Municipal Bond Basics

Trust Indenture

A bond's indenture describes the rights and duties of the municipality and the trustee - The trustee represents the bondholders - The trust indenture includes the bond's reserve needs and rate schedules - The trust documents are prepared by bond counsel, not the underwriter or the syndicate

"Capitalized Interest" or "Funded Interest"

During the construction stage, before a project begins to generate revenues, interest paid to bondholders comes from the proceeds of the bond issue and is called "Capitalized Interest" or "Funded Interest"

Industrial Development Bonds

Industrial Development Bonds, aka Industrial Revenue Bonds - These bonds are risky - They are not backed by the municipality but by a corporation - The municipality approves the sale of bonds "on behalf of" a company or corporation - Enables the company to borrow at tax free rates - Interest and principal are paid solely by the company - Company is ultimately responsible for the debt - Substantial users may be taxed on interest

Feasability Study

Prior to the issuance of a revenue bond the municipality will do a "feasibility study" to determine estimated costs and revenues of the project - The study considers construction expenses, service charges, and estimates of users - The Indenture Agreement is not a factor when an anayst does a study

Analysis of Authority of the Issuer

When bond counsel analyzes the authority of the issuer to issue bonds they would research 1. The municipality's local statutes 2. Judicial opinions 3. The constitution of the state 4. Legislation and procedures of the state Note: - Bond counsel would not need legislative approval for the bond issue

Legal Opinion Important Points

- Since the early 1950s, a legal opinion is usually printed on the bond itself - The legal opinion determines the tax exempt status of municipal bond interest

Gross Revenue Pledge

"Flow of Funds" Provision- how revenue from that facility are to be applied. There are two types of provisions which can be used by the municipality: - Under a Gross Revenue Pledge, funds would be applied in the following sequence: 1. Bond service account for principal and interest 2. Operation and maintenance fund 3. Debt service reserve fund and/or sinking fund 4. Reserve maintenance fund, renewal and replacement (depreciation) fund 5. Surplus fund or general fund of the municipality Memory Hook: It is Gross to have B.O.

Bonds Funds

- Are Open-End funds that are actively managed and therefore have a portfolio manager - Are continually offered Important Comparison: - UITs have no manager and the portfolio diminished over time - Income from bonds that mature or are sold is reinvested and not distributed

Term Bonds

- Are all issued with the same maturity date - Are also known as "Dollar Bonds" because dealers quote them in dollars (@ 99 1/2) rather than in YTM - Usually have sinking fund provisions 1. When a term bond has an "average life" of less than its term maturity date, that means that part of the issue would have been called in by the issuer generally through a sinking fund provision (e.g., 20 year bond with an average life of 15 years). 2. When a partial call is made on a term bond issue, the called bonds are selected randomly

Sinking Funds and Bond Repayment

- Ensure that the municipality will have the necessary funds at hand to retire term bonds - A sinking fun generally means that the municipality deposits money into the sinking fund each year * The sinking fund provision may contain "sinking call" provisions which may require that a certain number of bonds be retired in annual or semi-annual installments Bond Repayment - A municipality may refund a maturing bond issue in either of two basic ways. It can pay off the original bondholders with: * Cash received from a new issue * the exchanging of new bonds for the original bonds

Types of Muni Investment Companies

- Some investment companies are formed with only municipal bonds in the portfolio - These two types of investment companies include: * Unit Investment Trusts * Bond Funds

GO Credit Analysis

- GOs are frequently rated by analysts to determine creditworthiness of the issuer * Rating services: Moody's Standard & Poors, Fitch * Items considered when rating (e.g., AAA) a GO: a. Outstanding Debt - Stable or low levels of debt are positive - Unstable of high levels are negative b. Per-Capita Debt - Low levels are positive/High levels are negative c. Debt/Value Ratio - Low ratio is positive/High rartio is negative d. Debt to Property Value Ratio (Debt of municipality in relation to the property values of taxable real estate) - Low ratio is positive/High is negative e. Character of the Economy - Stable or booming economy is positive - Unstable or faltering is negative f. Tax Collection Record - Good tax collection record, signified by collections in full and on time, is positive - Poor tax collection record, signified by late, partial, or non-existant collections, is considered negative g. Property Valuation Trends - Increasing property value- positive - Decreasing property values- negative h. Tax Rates - Stable or decreasing tax rates- positive - Unstable or increasing tax rates- negative i. Unfunded Liabilities - Stable or low levels are positive - Unstable or high levels are negative j. Operating Deficits - Low levels are positive - High levels are negative k. Attitude of Municipality toward Debt - Municipality tries to avoid debt- positive - Municipality issues debt often/frivolously- negative l. Population Demographics (including average age, education, income, etc.) - Educated, young, growing- positive - Elderly and declining population- negative m. Budget Practices - Fiscally conservative municipality considered positive - Fiscally iresponsible municipality considered negative

Call Features

- Issued bonds may contain call features which allow the municipality to redeem the bonds according to a fixed price schedule prior to the maturity dates 1. Callable features are good for the issuer but usually are unattractive to investors 2. A bond called at a par or at a premium may not compensate the investor for the lost yield because of the risk of investing at lower yields 3. Most revenue bonds are callable and most GO bonds are not callable 4. Callable bonds usually have higher coupons than non-callable bonds 5. Prior notice of a call is required 6. Callable municipal bonds are required to be priced to the lowest of all possible yields. Customers must be quoted the "worst case scenario" yield on a bond a. The price of a callable bond is calculated on the lower of the yield to maturity or yield to call b. Callable bonds trading at a premium are always priced to the call date, which is worst case scenario for customer 1. Would get bonds taken away from them early 2. Is paid the par value or a slight premium 3. Would then reinvest the money received

Legal Opinion

- Municipal bonds are delivered to the buyer with a legal opinion printed on the bond - The legal opinion is a statement from a reputable independent law firm hired by the issuer

Pre/Advance Refunding Bonds

- Municipality issues new bonds whose proceeds will be used in the future to pay off existing bonds - Proceeds of new issues are invested in U.S. Government Securities - principal and interest invested in government securities is pledged exclusively to the payment of principal and interes of the existing issue (Escrowed to Maturity), therefore there is a high degree of safety - This pledge, in effect, eliminates ("defeases") the old bond issue as part of the municipality debt limit and significantly reduces the credit risk of the outstanding bonds 1. Pre-Refunding - Original issue is redeemed at the earliest call date - Only can be done within 90 days of call date - The "call price" can be more than the par value of the bond 2. Advance Refunding - Bonds are generally non-callable and are redeemed at the original maturity date - The new bonds must remain outstanding for more than 90 days

Tender Offers

- Occasionaly a municipality may wish to retire its debt prior to maturity (redemption) dates - In these cases the municipality could annouce a tender for some or all of the outstanding bonds

Municipal Notes

- Short term debt instruments used for temporary (interim) financing 1. Tax Anticipation Notes- A TAN is used to raise monies which will be paid off with tax receipts in the near future 2. Revenue Anticipation Note- A RAN raises monies which will be paid off when certain revenues are realized or received 3. Tax and Revenue Anticipation Notes- A TRAN is a combination of a tax and revenue note 4. Bond Anticipation Notes- A BAN is used to raise money which will be paid off from the sale of bonds in the future. Notes are issued to carry though until bond revenues are received 5. Grant Anticipation Notes (GANs) are grants received by municipalities from the federal government generally from the federal transit authority program for the purchase of buses, trains, ferries, vans, and support equipment. These grants are dependent on Congressional appropriation 6. Other types of short-term obligations of a municipality include: a. Construction Loans Notes (CLNs) b. Demand Notes c. Tax-Exempt Commercial Paper issued to: * Raise working capital * Cover extraordinary expenses, or * Cover construction or maintenance costs Note: - Commercial paper is not issued to refund outstanding bonds

Moral Obligation Bonds

- They are usually issued when a municipality is near or going into bankruptcy - Are revenue bonds issued by an authority created by a state or municipality - If the issuing authority cannot pay, state legislative appropriations would be required Important Note: - Industrial Development and Moral Obligation Bonds are considered to be Risky Municipal Investments

Serial Bonds

- Think of breakfast cereal (issued bowl - eat bite by bite) - Have annual or staggered maturity dates - Are quoted in terms of Yield to Maturity (3.4% Basis) * Shorter maturities have lower yield * Longer maturities have higher yield - Serial bonds with a large term maturity in the final year are referred to as issued with a "Balloon" or term maturity

Additional Rating Information

- Under Standard and Poor's categories AA to BB, a plus sign is added to show high relative standing, a minus sign to show low relative standing * For Example: AA+ and BB- - Under Moody's ratings, bonds of the highest quality within a grade are designated by adding a "1" * For Example: A-1 and Baa-1

Muni Bond UITs

- aka, Tax Exempt Unit Investment Trusts - Have the following characteristics: 1. Are individual entities created by an indenture 2. Since securities are redeemable, customers may tender at any time 3. Trust size is reduced as bonds mature or are called 4. Since portfolios are fixed, there are no portfolio managers

Variable-Rate Demand Bonds

- are long term municipal bonds: 1. Whose interest rates are generally reset periodically on a daily, weekly, or monthly basis and 2. That allow bonholders to tender ("put") the bonds back to a municipal bond dealer at par plus accrued interest when interest rates are reset The key characteristics of these bonds are: 1. They are issued at par in $100,000 increments 2. A municipal bond dealer designated as a "remarketing agent" resets the interest rates and uses its best efforts to sell (remarket) bonds that have been tendered by bondholders when the interest rates have been reset 3. If the bonds cannot be remarketed, the remarketing agent may sell the bonds to a large bank that has issued a letter of credit or an insurance company that has entered into a standby bond purchase agreement. The issuer is only responsible to redeem the bonds at maturity 4. These bonds provide the bondholder with some protection against the interest rate risk because the interest rate is not fixed 5. Despite high credit ratings, these bonds are still subject to the risks that there may not be an active secondary market for the bonds and that the issuer and/or remarketing agent may default

Other Facts about G.O. analysis

1. The "debt to value" ratio is significant when evaluating general obligation bonds. The "debt service coverage" is significant when evaluating revenue bonds 2. "Budgetary practices" are important when analyzing a GO bond - Factors used to evaluate revenue bonds include feasibility studies, covenants, and competing facilities 3. Comparisons between two municipalities must be closely evaluated because the basis of assessing the value of property and assets is different from municipality to municipality

Legal Opinion Additional Information

A municipal bond attorney: - Can never guarantee that principal and interest will be paid on time for a particular municipal issue - Can only guarantee that the issue was issued in accordance with the statutes of the municipality

Advance Refunding

Advance refunding is done to: 1. Restructure a debt issue 2. To remove restrictive covenants 3. To reduce interest costs Advance refunding is not done: 1. To pay the municipality's expenses 2. To earn profits from the difference between interest rates being paid out on the outstanding bonds and interest being earned on govt. securities Pre-Refunding and Advance Refunding improve the quality rating of the original issue since the new issue is now backed by U.S. Government Securities

"Call Protection" & Put Bonds

An investor looking for "call protection" would avoid purchasing callable bonds at a premium if the bonds are callable at par Put Bond/Tender Option Bond - A feature which allows the holder of the bond to "put" or redeem the bond back to the issuer or agent usually at par on certain stated dates - Does not guarantee a customer against loss - The investor would put the bond if prices declined or yields were to rise

Diversification

Bond ratings may be withdrawn if the rating agency does not receive current financial information about the issue and issuer An investor should diversify his portfolio: 1. Geographically 2. By maturity 3. By Purpose 4. Security 5. Quality Note: - Denominations of the bond certificates would not be a major consideration when diversifying a portfolio of bonds

Revenue Bonds

Bonds for which the payment of interest and principal depends on specified identified sources of revenue such as: - User Charges - Lease Payments - License fees - "Special" or "Excise" taxes (like tobacco or liquor) Note: - Revenue bonds are not backed by the taxing powers of a city, town, or state. Are not repaid from ad-valorem taxes.

Refunding Bonds

Bonds issued by a municipality in order to pay off existing bonds - Municipality calls in old bonds with monies generated from the sale of the new bonds - Three Primary Reasons for Refunding 1. To lower interest costs 2. To change the maturity of amortization schedule of bonds 3. To liberalize the bond's indenture provisions

Zero Coupon Municipal Bonds

Bonds sold at deep discounts and mature at face value - The most sensitive and volatile of all municipal bonds, their characteristics include: 1. Do not pay interest semi-annually, but subject to accretion 2. Amount of accretion determined by purchase date, purchase price, and maturity date, not by sales price 3. The annual amount of accretion or "imputed interest" is exempt from Federal tax and may be exempt from state tax but must be reported annually 4. To determine if a zero coupon municipal bond is trading at a premium or a discount to its accreted value, you work from the bond's original yield 5. They may be callable. If called, they are called at 102% of the current accreted value 6. Can be bought by investors planning for future events, such as child's college expenses

General Obligation Bonds

Bonds that are a general obligation of the issuing municipality - State, County, City, School District, etc. Also known as "Full Faith and Credit" Bonds Most States Require Voter Approval for issuance Amounts are subject to statuatory or constitutional debt limit

Muni Bond Attorney Functions

Functions of a municipal bond attorney (counsel): 1. Establish that the legal opinion determines the tax exempt status of municipal bond interest 2. Determining legal issuance in accordance with the issuer's statuses 3. Preparation and examination of the original draft and proceedings prior to adoption 4. Examination of the bonds to see they are properly executed Note: - Bond counsel does not pay for the printing of bondsa

Municipal Tax Income

General obligation bonds are secured by taxes collected by the municipality and are not limited to the revenues derived from any one specific project. They are issued to finance non-revenue producing projects 1. State Level- secured by Sales and/or Income Tax 2. Local Level- secured by Property Taxes a. Real Estate/Property Tax Assessments - Two values: Market vs. Assessed - Always taxed at the Assessed Value - Taxed in Mills (1 mill = $0.001) - An ad-valorem tax is a tax "according to value" for General Obligation bonds backed by assessed valuations on property * State governments receive little or no revenue from real estate (ad-valorem) tax * Real estate assessments and how they are computed may vary from district to district * These taxes do not fund revenue bonds 3. Limited Tax Bonds- are GO bonds where the municipality puts a statuatory limit on the tax rate that may be levied. Prior to issuance, these bonds require voter approval like any other GO bonds

General/Legislative Risk

General risk factors- when comparing a GO to a Revenue Bond, the GO would generally be considered to be safer because the GOs are backed by taxes whereas the Revenue Bond is dependent on user changes Legislative Risk- If the federal tax exempt status was removed, it would have a devastating effect for municipal bonds. The benefits of investing in municipal bonds include: 1. Interest is exempt from federal income tax 2. Interest may be exempt from state and local income tax 3. Principal and interest payments are fixed 4. There's a wide range of issuers and maturities 5. Geographic diversification Note: - Muni bonds are subject to interest rate risk and inflation or purchasing power risk

Additional Information

In addition to legality and tax exemption, opinions cover the effect of the U.S. Treasury Department arbitrage regulations A legal opinion bond counsel would not cinsider the re-offering yields of a bond issue

Credit Worthiness

In analyzing the credit worthiness of a revenue bond, the following factors are relevant: 1. Purpose for which the bonds are issued 2. Competing facilities 3. Coverage ratios 4. Rate covenants Note: - Analysis of revenue bonds would not consider the: * Per Capita debt (GOs) * Tax collection record of the issuer (GOs) - Overlapping debt (GOs)

Double-Barreled Bonds

In some instances, revenue bonds are also backed by the full faith and credit of a city and thus they would be called "Double Barreled" bonds because they are secured by two sources of income The safety of these bonds is greater than the safety of bonds backed by revenues alone

Protective Covenants

Issuance of revenue bonds is generally accompanied by agreements in the bond's indenture to do certain things during the life of the bonds - These agreements are called covenants 1. Maintenance Covenant- Requires that the facility is maintained in good operating condition 2. Debt Service or Rate Covenant- Requires the issuer to charge rates sufficient to meet financial requirements plus a margin of safety - The rate covenant does not cover sinking fund requirements or call provisions 3. Insurance Covenant- Requires adequate insurance on the facility to protect investors from damage or destruction. In cases of catastrophe or unusual circumstances, a Catastrophic or Extraordinary Call provision may be used to call bonds prior to maturity 4. Financial Report Covenant- Requires an audited annual income statement and balance sheet on a facility 5. Consulting Covenant- Requires that services of a consulting engineer of good reputation be retained 6. Anti-Discrimination Covenant- Requires that no discrimination will be practiced in the facility's hiring policies, services provided, or rates charged 7. Additional Bond Covenant - Regulates the municipality's ability to sell additional bonds payable from the revenue of the project. Two Types: - Closed-End- Prohibits sale of additional bonds from revenues of the project - Open-End- Permits sales of additional bonds. Sometimes an Earnings Test must be met

Lease Rental/Revenue/Back Bonds

Lease Rental/Lease Revenue/Leaseback Bonds - Municipality forms an authority to sell bonds to construct a facility - Examples: courthouses, schools, etc. - The authority then leases the facility back to the city or or school district - The security for this revenue bond is the lease, not tax assessments

Municipal Bond

Municipal bonds are bonds issued by state and local government entities such as cities, counties, school districts, and the state We can divide municipal bonds into three major categories: - General Obligation Bonds (GOs) - Revenue Bonds - Municipal Notes

Types of Legal Opinions

Municipal bonds are either: 1. Unqualified Opinion - is absolute and unconditional - an indication that the bonds are "legal, valid, binding..." and qualify for the tax exemption 2. A Qualified Opinion - specifies that the validity and tax exempt status are conditional in some way - Something may be wrong with the bonds

Muni Bonds Offered "At Par"

Municipal bonds that are offered "at par" and are "non-callable" are more marketable than those sold at a premium and/or with a call feature

Direct and Overlapping Debt

Municipalities generally have two types of debt: 1. Direct Debt - Debt for which the municipality is soley responsible 2. Overlapping Debt - Debt for which more than one municipality entity is reponsible - Overlapping debt only occurs at the local government level and is supported by taxes. Examples: a. Library district b. School district c. Park district But not an airport authority (Revenue Bond) 3. Contiguous Overlapping Debt- is debt shared by different municipalities sharing the same borders Important Note: - Overlapping Debt never occurs at the State level 4. Direct debt + overlapping debt = Net overall debt

Muni Bond Insurer and Letters of Credit

National Public Finance Guarantee Corp (formerly MBIA- Municipal Bond Insurance Association) Assured Guaranty Municipal Corp Build America Mutual Assurance Company - These organization insure municipal bonds against default in the payment of principal and interest - Issuers would insure their bonds to pay a lower rate of interest, not to improve the rating of the bond - Insurance does not guarantee that the issuer will permanently have a good rating A Letter of Credit from a bank: - Is considered a Credit Enhancement - The bank commits to paying principal and interest on the securities in the event that the issuer is unable to do so

New Housing Authority Bonds & PHAs

New Housing Authority/Public Housing Authority Bonds - Important Note: These are ALWAYS the safest municipal bonds issued because they are backed by the U.S. Government - Usually subsidized housing in some form - Retirement, Low-Income, and Project Housing - These are Revenue Bonds issued by local housing authority - Interest and principal is paid from rents collected - Also backed by PHA, a division of HUD - The only Municipal Bonds backed by the US Government - Makes them the highest quality municipal bond

Revenue Bond Purposes

Reasons for issuing Revenue Bonds: 1. Airports 2. Harbors 3. Water, Sewer, and Electric systems 4. Hospitals and Nursing Homes 5. Toll Roads 6. Skating Rinks and Golf Courses 7. Mass Transit Systems 8. Stadiums 9. Arenas 10. Convention Centers 11. Single and multi-family housing 12. Interstate authorities (e.g., Port Authority of NY & NJ) Note: - If the number of "users" of these facilities declined it would have a negative effect on the underlying Revenue Bonds

Repurchase Agreement/Parity Bonds

Repurchase Agreement - A "Repo" is an agreement whereby securities are sold by a firm with the agreement to repurchase them at a later date at an agreed upon price - Such agreements are usually short term - Record on Repos must be kept for 3 years Parity Bonds occur when an issuer issues new bonds which have equal claim or rights as other bonds that were previously issued

Revenue Bond Popularity

Revenue bonds have become increasingly more popular in recent years because they: 1. Do not require a positive vote of citizens 2. Do not count toward constitutional or statuatory limits or the amount of debt that a municipality may incur 3. Are not payable from taxes and will not contribute toward any possible future increase in taxes

Risks in Municipal Market

Risks in the municipal bond market include: 1. Interest rate risk 2. Inflationary or purchasing power risk 3. Market risk 4. Credit risk 5. Reinvestment risk 6. Regulation risk 7. Political risk When appraising the value of a municipal bond, the most important factor to consider is the current market value of similar bonds

Unrated Bonds and MIG Ratings

Some municipal bonds are not rated because the issuer's total debt is relatively small - Without a sifficient history of bond issues or credit history, it may be difficult to rate the bonds MIG Ratings (Moody's Investment Grade): - Evaluate the level of quality of Municipal Notes - A MIG 1 rating on a note is comparable to a AAA rating on a bond - Shorter maturities are ALWAYS safer than long maturities

Special Assessment & Tax Bonds

Special Assessment Bonds - Issued by municipalities - Principal and interest is payable from an assessment on the benefited property - Classified as revenue bonds - Assessments could be collected from the users of sewer, lighting, or electricity districts Special Tax Bonds - Paid from excise taxes levied on purchases of certain products

UIT Selling Points

UITs are purchased by investors for the following reasons: 1. Diversification of issuers 2. Geographic diversification 3. Ease in the collection of interest

Private Activity/Purpose Bonds

Types of municipal bonds issued to finance "private" activities - The interest may be subject to taxation and/or subject to the Alternative Minimum Tax (AMT)

Net Revenue Pledge

Under a Net Revenue Pledge, funds would be applied in the following sequence: 1. Operation and Maintenance fund - Used to maintain facility on a "regular" basis 2. Bond service account for principal and interest 3. Debt service reserve fund or sinking fund 4. Reserve maintenance fund, renewal and replacement (depreciation) fund - Used to maintain facility on an "irregular" basis 5. Surplus fund or general fund of the municipality Memory Hook: O.B.s are D.R.S.

Build America Bonds (BABs)

are taxable municipal bonds issued for infrastructure rebuilding. (schools, hospitals, roads, etc.) - BAB's cannot be used to refinance outstanding debt - Interest payments are fully taxable to investors - Interest paid by the municipality is subsidized either by the Federal Government paying back the municipality 35% of the interest paid out or bondholders may take a Federal tax credit equal to 35% of the interest expense - Expands the market for municipal bonds to pension plans and foreign investors

S&P and Moody's

evaluate the credit quality of municipal bonds and emphasize the default risk associated with the bonds

Effect of Inflation/Deflation

on Municipal Securities: 1. In periods of inflation, interest rates increase and bond prices decline 2. In periods of deflation, interest rates decline and the bond prices appreciate - An investor would buy short term bonds if he anticipates rising interest rates - An investor would buy long-term bonds if he anticipates declining interest rates