretion. B) straight-line amortization. C) compound amortization. D) straight-line accretion.

B) Explanation Amortization is the process by which the cost basis of a bond bought at a premium is decreased during the holding period. Because the cost basis is reduced by equal amounts every year, amortization is done on a straight-line basis. At maturity, the cost basis has been reduced to par. LO 6.e

Municipal brokers' brokers deal with all of the following except A) bank dealers. B) individuals. C) institutions. D) municipal dealers.

B) Explanation As the term suggests, a municipal broker's broker deals with other dealers and institutions, not with the general public. LO 6.d

Your customer, a small-business owner, likes investments that are short term, relatively safe from credit risk, and liquid. He's heard that higher rates of return can be realized from auction rate securities than the rates he is currently getting on the Treasury bills in his portfolio. He asks you to explain them to him. Which of the following would you note as being reasons why they are not suitable for him? I) Auction rate securities are intended as long-term investments. II) Interest or dividend rates are reset at established intervals based on a Dutch auction. III) If the auction fails, holders of ARSs may not have immediate access to their funds. IV) The interest or dividend rate is set as the lowest rate to match supply and demand at the time of the auction. A) I and IV B) I and III C) II and III D) II and IV

B) Explanation Auction rate securities (ARSs) are long-term variable rate bonds with maturities of 20 to 30 years tied to short-term interest rates. As long-term instruments, they are not suitable for an investor favoring short-term investments. Additionally, interest rates are reset using a Dutch auction method at predetermined intervals, typically 7, 28, or 35 days. A failed auction can occur due to lack of demand; in this case, no bids are received to reset the rate. This risk would not align the investment objectives of safety and liquidity. LO 6.b

If an investor purchases a bond anticipation note (BAN) that matures in one year, when will the investor collect the interest? A) Semiannually B) At maturity C) Quarterly D) Monthly

B) Explanation BANs are short-term money market instruments. Interest is paid at maturity. LO 6.b

In addition to their tax advantages, municipal bonds are often purchased for their safety. Your client wishing to purchase municipal bonds with the utmost in safety should buy A) general obligation bonds. B) New Housing Authority bonds. C) moral obligation bonds. D) double-barreled bonds.

B) Explanation NHAs, sometimes called Public Housing Authority or PHA bonds, have the backing of the federal government. As such, they are the safest of all municipal securities. LO 6.b

A 27-year-old client is in the lowest tax bracket and seeks an aggressive long-term growth investment. If his investment adviser representative recommends a high-rated general obligation municipal bond, the investment adviser representative (IAR) has A) made an unsuitable recommendation because a municipal revenue bond would have been more appropriate. B) made an unsuitable recommendation based on the client's needs and objectives. C) committed no violation because municipal bonds are well suited for the market's volatility. D) recommended a suitable investment because general obligations are good long-term investments.

B) Explanation In recommending a conservative, tax-exempt investment to this customer, the IAR has failed to make a suitable recommendation given the client's objectives. Municipal bonds are better suited for individuals in high tax brackets and offer little upside appreciation potential. LO 6.f

The Interstate Bridge Authority has an outstanding revenue bond. For the most recent operating period, the Authority has net revenue of $36 million, operations and maintenance expenses of $16 million, debt service requirements of $18 million, and surplus funds of $2 million. The debt service coverage ratio for the Interstate Bridge Authority's revenue bond is A) 2.25:1. B) 2:1. C) 1:1. D) 1:11:1.

B) Explanation In the absence of a described revenue pledge (net or gross), the net revenue pledge should be used. This means that the debt is serviced after the expenses for operations and maintenance have been satisfied. The net revenue of the project is revenues after subtracting those expenses. In this question, that is the $36 million figure given. The debt service coverage ratio is determined by dividing the net revenue by the debt service requirement. In this question, the debt service coverage ratio would be 2:1 ($36 million divided by $18 million = 2). If you subtracted the $16 million of expenses because you did not notice that we gave you the net revenue, your ratio was 20 divided by 18 = 1.11 to 1. If you added the surplus (not an expense), your ratio was 18 divided by 18 = 1:1. It is not uncommon to have information in a question that is not needed to arrive at the solution. LO 6.c

B) Explanation Interest accrues on municipal bonds on a 360-day-year basis, with all months having 30 days. This bond pays interest on January and July 1 (J & J 1). Therefore, July, August, and September each have 30 days of accrued interest, and October has 19 days of accrued interest; this totals 109 days. Settlement date is Friday, October 20. LO 6.e

Relative to a newly issued bond, what begins on the dated date? A) The date of all mathematical computations B) Accrual of interest C) Settlement and delivery D) The computation of principal payment

B) Explanation Interest begins accruing on the dated date on new bond issues. LO 6.e

The alternative minimum tax (AMT) is designed to present an alternative tax computation that disallows deductions for certain tax preference items and includes certain nontaxable income. Which of the following is not a tax preference item? A) Tax-exempt interest received on private purpose bonds B) Interest received on corporate bonds C) Certain costs associated with an oil and gas drilling program D) Local income and property taxes

B) Explanation Interest on corporate bonds is taxable and included in an investor's adjusted gross income (AGI), but not for the AMT. Tax-exempt interest on private activity bonds and excess intangible drilling costs in an oil and gas DPP are included as tax preferences. In addition, state and local taxes and accelerated depreciation are in the list of preference items. LO 6.f

Municipal bonds would be considered the most suitable for which of the following customer scenarios? A) An investor in a low income bracket wanting income in their IRA B) An investor in a high-income tax bracket wanting income for their investment account C) An investor in a moderate income tax bracket seeking growth in their employer-sponsored 401(k) plan D) An investor in a high-income bracket wanting growth for their investment account

B) Explanation Interest received from bonds make them more appropriate for investors with income objectives rather than growth objectives. Because interest from municipal bonds is tax free, they benefit those in higher tax brackets the most. Lastly, because the interest is tax free, they have no place in a tax-favored account such as an IRA or 401(k) plan. LO 6.f

Which of the following is not under governance of the Municipal Securities Rulemaking Board (MSRB)? I) Issuers of municipal fund securities II) Broker-dealers that sell municipal fund securities III) Issuers of municipal bonds IV) Banks that sell municipal securities A) I and II B) I and III C) II and III D) II and IV

B) Explanation Issuers of municipal or municipal fund securities are exempt issuers and are not regulated or under the guidance of the MSRB or any other self-regulatory organization. LO 6.h

When acting as an agent for a customer, Municipal Securities Rulemaking Board (MSRB) rules require the broker to make a reasonable effort to obtain which of the following? I) A fair price in relation to prevailing market conditions II) The best price III) A reasonable price in relation to prevailing market conditions IV) Quotes from at least three municipal dealers or one broker's broker A) II and IV B) I and III C) I and IV D) II and III

B) Explanation MSRB rules require only that municipal securities dealers effect trades for customers at prices that are fair and reasonable in current market conditions. LO 6.h

Which of the following regarding a municipal bond broker's broker are true? I) Protects customer identity II)Must disclose the identity of customers III) Has no inventory IV) Maintains an inventory A) II and III B) I and III C) II and IV D) I and IV

B) Explanation Municipal brokers' brokers generally purchase and sell securities on an anonymous basis for institutional clients. They are not in the business of making a market; therefore, they maintain no inventory. LO 6.d

A municipal securities principal must approve all of the following except A) each transaction in municipal securities. B) legal opinions. C) the handling of written customer complaints. D) the opening of new customer accounts.

B) Explanation Municipal securities principals are required to approve all new customer accounts, all municipal transactions, and the handling of customer complaints. Legal opinions are prepared by bond counsel to determine the authority of an issuer and tax treatment of new municipal issues. LO 6.a

Net overall debt of a municipality is A) funded debt minus overlapping debt. B) net direct debt plus overlapping debt. C) funded debt plus overlapping debt. D) net direct debt minus overlapping debt.

B) Explanation Net overall debt of a municipality is defined as net direct debt plus overlapping debt. LO 6.b

You are having a discussion with one of your clients regarding suitable investments. The client is in a high-income tax bracket and has a high net worth as well. During the conversation, your client mentions several investments that he is thinking about that might be beneficial to him now. Of those listed, which would be the best recommendation? A) A real estate investment trust (REIT) B) Municipal bonds C) A corporate blue-chip balanced mutual fund D) Noninvestment-grade corporate bonds

B) Explanation Of the choices listed, only municipal bonds offer a tax consequence suitable for high-income, high-net-worth investors in the form of tax-free interest payments. Corporate bond interest, mutual fund dividends, and income earned from REITs are all taxable. LO 6.b

Revenue bond rate covenants require the user fees to be high enough to cover all of the following obligations of the issuing authority except A) the debt service. B) the optional call provisions. C) the debt service reserve fund. D) the operations and maintenance.

B) Explanation Optional call provisions are at the option of the issuer. Rate covenants of an issue will not require enough to be collected to cover a call on the bonds. LO 6.c

Which of the following municipal issues would least likely involve overlapping debt? A) A library district B) An airport district C) A park district D) A school district

B) Explanation Overlapping debt refers to property tax districts (areas). Airport issues are usually revenue issues of an authority that has no property taxing powers. LO 6.b

All of the following are regulated by the Municipal Securities Rulemaking Board (MSRB) except A) quotes. B) issuers. C) sales representatives. D) dealers.

B) Explanation Quotes, dealers, and sales representatives are regulated by the MSRB, but issuers are not. LO 6.h

A couple's home has an assessed value of $40,000 and a market value of $100,000. What will the tax be if a rate of 5 mills is used? A) $2,000 B) $200 C) $500 D) $5,000

B) Explanation Real property tax is based on the assessed value assigned to the property by the municipality's tax assessor (in this case, $40,000). Property tax rates use the mill as a base unit. One mill equals $1 of tax per year for each $1,000 of assessed value. Five mills would equal $5 for each $1,000 of assessed value. Because there are 40 thousands, 40 × $5 equals $200 in annual tax. A shortcut method is as follows: take the assessed value, remove the last three 0s, and multiply by the number of mills of tax ($40 × 5 mills = $200). LO 6.c

Which of the following statements regarding municipal revenue bond issues are generally true? I) The bonds' feasibility is dependent on the earnings potential of the II) facility or project. II) The bonds are backed by unlimited taxing power of the issuer. III) User fees provide revenue for bondholders. IV) Revenue bonds are most suitable for investors with high risk tolerance. A) I and IV B) I and III C) II and III D) II and IV

B) Explanation Revenue bonds are backed by project earnings (user fees), not taxes, and are generally considered low risk. LO 6.c

The Municipal Securities Rulemaking Board (MSRB) writes the rules in the municipal bond market. The MSRB A) is not regulated as an SRO by the SEC. B) does not enforce its own rules. C) is the enforcement body in the municipal bond market. D) must comply with IRS regulations.

B) Explanation The MSRB writes the rules for the municipal bond market, but is not an enforcement authority. The rules are enforced by other regulatory bodies depending on who the bond dealer making the trade is. If it was completed by a community bank, the FDIC is the enforcement body. If it is done by a member bank of the Federal Reserve, the regulator is the Federal Reserve Board (FRB). If the trade is made through a FINRA member firm, then FINRA is the enforcer. The SEC has regulatory authority over the MSRB and all other self-regulatory organizations (SROs) not the IRS. LO 6.h

If an investor in the 27% federal marginal income tax bracket invests in municipal general obligation public purpose bonds nominally yielding 4.5%, what is the tax-equivalent yield? A) 16.67% B) 6.16% C) 5.72% D) 3.29%

B) Explanation The formula for computing tax-equivalent yield is: nominal yield ÷ (1 − federal marginal income tax rate). Let's plug in the numbers: 0.045 ÷ (1 − 0.27) = 0.045 ÷ 0.73 = 6.16%. This tells the investor that they would have to receive 6.16% interest on a taxable bond to have the same after-tax return as earning 4.5% tax-free. You can check it out by working backwards. If an investor receives 6.16% taxable, they will have to pay 27% (in this person's bracket) in income tax. That is a tax of 1.66% (6.16 x 27% = 1.66). Subtract 1.66 in tax from 6.16 and the result is 4.50%. LO 6.f

A municipality's net total debt is calculated as A) the total debt minus self-supporting debt plus sinking fund accumulations plus overlapping debt. B) the total debt minus self-supporting debt minus sinking fund accumulations plus overlapping debt. C) the total debt plus self-supporting debt plus sinking fund accumulations minus overlapping debt. D) the total debt plus self-supporting debt minus sinking fund accumulations minus overlapping debt.

B) Explanation The net total debt of a municipality is the net overall debt (total debt minus self-supporting debt minus sinking fund accumulations) plus overlapping debt (shared with other municipalities). States cannot have overlapping debt; it is their municipalities that can. LO 6.c

A municipality's net total debt is calculated as A) the total debt plus self-supporting debt minus sinking fund accumulations minus overlapping debt. B) the total debt minus self-supporting debt minus sinking fund accumulations plus overlapping debt. C) the total debt plus self-supporting debt plus sinking fund accumulations minus overlapping debt. D) the total debt minus self-supporting debt plus sinking fund accumulations plus overlapping debt.

Badentown is planning to raise money in three months to build a new city hall. The mayor wishes to start ground preparation immediately. How could money be raised to fund the work? A) Special assessment bond B) Bond anticipation note (BAN) C) Limited tax bond D) Construction loan note

B) Explanation The new city hall will be funded with a bond three months from now. A three-month BAN will raise money now for ground preparation. The note's maturity will be set so that it can be paid off with proceeds from the bond sale. LO 6.b

Which of the following statements regarding the flow of funds found within a municipal trust indenture are true? I) It describes the disbursement of funds for revenue bond issues. II) It describes the disbursement of funds for general obligation issues. III) It is found within the official statement. IV) It is found within the bond contract. A) II and III B) I and IV C) I and III D) II and IV

B) Explanation The term flow of funds relates to revenue bond offerings only and describes the priority of disbursing revenues from the project. Generally, the revenues are deposited into a general collection account for disbursement into other accounts, as specified in the trust indenture found in the bond contract. LO 6.c

If an indenture has a closed-end provision, this means A) a sinking or surplus fund must be established. B) additional issues will have junior liens. C) additional issues have no lien on the revenue stream. D) the bonds must be called before maturity.

B) Explanation These additional issues are also known as junior lien bonds. Under a closed-end indenture, additional bonds issued against the same stream of revenues have a junior (subordinate) claim to those already outstanding unless the funds are required to complete construction of the facility. LO 6.b

A customer bought a bond that yields 6.5% with a 5% coupon. If the bond matures at this point, the customer will receive A) $1,000 plus a call premium. B) $1,025. C) $1,065. D) $1,050.

B) Explanation Upon redemption of a bond, whatever current interest rates may be, the investor receives par ($1,000) plus the final semiannual interest payment ($25 in this case), for a total of $1,025. LO 6.e

An investor anticipating a rise in interest rates would likely purchase A) bonds issued by the U.S. Treasury. B) variable-rate demand obligations or reset bonds. C) corporate bonds. D) callable bonds.

B) Explanation Variable-rate or reset bonds have coupons that are adjusted based on the movements of other specified interest rates. A callable bond works to the issuer's advantage when interest rates fall but offers no added benefit to an investor when interest rates rise. Generic corporate or government-issued bonds offer no advantage for an investor anticipating a rise in interest rates. LO 6.b

An investor anticipating a rise in interest rates would likely purchase A) callable bonds. B) variable-rate demand obligations or reset bonds. C) corporate bonds. D) bonds issued by the U.S. Treasury.

The City of Podunk has an outstanding 25-year maturity issue that is callable in seven years. It has prerefunded the issue and established an escrow account containing the proper government securities with face amounts and maturities approximating the call provisions of the original issue. In quoting the original issue, which of the following must be used? A) Yield to maturity B) Yield to call C) The lower of the yield to call or the yield to maturity D) Current yield

B) Explanation When a bond issue is prerefunded, the issuer is going to redeem the bond on the first call date. The yield must be quoted to call. LO 6.h

A municipal bond, issued with a covenant that states, "If revenue collections are not sufficient to meet debt service requirements, the issue will be backed by the full faith and credit of the municipality," is known as A) a contingent liability bond. B) a double-barreled bond. C) a moral obligation bond. D) a Section 8 bond.

B) Explanation When a municipal bond is backed by both a source of revenue and the taxing ability of the issuer, this is referred to as a double-barreled bond. LO 6.b

If a municipal bond is purchased at a discount, which of the following is true? A) The discount is amortized and increases cost basis each year until maturity. B) The discount is accreted and increases cost basis each year until maturity. C) The discount is amortized and decreases cost basis each year until maturity. D) The discount is accreted and decreases cost basis each year until maturity.

B) Explanation When a municipal bond is purchased at a discount, the amount of the discount is accreted. Accretion is the process of upwardly adjusting the cost basis each year until maturity. At maturity, the cost basis will equal PAR. LO 6.e

An investor purchases a municipal bond at par for $10,000 on February 15, 1997. On August 15, 1997, if the investor sells the bond for $10,500, for tax purposes, the $500 profit is recognized as A) interest income. B) a short-term capital gain. C) a tax-free capital gain. D) a long-term capital gain.

B) Explanation When municipal bonds are purchased at par and subsequently sold at a higher price, the resulting profit is taxed as a capital gain. Only interest income from municipal bonds is exempt from taxation. This gain is not classified as long-term because the investor did not hold the bond for more than one year. LO 6.f

If a broker-dealer is acting as a financial advisor to a municipality, which of the following statements is true? I) Municipal Securities Rulemaking Board (MSRB) rules prohibit the broker-dealer from acting as an underwriter for the issuer unless they meet the criteria of specific allowable exceptions. II) The broker-dealer can act as both financial advisor and underwriter with no limitations. III) The broker-dealer may only act in an underwriting capacity if the underwriting agreement was done as a negotiated underwriting. IV) There are some underwriting functions that the broker-dealer, in their advisory capacity, may be allowed to participate in, such as assisting with the preparation of the official statement. A) II and IV B) I and IV C) I and III D) II and III

B) I and IV Explanation If a broker-dealer has a formal advisory relationship with an issuer, it may not generally act as underwriter for the issuer's bonds. This applies regardless of whether the underwriting is a negotiated or competitive bid underwriting. There are exceptions and some functions associated with underwriting that the MSRB rules do allow, but in those instances, the broker-dealer could only be compensated for the broker-dealer's advisory services and not for any underwriting services or related functions. LO 6.h

If a municipal bond with 10 years to maturity is purchased from the issuer for 110, and after two years, it is sold for 110, the bondholder must report A) capital gain of 20 points. B) capital gain of two points. C) no capital gain or loss. D) capital loss of two points. Explanation Municipal bonds bought at a premium must be amortized. The amount of the premium is 10 points. With 10 years to maturity, the annual amortization is one point. After two years, the bond's cost basis has been amortized down to 108. If at that point it is sold for 110, there is a two-point capital gain. LO 6.

B) If a municipal bond with 10 years to maturity is purchased from the issuer for 110, and after two years, it is sold for 110, the bondholder must report A) capital gain of 20 points. B) capital gain of two points. C) no capital gain or loss. D) capital loss of two points. Explanation Municipal bonds bought at a premium must be amortized. The amount of the premium is 10 points. With 10 years to maturity, the annual amortization is one point. After two years, the bond's cost basis has been amortized down to 108. If at that point it is sold for 110, there is a two-point capital gain. LO 6.e

If an investor were to purchase a bond in the secondary market several years after the public offering, which of the following would factor in calculating the total dollar amount paid for the bond? I) Settlement date II) Dated date III) Coupon IV) Scale A) I and IV B) II and III C) I and III D) II and IV

C) Explanation Accrued interest is part of a bond transaction's total dollar amount. To calculate the accrued interest, you must know the settlement date. The dated date is only relevant for the first interest payment, so it would not apply to this trade. LO 6.e

A town's ad valorem tax rate is 20 mills on 60% of the assessed value. Your client owns a property with a market value of $500,000, and the town has assessed it at $400,000. The taxes due on this property are A) $800. B) $8,000. C) $4,800. D) $480.

C) Explanation Ad valorem tax rates are based on mills with one mill being equal to $0.001 (1/10th of a cent).The amount of taxes to be paid on the property is determined by multiplying the millage rate—in this case 2 cents (20 mills at $0.001 = $0.02) times the taxable assessed property value. Note that this town is only taxing on 60% of the assessed value. That would be 60% of the $400,000 assessed value, or $240,000. Therefore, the tax is $0.02 times $240,000. The market value is irrelevant. For those who have difficulty determining where the decimal point goes, on any question like this, drop the last three 000s from the assessed value and multiply by the millage rate. In this question, that would be $240 times 20 and that equals the correct answer of $4,800. LO 6.c

Municipal bonds—known as dollar bonds—are generally quoted A) yield to call. B) net yield. C) as a percentage of par. D) yield to maturity.

C) Explanation Although municipal bonds are usually quoted on a yield basis, actively traded bonds known as dollar bonds are often quoted as a percentage of par (price). The term dollar bond comes from the quote being made in dollars. Remember that a percentage of par value ($1,000) equals a dollar price. LO 6.a

One of your customers called you with the good news that they are new grandparents. They are looking for a way to provide funds for the new child's college education and would like some kind of tax break if possible. What would be the most suitable suggestion? A) Donate money to an UTMA account naming the child's parent as custodian B) Start an IRA in the child's name and make annual contributions on the child's behalf. C) Start a Section 529 plan for the child D) Purchase zero-coupon bonds maturing in 18-20 years

C) Explanation Among the many benefits of the Section 529 plan is that all earnings between now and withdrawal can be tax free when used for qualified expenses. In addition, if the grandparents have a substantial estate, they can contribute up to $75,000 ($150,000 if a joint gift) without any gift tax ramifications. The income from an UTMA account is taxable in the year received. The annual accretion is taxable on the zero-coupon bonds. Although it is true that the child's income from the investments may be below the taxable threshold today, in the later years that might not be the case. IRAs can only be funded from earned income, not gifts. LO 6.g

Your new customer lists tax-free income as an investment objective but notes that he will need access to $50,000 within the next four to six months for a down payment on a vacation home he is purchasing. To meet the objective of tax-free income, a registered representative considers municipal securities for the $50,000. Which of the following municipal securities recommendations would be the least suitable? A) A variable-rate demand note (VRDN) B) A bond anticipation note (BAN) C) An auction rate security (ARS) D) A tax anticipation note (TAN)

C) Explanation An ARS is a long-term instrument tied to short-term interest rates, and therefore, would not be suitable for someone with a short-term time horizon. Each of the remaining answer choices are short-term notes aligning better with the customer's need to access the funds in the next four to six months. LO 6.b

All of the following would be indications of a deteriorating credit situation except A) an increase in personal bankruptcies. B) an increase in tax delinquencies. C) an increase in municipal assessed valuations. D) an increase in the per capita debt.

C) Explanation An increase in assessed property values would theoretically mean an increase in taxes collected, thus increasing a municipality's credit standing. LO 6.b

Municipal securities broker's brokers A) bid on negotiated underwritings. B) share the names of their clients with the executing dealers. C) execute trades for other municipal securities broker-dealers. D) participate in selling groups on new municipal issues.

C) Explanation Broker's brokers are what the term implies. They represent other firms and use their connections to facilitate trades, usually with institutions. They never take an inventory position or get involved with underwriting new issues. One of their key roles is preserving the anonymity of their clients. LO 6.d

All of the following regarding Section 529 education savings plans are true except A) withdrawals at the federal level for qualified education expenses are tax free. B) there are high contribution limits. C) tax-deductible contributions are at the federal level. D) they are not subject to income limitations.

C) Explanation Contributions are made with after-tax dollars and are not deductible. LO 6.g

Having a five-year-old child, a couple wants to begin saving for her college education. They can currently budget $350 per month toward the goal. They know that college costs 13 years in the future need to be factored, but they are not too comfortable with market risk. Which would best align with their profile? A) Coverdell Education Savings Account (ESA) B) Money market mutual fund C) 529 prepaid tuition plan D) Variable annuity plan

C) Explanation Coverdell ESAs and Section 529 plans are the only choices here specifically associated with saving for education. Because the Coverdell ESA can only accept $2,000 per child, per year, and the couple can currently invest more than twice that amount, the 529 plan is the better choice. Additionally, being concerned about inflation and not comfortable with market risk, investing in a 529 prepaid tuition plan enables them to purchase tomorrow's tuition at today's prices. LO 6.g

Debt service is best described as A) total of the direct debt of a municipality and the debt of its political subdivisions. B) services provided by the paying agent for a bond issue. C) the total of interest and principal payable by the issuer plus any amount required to be deposited into a sinking fund. D) net interest on a new issue of a municipal bond.

C) Explanation Debt service is the total of interest and principal payable by the issuer plus any amount required to be deposited into a sinking or surplus fund. LO 6.b

C) Explanation If a broker-dealer has a formal advisory relationship with an issuer, it may not generally act as underwriter for the issuer's bonds. This applies regardless of whether the underwriting is a negotiated or competitive bid underwriting. There are exceptions and some functions associated with underwriting that the MSRB rules do allow, but in those instances, the broker-dealer could only be compensated for the broker-dealer's advisory services and not for any underwriting services or related functions. LO 6.h

If a state agency has issued a moral obligation bond that runs into difficulty and requires the secondary backing to be implemented, what is necessary? A) Administrative approval B) Voter approval C) Legislative approval D) MSRB approval

C) Explanation If a state agency that has issued a moral obligation bond requires that secondary backing, the agency must apply to the legislature for approval. If approved by the legislature, the funds will be made available. If not approved, the issue might go into default. LO 6.b

Debt service on an industrial revenue bond is secured by A) ad valorem taxes. B) special assessments. C) lease payments paid by a corporation. D) sales taxes.

C) Explanation Industrial revenue bonds are issued by a municipality or an authority established by a municipality. No municipal assets or general revenues are pledged to secure the issue. The net lease payments by the corporate user of the facility are the only source of revenue for debt service. LO 6.b

Debt service on an industrial revenue bond is secured by A) special assessments. B) sales taxes. C) lease payments paid by a corporation. D) ad valorem taxes.

The interest from which of the following bonds might be included in the alternative minimum tax calculation? A) Special assessment bonds B) Tax anticipation notes C) Industrial development revenue bonds D) General obligation bonds

C) Explanation Industrial revenue bonds, sometimes called industrial development bonds, may be nonpublic purpose bonds, and the proceeds are used to benefit private corporations. As such, the interest income from these bonds is a tax preference item in the alternative minimum tax calculation. LO 6.b

The alternative minimum tax (AMT) is designed to present an alternative tax computation that disallows deductions for certain tax preference items and includes certain nontaxable income. Which of the following is not a tax preference item? A) Certain costs associated with an oil and gas drilling program B) Tax-exempt interest received on private purpose bonds C) Interest received on corporate bonds D) Local income and property taxes

C) Explanation Interest on corporate bonds is taxable and included in an investor's adjusted gross income (AGI), but not for the AMT. Tax-exempt interest on private activity bonds and excess intangible drilling costs in an oil and gas DPP are included as tax preferences. In addition, state and local taxes and accelerated depreciation are in the list of preference items. LO 6.f

The interest that municipal securities pay is A) not taxed at the state, local, or federal levels. B) fully taxed. C) federally tax exempt. D) exempt from both state and local taxation.

C) Explanation Interest paid on securities issued by municipalities is generally exempt from taxation at the federal level. It may also be exempt from state and local taxation if the purchaser resides in the issuing state. LO 6.f

According to MSRB rules, a control relationship would exist between a municipal securities firm and an issuer when A) senior officers of the firm live in the municipality. B) the firm has an inventory of the issuer's bonds. C) an officer of the firm is in a position of authority over the issuer. D) the firm recently completed a negotiated underwriting for the municipality.

C) Explanation MSRB Rule G-22 deals with control relationships. Their interpretive letters indicate that it is only when the individual has the authority to exercise control that the disclosure rules apply. Here is how they put it: "For example, rule G-22 applies if the associated person is the chairman of an issuing authority and, in that capacity, actually makes the decision on behalf of the issuing authority to issue securities. The rule does not apply if the associated person as chairman does not make that decision and does not have the authority alone to make the decision, or if the decision is made by a governing body of which he is only one of several members." LO 6.h

According to Municipal Securities Rulemaking Board (MSRB) rules, if a municipal securities broker-dealer receives an advisory fee from an issuer, it must notify, in writing, any of its customers purchasing bonds issued by that municipality of A) a negative outlook from Standard & Poor's. B) the placement ratio. C) any advisory relationship existing between itself and the issuing municipality. D) all of these.

C) Explanation MSRB rules require that if a broker-dealer has an advisory relationship with a municipality, that relationship must be disclosed to any of the broker-dealer's clients who are buying bonds issued by the municipality. LO 6.h

While acting in a financial advisory capacity to a municipal issuer, a municipal securities dealer wants to be part of a syndicate in the underwriting of one of the issuer's new bonds. Which of the following statements regarding this situation is true? A) The dealer would be allowed to participate and collect fees for both advisory and underwriting services supplied. B) The dealer must obtain the MSRB's written approval before signing the syndicate letter. C) This is recognized by the MSRB as a potential conflict of interest; municipal rules generally prohibit a broker-dealer from acting in both capacities. D) Only an approval by the SEC could allow the broker-dealer to function in both capacities.

C) Explanation MSRB rules to eliminate conflicts of interest generally prohibit broker-dealers from acting in both an advisory capacity to an issuer and as an underwriter of the issuer's bonds. The MSRB rules do address certain allowable exceptions, but neither MSRB written approval nor the approval of the SEC would be required should the conditions of the allowable exceptions exist. LO 6.h

Which of the following is least important to a municipal bond analyst? A) Debt service to annual revenues B) Revenue collection record C) Legality of the issue D) Tax collection ratio

C) Explanation Municipal bond analysts are concerned with the financial aspects of municipal bonds to ensure that they do not default. Various financial ratios and collection records are critical to their analysis. The legality of the municipal issue, as determined by the legal opinion, is important to issuers. LO 6.c

A municipal bond is purchased in the secondary market at 102½. The bond has five years to maturity. Two years later, the bond is sold for 102. The tax consequence to the investor is A) a capital loss of $5 per bond. B) no capital gain or loss. C) a capital gain of $5 per bond. D) a capital loss of $20 per bond.

C) Explanation Municipal bonds bought at a premium, either in the new issue or secondary market, must be amortized. The amount of the premium is 2½ points, or $25. As the bond has five years to maturity, the annual amortization amount is $5 per bond. After two years, the bond's basis has been amortized down to 101½. At that point, a sale at 102 generates a capital gain of $5 per bond. LO 6.e

The date on which interest will begin accruing on a new municipal issue is A) the delivery date. B) the filing date. C) the dated date. D) the closing date.

C) Explanation New issues of municipal bonds begin accruing interest as of the dated date. LO 6.e

A customer purchases $100,000 of original issue discount municipal bonds. How will this trade be considered for tax purposes when the bonds mature? A) Taxable as short-term gain B) Fully taxable on capital gain C) No capital gain D) Taxable as long-term gain

C) Explanation Original issue discount profit at maturity is treated as part of the tax-free interest on a municipal bond. However, for a municipal bond bought at a discount in the secondary market, the discount is considered ordinary income subject to tax. LO 6.f

Which of the following insures general obligation bonds? A) Syndicate manager B) Federal Deposit Insurance Corporation (FDIC) C) National Public Finance Guarantee Corp. and AMBAC D) Securities Investors Protection Corporation (SIPC)

C) Explanation Outstanding municipal general obligation bonds have been insured by the National Public Finance Guarantee Corp. and AMBAC. Insured bonds are typically AAA-implied rated. SIPC protects customer accounts against broker-dealer failure. The FDIC protects customer deposits against bank failure. LO 6.d

A customer buys a new issue municipal bond with a dated date of January 1 for settlement on January 31. If the first interest payment date is March 1, how many days of accrued interest will the customer pay to the syndicate? A) 0 B) 60 C) 31 D) 30

D) Explanation In this new issue, interest begins to accrue as of the dated date, so the customer (buyer) must pay the syndicate interest from the dated date up to, but not including, the settlement date. The number of days from January 1 up to, but not including, January 31 is 30. LO 6.e

A municipal finance professional (MFP) is A) employed by a municipality to oversee the issuance of municipal bonds. B) an elected official of a municipality having some decision-making authority regarding new municipal bond issues. C) an employee of a broker-dealer engaged in municipal security representative activities other than retail sales or who solicits municipal securities business for the broker-dealer. D) an employee of the Municipal Securities Rulemaking Board (MSRB) specializing in seeing that broker-dealers adhere to the MSRB rules and regulations regarding the sales of municipal bonds to retail customers.

C) Explanation Per the MSRB, an MFP is an associated person of a broker-dealer who is primarily engaged in municipal securities representative activities other than retail sales to individuals, who solicits municipal securities business for the broker-dealer, or who is in the supervisory chain above MFPs. LO 6.h

The term municipal fund security refers to A) an advance refunded municipal bond. B) a Section 529 savings plan. C) a mutual fund whose portfolio is exclusively municipal bonds. D) a municipal bond with a sinking fund.

C) Explanation Section 529 plans, used primary for saving for college, are legally considered municipal fund securities. LO 6.g

Each of the following are generally used to service state general obligation bond issues except A) income taxes. B) sales taxes. C) real estate taxes. D) motor vehicle license fees.

C) Explanation State-issued municipals are backed by state revenues, including sales and income taxes, as well as fees for state-issued licenses and permits. States do not normally levy property (real estate) taxes. Real estate taxes—known as ad valorem taxes—are typically levied by local municipalities such as cities and counties. LO 6.b

Amortization of a municipal bond premium does which of the following? I) Increases cost basis II) Decreases cost basis III) Increases reported interest income IV) Decreases reported interest income A) II and III B) I and IV C) II and IV D) I and III

C) Explanation Tax law requires municipal bond premiums to be amortized. The effect of amortization is to decrease reported interest income and cost basis. If held to maturity, the cost basis will have been amortized down to par. Therefore, at maturity, there is no reported capital loss. LO 6.e

To calculate a capital gain or loss on the sale of an original issue discount municipal bond, the discount must be A) amortized. B) depleted. C) accreted. D) depreciated.

C) Explanation The IRS term for adjusting the cost basis of a discount bond upward is accretion. Amortization is the means of adjusting a premium bond's cost basis. LO 6.f

A moral obligation bond is one where A) the U.S. government is empowered, but not obligated to appropriate funds to prevent the bond from going into default. B) the bondholders are empowered, but not obligated to appropriate funds to prevent the bond from going into default. C) the governing legislature is empowered, but not obligated to appropriate funds to prevent the bond from going into default. D) the board of directors of the entity is empowered, but not obligated to appropriate funds to prevent the bond from going into default.

C) Explanation The MSRB defines a moral obligation bond as: "A bond that, in addition to its primary source of security, is also secured by non-binding covenant that any amount necessary to make up any deficiency in debt service will be included in the budget recommendation made to the governing body, which may appropriate funds to make up the shortfall. The governing body, however, is not legally obligated to make such an appropriation." LO 6.b

A significant portion of municipal bond trading is done by dealer banks. These are commercial banks that are not members of FINRA or any exchange. For those market participants, enforcement is in the hands of all of the following except A) The Office of the Controller of the Currency (OCC). B) The Federal Deposit Insurance Corporation (FDIC). C) The Municipal Securities Rulemaking Board (MSRB). D) The Federal Reserve Board (FRB).

C) Explanation The MSRB makes rules but is not the one who enforces them. When it comes to bank dealers, those MSRB rules are enforced by these banking agencies. For securities firms, enforcement is in the hands of FINRA. LO 6.h

The call provisions of a municipal issue would be detailed most completely in A) the official notice of sale. B) The Bond Buyer. C) the bond resolution. D) the legal opinion.

C) Explanation The bond resolution is the document that authorizes the issuance of a municipal bond. The resolution also describes the proposed issue's features and the issuer's responsibilities to its bondholders. LO 6.b

Paying a premium of $10 per bond, Tracey bought 10 municipal bonds with 20 years to maturity. Ten years later, she sold the bonds for 103. For tax purposes, she has A) a $200 gain. B) a $200 loss. C) a $250 gain. D) a $300 loss.

C) Explanation The cost per bond is $1,010. The amortization amount each year is 10/20 years, which equals $0.50 per year. $0.50 per year × 10 years = $5 per bond. After 10 years, the adjusted cost basis is $1,005 per bond. She sells the bonds for $1,030 per bond. $1,030 − $1,005 = $25 per bond 25 × 10 = $250 gain. LO 6.e

When does pension payment liability affect the credit rating of a municipality? A) Never B) When the return on funds invested to meet future needs exceeds anticipated payments C) When funds needed to make payments exceed funds available D) When funds are invested presently to meet future pension needs

C) Explanation The credit rating for a municipality's debt would be adversely affected if funds needed to make payments exceeded funds available. This is an unfunded pension liability and can result if monies set aside to make future payments are not enough or if poor investment decisions deplete the funds. LO 6.d

A municipality has prerefunded its bond issue maturing in five years. This would mean all of the following except A) a higher rating. B) greater marketability. C) a reduction to the coupon rate. D) the bonds will be called in more than 90 days.

C) Explanation The current bond still exists until the specified call date. As such, the coupon has not changed. Advance or prerefunding is refinancing an existing municipal bond issue before its maturity or call date by using money from the sale of a new bond issue. Because the proceeds of the new issue are placed into special U.S. government securities, the rating is automatically at the top. The higher rating increases the marketability. If the refunding is done in 90 days or less, it is called current refunding. LO 6.d

A customer buys a municipal bond at 106 with eight years to maturity. What is the amount of unamortized premium at the end of four years? A) $36 B) $50 C) $40 D) $30

D) Explanation The original premium was $60 for eight years, which means that after four years, the remaining premium is half that amount. LO 6.e

A municipality has prerefunded its bond issue maturing in five years. This would mean all of the following except A) a higher rating. B) the bonds will be called in more than 90 days. C) a reduction to the coupon rate. D) greater marketability.

When creating a diversified municipal bond portfolio, all of the following should be considered except A) the credit rating. B) the source of funds backing the bonds. C) the denomination of the bonds included in the portfolio. D) the geographic location of the issuer.

C) Explanation The denomination of the bonds in a portfolio is not relevant to diversification. LO 6.d

An investor purchases an original issue discount general obligation municipal bond (OID) on the offering and holds it to maturity. The IRS treats the accretion of the discount as A) short-term capital gain. B) taxable interest income. C) tax-free interest income. D) long-term capital gain.

C) Explanation The discount on an OID municipal bond is considered the bond's interest. Because interest on a GO municipal bond is tax free, when that interest is ultimately paid at maturity date, the tax treatment is the same as if interest was paid semiannually. There is a more complicated situation when the OID bond is purchased in the secondary market or when regular municipal bonds are purchased at discount in the market. LO 6.f

Which of the following statements describing Section 529 plans is true? A) The fees associated with them are generally the same from state to state. B) Most state college savings plans require either the owner or the beneficiary of the plan to be a state resident. C) The maximum lifetime contribution varies from state to state. D) They can only be opened for children under the age of 18.

C) Explanation The features of Section 529 plans, including their contribution limits and fees, vary widely from state to state. Section 529 plans have no age limits as to participation; they are open to both children and adults who plan to attend college or graduate school. For college savings plans, there is no state residency requirement for either owners or beneficiaries of Section 529 plans. LO 6.g

C) Explanation The formula for computing tax-equivalent yield is: nominal yield ÷ (1 − federal marginal income tax rate). Let's plug in the numbers: 0.045 ÷ (1 − 0.27) = 0.045 ÷ 0.73 = 6.16%. This tells the investor that they would have to receive 6.16% interest on a taxable bond to have the same after-tax return as earning 4.5% tax-free. You can check it out by working backwards. If an investor receives 6.16% taxable, they will have to pay 27% (in this person's bracket) in income tax. That is a tax of 1.66% (6.16 x 27% = 1.66). Subtract 1.66 in tax from 6.16 and the result is 4.50%. LO 6.f

Who has the final responsibility for debt service on an industrial revenue bond? A) The MSRB B) The municipal issuer of the bonds C) The corporation leasing the facility D) The municipal authority established by the issuer

C) Explanation The issuer of industrial revenue bonds is a municipality or an authority established by a municipality. However, no municipal assets or general revenues are pledged to secure the issue. The net lease payments by the corporate user of the facility are the source of revenue for debt service. Therefore, the ultimate responsibility for the payment of the principal and interest on an industrial revenue bond rests with the corporate lessee. LO 6.b

A municipal finance professional, who is eligible to vote in a municipality that frequently issues debt securities, has made a contribution to the political campaign of one of the issuer's elected officials. More than which amount would disqualify the firm from engaging in certain municipal businesses with that issuer for two years? A) $1,000 B) $5,000 C) $250 D) $100

C) Explanation The maximum political contribution allowed under Municipal Securities Rulemaking Board rules for those eligible to vote in the municipality issuing debt on a negotiated basis is $250. LO 6.h

A customer buys five municipal bonds maturing in 20 years for 104. If he sells the bonds after 10 years at 103, the customer has A) a $100 capital gain. B) a $100 capital loss. C) a $50 capital gain. D) a $50 capital loss.

C) Explanation The premium on the municipal bonds must be amortized. The tax rules require that when you purchase a bond at a premium, you have to reduce the cost basis of the bond each year. Even though there are five bonds in the question, here's the math on one bond and then we'll multiply by five to get the total amount. The investor buys the bond at 104 or $1,040 and the bond is due to mature in 20 years. Take the $40 premium divided by the 20 years to maturity and that will tell us the amount that we amortize/reduce the cost basis by each year. $40/20=$2. It then tells us that the bond is sold after 10 years. Ten years of amortization is $2 per year x 10 years = $20. That lowers the basis of the bond to $1,020 ( $1,040 - $20 = $1,020). The bonds are sold at 103 or $1,030, so the gain is $10 per bond times five bonds for a total gain of $50. LO 6.e

A customer buys five municipal bonds maturing in 20 years for 104. If he sells the bonds after 10 years at 103, the customer has A) a $100 capital gain. B) a $50 capital loss. C) a $50 capital gain. D) a $100 capital loss.

One of your customers set up a Section 529 plan for a child of one of his neighbors and contributed to it for some years. When the child reached age 17, it was obvious that she had no plans to pursue education beyond high school and your customer decided to redesignate the account. Which of the following would be a permissible new beneficiary? A) The winner of an informal essay contest to be held among high school-aged children in the neighborhood B) One of the children of another of your customer's neighbors C) The original beneficiary's younger sister D) One of the donor's own grandchildren

C) Explanation There are few restrictions on who may be the first beneficiary of a Section 529 plan. However, if the beneficiary is redesignated, the new beneficiary must be a close family member of the first. LO 6.g

Covenants in the trust indenture of a municipal revenue bond are promises made by the issuer to the bondholders. All of the following are potential covenants except A) the insurance covenant. B) the rate covenant. C) the interest rate covenant. D) the maintenance covenant.

C) Explanation There is no such thing as an interest rate covenant in a trust indenture. The interest rate will be stated, but not in the form of a covenant. In the maintenance covenant, the bond issuer promises to perform proper maintenance on the facility the bonds are financing. The insurance covenant requires the issuer to maintain property insurance on the facility to repair or replace the facility. The rate covenant requires the issuer to maintain the user fee for a revenue bond at a level sufficient to service the debt. LO 6.b

The MSRB defines an associated person of a broker-dealer who is primarily engaged in municipal securities activities other than retail sales to individuals as A) a municipal securities professional (MSP). B) a municipal securities registered principal (Series 53). C) a municipal financial professional (MFP). D) a municipal securities registered representative (Series 52).

C) Explanation These MFPs are involved with functions other that retail sales of municipal bonds. The definition is an outgrowth of the "pay to play" rule because these are the individuals covered by that rule. LO 6.h

All of the following statements regarding Section 529 plans are true except A) contributions to a 529 plan may be subject to gift taxation. B) states impose very high overall contribution limits. C) the income level of the contributor can affect the annual contribution amount. D) the assets in the account are controlled by the account owner, not the child.

C) Explanation Unlike Coverdell ESAs, the income level of the contributor will not affect annual contributions under a Section 529 plan. LO 6.g

In addition to their tax advantages, municipal bonds are often purchased for their safety. Your client wishing to purchase municipal bonds with the utmost in safety should buy A) moral obligation bonds. B) double-barreled bonds. C) New Housing Authority bonds. D) general obligation bonds.

C) NHAs, sometimes called Public Housing Authority or PHA bonds, have the backing of the federal government. As such, they are the safest of all municipal securities. LO 6.b

One of your customers calls you to say that he received a letter saying that his local water works revenue bonds were being defeased. How would that affect the customer? A) Because of failure to generate sufficient revenue, interest payments are suspended temporarily. B) The maturity date is being automatically extended as called for in the official statement. C) The customer would be receiving payment of the principal plus any accrued interest after the defeasance is completed. D) The customer will need to file a claim with the appropriate court to receive payment for the bonds.

C) The customer would be receiving payment of the principal plus any accrued interest after the defeasance is completed. Explanation Defeasance occurs when an outstanding bond issue is paid off prior to maturity through a refunding. Once the creditors (the bondholders) have received their funds, any liens on assets or revenues are terminated. **This question deals with material not covered in your LEM, but it relates to recent rule changes and/or student feedback. LO 6.d

An investor has losses on the sale of municipal bonds. Which of the following, for tax purposes, is true? A) The losses can be applied only against gains on the sale of other municipal bonds. B) No losses on municipal bonds can be applied against gains on sales of any securities. C) The losses can be applied only against gains on the sale of other debt instruments (bonds). D) The losses can be applied against the gains on the sale of any other security.

D) Explanation Losses on the sale of one investment can generally be deducted against gains on the sale of any other investment. LO 6.f

On February 13, your customer buys an 8% Treasury bond maturing in 2019 for settlement on February 14. If the bonds pay interest on January 1 and July 1, how many days of accrued interest are added to the buyer's price? A) 14 B) 45 C) 43 D) 44

D) 44 Explanation Accrued interest for government bonds is figured on an actual-days-elapsed basis. The number of days begins with the previous coupon date and continues up to, but not including, the settlement date. The bonds pay interest on January 1. There are 31 days of accrued interest for January. The bonds settle February 14. There are 13 days of accrued interest for February. Do not count the settlement date (31 + 13 = 44 days). LO 6.e

All of the following statements regarding municipal bond official statements are true except A) a municipal securities broker-dealer may satisfy the delivery requirements by providing a notice advising the customer how to obtain the official statement from Electronic Municipal Market Access (EMMA). B) all retail purchasers of a new municipal bond issue must receive a final official statement. C) a retail customer must receive an official statement no later than the settlement date. D) an official statement must be delivered only upon request of a retail customer.

D) Explanation A final official statement must be delivered to retail buyers of a new issue on or before the settlement date. With today's technology, most investors receive their official statement through EMMA. LO 6.a

Which of the following is limited in the case of a limited tax municipal bond? A) The number of buyers B) The number of taxpayers C) The number of bonds issued D) The type of tax that can be used to service the debt

D) Explanation A general obligation (GO) bond may be backed by a specific tax. For example, a limited tax GO may be serviced only from sales tax revenue, not income tax revenue. As the source of debt service is limited (it is not backed by the full taxing authority of the issuer), these bonds are sold with higher yields than conventional GOs. LO 6.b

Which of the following statements regarding a bond trading flat is not true? A) It may have interest in arrears. B) It may be an income bond. C) It may be a bond in default. D) It may be traded with accrued interest.

D) Explanation A municipal or corporate bond trading flat is trading without accrued interest. The bond may be an income bond, which normally pays no interest, or it may be a bond currently paying no interest because it is in default. LO 6.e

Benefits of a municipal bond advance refunding include A) a higher rating and lower coupon rate. B) a decrease to the issuer's current interest cost. C) tax savings. D) a higher rating and greater marketability.

D) Explanation Advance or prerefunding is refinancing an existing municipal bond issue before its maturity or call date by using money from the sale of a new bond issue. Because the proceeds of the new issue are placed into special U.S. government securities, the rating is automatically at the top. The higher rating increases the marketability. The current bond still exists until the specified call date. As such, the coupon has not changed. There are no taxes to be saved. LO 6.d

Tax preference items are used for the purpose of computing the alternative minimum tax. They include I) excess intangible drilling costs (wages, fuel, repairs). II) accelerated depreciation. III) percentage depletion in excess of basis. A) I and III B) I and II C) II and III D) I, II, and III

D) Explanation All of these are tax preference items. Note that straight-line depreciation is not a tax preference item. LO 6.f

Which of the following may not lead to an industrial development bond being called? A) Funds are available in the surplus account to call the bond. B) Interest rates are falling. C) The facility is destroyed by a storm. D) The municipality is approaching a statutory debt limit.

D) Explanation An issuer of industrial development revenue bonds is likely to call bonds to reduce interest costs when interest rates are falling, discontinue interest payments if the facility is destroyed by a natural disaster, or reduce debt if funds are available in a surplus account. Industrial development revenue bonds are not affected by the issuer's statutory debt limits, as they affect the issuance of general obligation bonds only. LO 6.b

The dated date on a municipal bond issue is A) the date on which the bonds are delivered to the buyer. B) the settlement date. C) the trade date. D) the date on which the bonds begin accruing interest.

D) Explanation The dated date is the date on which newly issued bonds begin to accrue interest. LO 6.e

According to Municipal Securities Rulemaking Board (MSRB) rules, a municipal finance professional (MFP) is I) an associated person of a broker-dealer engaged in municipal securities representative activities other than retail sales. II) a registered representative engaged in the retail sale of municipal securities to individual investors. II) subject to the political contribution rules as outlined in MSRB Rule G-37. IV) not subject to the political contribution rules as outlined in MSRB Rule G-37. A) II and III B) II and IV C) I and IV D) I and III

D) Explanation As defined by the MSRB, an MFP is an associated person of a broker-dealer who is primarily engaged in municipal securities representative activities other than retail sales to individuals, who solicits municipal securities business for the broker-dealer, or who is in the supervisory chain above MFPs as described. MFPs are subject to the political contribution reporting rules as outlined in MSRB Rule G-37. Though there are exceptions for de minimis contributions, exceeding the allowable contribution limits may trigger restrictions on engaging in municipal securities business by the broker-dealer for two years. LO 6.h

Which of the following statements regarding revenue bonds issued by a state or municipality is true? A) The bonds carry an unqualified promise to pay interest and principal backed by the power of the issuer to levy taxes. B) Interest and principal payment is guaranteed. C) Interest and principal payment is backed by the full faith and credit of the issuer. D) Interest will be paid only if the enterprise owned and operated by the state or municipality has sufficient earnings to cover the interest payments or the debt service reserve.

D) Explanation Because revenue bonds are not backed by the full faith and credit of the municipality that issues them, the earnings of the revenue-producing project must be large enough to cover the interest and principal payments. LO 6.b

A 3% bond with 20 years to maturity is being issued by a syndicate with a reoffering yield of 4%. What is the term used to describe this bond? A) Secondary market discount B) Original issue premium C) High-yield bond D) Original issue discount

D) Explanation Because the bond is being issued by a syndicate, it is a new issue (i.e., an original issue). Because the yield (4%) is higher than the coupon (3%), it is an original issue discount. LO 6.f

An investor purchased a municipal bond at par to yield 5.5% to maturity. If, two years later, she sold the bond at a price equivalent to a 5% yield to maturity, the investor incurred A) taxable interest income. B) no taxable result at this time. C) a capital loss. D) a capital gain.

D) Explanation Because the investor sold the bond at a price that will yield less than the yield when she purchased the bond, the bond must have been sold for more than the investor paid for it. Therefore, the investor profited by that difference. Remember, the higher the price, the lower the yield. LO 6.f

On Wednesday, April 22, 2020, your customer purchased a block of City Y 4% Recreation Authority term revenue bonds quoted at 22. The bond's stated interest payment dates are J/J 1. After receiving the confirmation, the customer called you and asked why there was no additional cost for accrued interest. The most likely reason for that is A) there was a mistake on the confirmation and it will be rectified shortly. B) the accrued interest is paid by the seller. C) the trade settled on an interest payment date. D) the bonds are trading flat.

D) Explanation Bonds trading without accrued interest are trading flat. Every bond trades flat twice a year: when the bond settles on an interest payment date. However, that is not the case here because this trade would settle on April 24 and interest payment dates are January and July 1. The price is a hint. A 4% bond selling at 22% of par indicates that this bond is likely in default of interest and that is why it is trading flat. LO 6.e

Which of the following statements regarding callable municipal bonds are true? Call premiums tend to increase over time. Call premiums tend to decrease over time. Call prices are stated as a percentage of the principal amount to be called. Call prices are stated as a percentage of the market value of the bonds to be called. A) I and IV B) II and IV C) I and III D) II and III

D) Explanation Call premiums tend to decrease over time. The longer a customer has to hold the bond (and receive semiannual interest), the less of a premium an issuer will pay to take away the bond before maturity. Call prices are always stated as a percentage of the principal amount (par) to be called. For example, a call price of 103 means the issuer will pay $1,030 for each bond called. LO 6.c

All of the following statements regarding 529 plans are true except A) a beneficiary of a 529 plan may also be the beneficiary of a Coverdell Education Savings Account. B) anyone can make a contribution on behalf of a beneficiary. C) earnings accumulate tax free if the money is used for qualified educational purposes. D) contributions are made with pretax dollars at the federal level.

D) Explanation Contributions are made with after-tax dollars. Withdrawals are tax free at the federal level if used for qualified higher education expenses. LO 6.g

A municipality that has issued grant anticipation notes (GANs) (short-term municipal notes) does so in expectation that the debt service will be paid by the receipt of funds attained A) from future tax revenue. B) through the issue of long-term bonds. C) from both tax and other anticipated revenue. D) via grants from the federal government.

D) Explanation GANs are short-term municipal notes issued in anticipation of funds via grants that the municipality is expecting from the federal government. LO 6.b

All of the following characteristics regarding industrial development bonds (IDBs) are true except A) the funds are used to construct a facility for a private corporation. B) the bonds are issued by municipalities or other governmental units. C) funds from the lease are used to pay the principal and interest on the bonds. D) the bonds are normally backed by the full faith and credit of the municipality.

D) Explanation IDBs are issued by a municipality, and the proceeds are used to construct facilities or purchase equipment for a private corporation. The corporation leases the facilities or equipment, and funds from the lease are used to repay investors. In addition to a first mortgage on the property, IDBs are backed by the full faith and credit of the corporation (not the municipality). LO 6.b

A customer purchases a 6% municipal bond in the secondary market on a 7% basis. The effective after-tax yield is A) greater than 7%. B) 7%. C) 6%. D) 6 to 7%.

D) Explanation In every case but one, the yield to maturity is the effective after-tax yield to a municipal bond buyer. The one exception is a bond bought at a discount in the secondary market. In this case, the annual accretion is taxed as ordinary income. The discount, which is included in the stated yield to maturity, is taxable, reducing the effective after-tax yield to somewhere between the coupon of 6% and the yield to maturity of 7%. LO 6.e

Your customer, a resident of New York, wants to open up a Section 529 plan for his 10-year-old son. Because his son wants to attend Notre Dame, your customer wants to start a plan sponsored by the state of Indiana. You should A) explain that the potential federal tax benefits available to residents of New York may not be available when opening out-of-state plans. B) not open the plan. C) open the plan as instructed by your customer. D) explain that the potential state tax benefits available to residents of New York may not be available when opening an out-of-state plan.

D) Explanation Many states offer tax benefits to residents who open 529 plans in their home state. These benefits are generally not available when opening out-of-state plans. Federal tax benefits are available regardless of the state where the plan is opened. LO 6.g

A customer buys a newly issued municipal zero-coupon original issue discount bond for 85. If the bond is held until maturity, the tax consequence A) is $150 loss. B) is $150 gain. C) cannot be calculated from the information given. D) is $0.

D) Explanation Municipal original issue discount bonds must be accreted. At maturity, the entire discount will be accreted, and the cost basis will be equal to the par value. No gain or loss will occur at maturity. LO 6.f

A legal opinion issued for a municipal bond covers which of the following? Feasibility of public works projects Creditworthiness of the issuing municipality Tax status of the municipal debt Constitutionality and legality of the municipal debt A) II and III B) I and II C) I and IV D) III and IV

D) Explanation Municipal securities are reviewed by specialized lawyers who render a legal opinion. The opinion covers two main issues: constitutionality (i.e., it ensures that the bonds are legal, valid, and binding obligations of the issuer) and verification of the tax status of the debt (i.e., interest on the bonds is exempt from federal income taxes as well as state and local taxes in some cases). LO 6.a

Because municipal bonds do not trade on any exchange, there is frequently a concern about their marketability. According to most industry experts, which of the following bonds would be the most marketable? A) $50,000 of State M general obligation bonds rated Aa B) $10,000 of State N general obligation bonds rated AA C) $5,000 of State O general obligation bonds rated Aa D) $100,000 of State L general obligation bonds rated AA

D) Explanation One of the many factors in the marketability of municipal bonds is the size of the block. With the normal block size being $100,000, municipal dealers will have an easier time trading the State L bonds. Note that S&P and Moody's ratings are the same. LO 6.d

A customer buys a new issue municipal bond at a discount. If held to maturity, the amount of the discount is A) accreted and taxed as ordinary income. B) taxed as a long-term capital gain. C) taxed as a short-term capital gain. D) accreted and is not taxed.

D) Explanation Original issue discounts are accreted, which allows for a step-up in cost basis. Accretion on original issue discount municipal bonds is not taxed. LO 6.f

Which of the following are directly backed by the U.S. government? A) Moral obligation bonds B) General obligation bonds C) Double-barreled bonds D) PHAs and NHAs

D) Explanation Public Housing Authority and New Housing Authority issues are unique as municipal instruments because they are fully backed by the U.S. government. LO 6.b

The Municipal Securities Rulemaking Board (MSRB) is authorized to adopt rules concerning all of the following except A) the form and content of price quotations. B) the sale of new issues to related portfolios. C) the regulation of municipal securities advertising. D) the information to be provided by municipal issuers.

D) Explanation The MSRB does not regulate issuers. Rather, it regulates the underwriting of municipal securities and subsequent secondary market trading. Disclosure requirements for issuers are mandated by the SEC. LO 6.h

The Municipal Securities Rulemaking Board (MSRB) is authorized under the Securities Exchange Act of 1934 to make rules about all of the following except A) the dissemination of price and yield quotes by municipal dealers. B) municipal dealer recordkeeping. C) dealers obtaining fair and reasonable prices for customers. D) information provided by municipal issuers.

D) Explanation The MSRB governs the practices of underwriting and trading municipal bonds. It does not govern municipal issuers. LO 6.h

Which of the following factors does not affect the marketability of a municipal bond? A) Call protection B) Rating C) Block size D) Commissions

D) Explanation The beginning of the MSRB's definition of marketability says "the ease or difficulty with which securities can be sold in the market." The amount of commissions charged by a specific broker-dealer has no impact on the ability to sell the security. LO 6.d

The bond resolution includes all covenants between A) the issuer and the bond counsel. B) the issuer and the Municipal Securities Rulemaking Board. C) the bond counsel and the bondholders. D) the issuer and the trustee acting for the bondholders.

D) Explanation The bond resolution describes not only the characteristics of the proposed offering, but also the obligations the issuer has to its bondholders. LO 6.a

The call provisions of a municipal issue would be detailed most completely in A) the legal opinion. B) the official notice of sale. C) The Bond Buyer. D) the bond resolution.

D) Explanation The bond resolution is the document that authorizes the issuance of a municipal bond. The resolution also describes the proposed issue's features and the issuer's responsibilities to its bondholders. LO 6.a

Which of the following would not be found in a municipal revenue bond resolution? A) Conditions of the maintenance covenant B) Terms of the rate covenant C) Reporting requirements regarding revenues collected D) Underwriting agreement

D) Explanation 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. The underwriting agreement is between the municipality and underwriters, and it spells out the terms agreed to for the underwriting of a new issue. LO 6.b

All of the following have an impact on the marketability of a block of municipal bonds except A) the price and date of call provisions. B) the length of time until the bonds mature. C) the quantity and quality of the bonds in the block available. D) the dated date of the bonds in the block.

D) Explanation The dated date has no effect on marketability. A close call date or low call premium can make an issue less marketable because the chance of a call is greater. Maturity, quality, and the size of the block affect marketability. LO 6.e

When auction rate securities (ARS) reset the yield to be paid in the upcoming period, the process used I) is a stop loss system. II) is a Dutch auction. III) establishes a clearing rate. IV) guarantees that every bidder will have their order filled. A) I and III B) II and IV C) I and IV D) II and III

D) Explanation The process used to reset the interest rate each period for ARS is called a Dutch auction, which is the lowest bid rate at which all of the bonds can be reset—or sold for new issues—at par. This newly established rate is known as the clearing rate, and bidders who bid at or below the clearing rate will now pay that rate. This means that those who bid above the established clearing rate will have their orders go unfilled. LO 6.b

If a municipal bond is issued at par and later purchased for 97 plus accrued interest of $32, what is the purchaser's cost basis? A) $1,002 B) $938 C) $1,000 D) $970

D) Explanation The purchase price of 97 ($970) represents the cost basis of the bond. The accrued interest paid by the buyer has no impact on the cost basis and represents the amount of interest that the seller is due, based on the holding period of the bond from its last interest payment date. The buyer will receive the full six-month interest payment the next time the coupon is paid. LO 6.f

If an M&N 1 corporate bond issued at par with a 6% coupon is later purchased in August for 97 plus accrued interest of $16, how much taxable interest must the investor report for the year? A) $16 B) $60 C) $30 D) $14

D) Explanation The purchaser of a bond pays the seller the interest that has accrued since the last interest payment date. A purchaser in August will pay the interest that has accrued since May 1. Then, on November 1, the investor will receive the entire six months of interest. We are told that the investor paid $16 in accrued interest. That is income to the seller. Then, when the November payment of $30 (6% coupon is $30 semiannually) is made, the investor must report the amount over the accrued interest paid out as income. In our question, that is $30 minus $16 = $14. LO 6.e

A city and school district are coterminous. When evaluating the debt issues of the city, the school district debt would be considered A) a double-barreled bond. B) secondary debt. C) underlying debt. D) overlapping debt.

D) Explanation The term overlapping debt refers to the issuer's proportionate share of the debt of other local governmental units that either overlap it (the issuer is located either wholly or partly with the geographical limits of the other units) or underlie it (the other units are located within the geographical limits of the issuer). In this case, the school district is probably within the geographical limits of the city. That's what coterminous means. LO 6.c

On Monday, June 1, an investor pays 92 to purchase a 5% J&J municipal bond maturing on July 1, 2030. Purchasers of bonds pay accrued interest to the seller, in addition to the market price of the bond. How many days of accrued interest will this seller receive? A) 153 B) 154 C) 151 D) 152

D) Explanation There are 152 days of accrued interest. On municipal bonds, the accrued interest calculation uses 30-day months and 360-day years. Interest begins to accrue on the last interest payment date and runs up to, but not including, the settlement date. This J&J bond pays interest on January 1 and July 1 of each year. Therefore, with a June purchase date, the most recent interest payment was on the previous January 1, the day that interest begins to accrue. The trade date is June 1 with a settlement date of June 3 (T+2). The buyer of the bond becomes the owner of the bond on June 3, and from that date forward, the buyer is entitled to the interest. That is why interest payable to the seller stops accruing on June 2. Here is the math. We have 5 months (January, February, March, April, and May) plus 2 days of accrued interest in June. With each month counting as 30 days, that is 150 days + 2 more in June equaling 152 days. How do we know that the J&J dates are the first of the month rather than the 15th? Good question. For the answer, we look to the maturity date of the bond. That is July 1, 2030, and is the clue that the interest payment dates are on the first of the month. LO 6.e

Which of the following would not be found within the protective covenants for a municipal revenue bond issue? A) Flow of funds B) Additional bonds test C) Catastrophe clause D) The issue's rating

D) Explanation There are different sources for bond ratings, but they would not be found within the revenue issue's protective covenants. The municipality agrees to abide by the covenants, and a trustee appointed in the bond indenture supervises the issuer's compliance with them. Some common covenants include rate or fee (promise to maintain user fees high enough to pay expense and debt service) maintenance, insurance, additional bonds test, sinking fund, catastrophe, flow of funds, books and records, and call or put features. LO 6.b

D) Explanation This is a tax-equivalent yield question. The interest paid on a corporate bond is taxable, while that of the municipal bond is tax free. The formula is: The coupon of the municipal bond divided by (100% − tax bracket). In our question, that would be 3.20% divided by 63%, or 5.08% LO 6.f

A customer in the 28% tax bracket wants to buy a municipal GO bond with a 7.5% yield that matures in 6 years. The tax-equivalent yield of this bond is A) 0.060. B) 0.075. C) 0.026. D) 0.104.

D) Explanation To calculate the taxable return, use the tax-free equivalent yield formula: municipal bond yield ÷ (1 − investor's tax bracket). Using this formula, 0.075 ÷ (1 - 0.28) = 0.104, or 10.4%. This means the investor, who is in the 28% tax bracket, must earn 10.4% in taxable interest to equal the 7.5% tax-free municipal interest yield. LO 6.f

If a municipal bond maturing in 10 years is bought for 110, its cost basis at the end of the sixth year is A) 101½. B) 106. C) 100. D) 104.

D) Explanation To establish the new cost basis, determine the amount of the premium to be amortized yearly. For this bond, the $100 premium is amortized over 10 years: $100 divided by 10 equals $10. Then, multiply the annual amortization amount by the number of years the bond is held ($10 × 6 = $60). Finally, subtract the amount of the amortized premium from the original cost of the bond ($1,100 − $60 = $1,040, or 104). LO 6.e

Each of the following would be disclosed to potential municipal bond buyers in the official statement of a new municipal bond issue except A) the source from which interest and principal will be paid. B) the creditworthiness of the issue. C) the issue's purpose. D) the disclosure that it was prepared by the underwriters.

D) Explanation While a broker-dealer acting in an underwriting capacity or in an advisory capacity may assist in preparing the official statement, it is considered to be the responsibility of, and prepared by, the issuer. The official statement identifies the issue's purpose, the source from which the interest and principal will be repaid, information regarding the issuer's financial and economic background, and information relating to the issue's creditworthiness. LO 6.a

All of the following trade with accrued interest except A) convertible bonds. B) Treasury bonds. C) jumbo certificates of deposit. D) zero coupon bonds.

D) Explanation Zero coupon bonds are issued at a deep discount from face value instead of providing semiannual interest payments. T-bonds, convertible bonds, and CDs all make periodic interest payments; thus, the seller receives any accrued interest from the buyer. LO 6.e

Which of the following bonds is issued to finance the construction of subsidized housing and is backed by rents and the taxing authority of the U.S. government? A) Special assessment B) Special tax C) Moral obligation D) Section 8

D) Section 8 Explanation Section 8 bonds, also known as Public Housing Authority bonds and New Housing Authority bonds, are used to finance subsidized housing. These bonds are backed by rental income. If this income is insufficient to service the debt, the U.S. government makes up the difference. Essentially, these are revenue bonds backed by the U.S. government, and are therefore AAA rated. LO 6.b

The bond resolution includes all covenants between A) the bond counsel and the bondholders. B) the issuer and the Municipal Securities Rulemaking Board. C) the issuer and the bond counsel. D) the issuer and the trustee acting for the bondholders.

D) The bond resolution describes not only the characteristics of the proposed offering, but also the obligations the issuer has to its bondholders. LO 6.a

Which of the following is least important to a municipal bond analyst? A) Debt service to annual revenues B) Revenue collection record C) Tax collection ratio

D)Legality of the issue Explanation Municipal bond analysts are concerned with the financial aspects of municipal bonds to ensure that they do not default. Various financial ratios and collection records are critical to their analysis. The legality of the municipal issue, as determined by the legal opinion, is important to issuers. LO 6.c

Unit 6: Municipal Bonds

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