SIE Municipal Bonds: Local Government Securities

Advertising and record keeping

A brokerage firm has to keep all advertising for a minimum of three years, and these ads must be easily accessible (not in a bus storage locker) for at least two years.

Industrial Development Revenue bonds (IDRs)

A municipality can also issue this type of bond to finance the construction of a facility for a corporation that moves into that municipality. Remember that even though a municipality issues these bonds, they're actually backed by lease payments made by a corporation. Because the corporation is backing the bonds, the credit rating of the bonds is derived from the credit rating of the corporation. Remember: generally considered the riskiest municipal bonds because they're backed by a corporation making lease payments rather than a municipality.

Gifts

According to MSRB rules, municipal securities dealers can't give gifts valued at more than $100 per year to customers. Business expenses are exempt from the rule. You should note that FINRA gift rules fall directly in line with MSRB's gift rules.

Rule G-21

Advertising. Advertisements by municipal securities dealers, brokers, and dealers can't contain false or misleading statements.

Confirmations

All confirmations of trades must be sent or given to customers at or before the completion of the transaction (settlement date). Municipal securities settle the regular way (two business days after the trade date - T+2). Each broker, dealer, or municipal securities dealer must report to the MSRB all transactions in municipal securities through the Real-Time Reporting System (RTRS). The RTRS will make public reports on market activity and prices. In addition, the MSRB will assess transaction fees to make sure that they are in line with MSRB rules.

Taxable Municipal Bonds

Although the interest on most municipal bonds is federally tax free and sometimes triple tax free (the interest is exempt from federal, state, and local taxes), you need to be aware that some bonds are taxable. These bonds are still issued and backed by a municipality, but are still taxable.

Rule G-7

Information concerning associated persons

Credit enhancement

Insurance of revenue bonds to protect investor in the case of default. Remember: other factors that provide investors with a certain degree of comfort are that municipalities must provide financial reports and are subject to outside audits for all their revenue bond issues.

Tax Credit BABs

Investors of this type of Build America Bonds receive tax credits equal to 35% of the coupon rate.

Negotiated offering

Like corporations and partnerships, municipalities need help selling their issues. This type of offering is where the issuer chooses the underwriter(s) directly with no competition from other underwriters. Since revenue bonds are not backed by taxing power (like GOs), the issuers are not obligated to get the best price or coupon rate for their bond issue.

Official statement

Municipal bonds don't have a prospectus; instead, municipal bonds usually provide this statement. As with prospectuses, these statements come in preliminary and final versions. The final version is the doc that the issuer prepares; it states what the fund will be used for, provides information about the municipality, and details how the funds will be repaid. It also includes: 1. The offering terms 2. The underwriting spread 3. A description of the bonds 4. A description of the issuer 5. The offering price 6. The coupon rate 7. The feasibility statement 8. The legal opinion

Rule G-37

Political contributions and prohibitions on municipal securities business. Prohibits brokers, dealers, etc., from engaging in municipal advisory business with entities if they've made political contributions to officials of such municipal entities. In the vent that they did make political contributions, they must disclose it to the public.

Rule G-9

Preservation of records. Most records have to be kept either four or six years.

Rule G-30

Pricing and commissions. The aggregate price including markdown or markup must be fair and reasonable.

Rule G-3

Professional qualification requirements

Build America Bonds (BABs)

These bonds were created under the Recovery and Reinvestment Act of 2009 with the idea to help municipalities raise money for infrastructure projects, such as tunnels, bridges, roads, etc. These bonds either have a higher coupon rate than most other municipal bonds because the municipality receives tax credits from the federal gov't or are more attractive because the investors receive tax credits from the federal gov't.

Revenue anticipation notes (RANs)

These notes provide financing for current operations in anticipation of future revenues that the municipality will collect.

Tax anticipation notes (TANs)

These notes provide financing for current operations in anticipation of future taxes that the municipality will collect.

Project notes (PNs)

These notes provide interim financing for the building of subsidized housing for low-income families.

Construction loan notes (CLNs)

These notes provide interim financing for the construction of multifamily apartment buildings.

Grant anticipation notes (GANs)

These notes provide interim financing for the municipality while it's waiting for a grant from the U.S. gov't. The notes are paid off from the grant funds once received.

Bond anticipation notes (BANs)

These notes provide interim financing for the municipality while it's waiting for long-term bonds to be issued.

Municipal bonds

Securities that state governments, local governments, or U.S. territories issue. The municipality uses the money it borrows from investors to fund and support projects, such as roads, sewer systems, hospitals, and so on. Remember: municipal bonds typically have lower yields than U.S. government bonds because municipal bonds have the tax advantage of interest received being federally tax-free. Interest received on U.S. gov't securities is state tax-free.

Commissions

All commissions, markups, and markdowns must be fair and reasonable, and policies can't discriminate among customers.

Rules G-8 and G-9

Books and records requirements

Rule G-25

Improper use of assets. No broker, dealer, or municipal securities dealer can make a guarantee against loss.

Rule G-13

Quotations. All quotes must be genuine.

Municipal Securities Rulemaking Board

MSRB

Rule G-2

Standards of professional qualifications

Municipal notes ratings (best to worst)

Moody's: MIG 1, MIG 2, MIG 3, MIG 4 S&P's: SP-1, SP-2, SP-3 Fitch: F-1, F-2, F-3

Tax and revenue anticipation notes (TRANs)

These notes are a combination of TANs and RANs.

Pre-sale period

This is the period preceding the date of sale.

Revenue bonds

Unlike tax-backed GO bonds, these bonds are issued to fund municipal facilities that'll generate enough income to support the bonds. These bonds raise money for certain utilities, toll roads, airports, hospitals, student loans, and so on. General characteristics: 1. They don't need voter approval. Because these bonds fund a revenue-producing facility and therefore aren't backed by taxes, they don't require voter approval. The revenues pay off the debt. 2. They require a feasibility study. Prior to the issue, the municipality hires consultants to prepare a feasibility study. The study basically answers the question: "does this make sense?"

Competitive offering

Because GO bonds are backed by the taxing power of the municipality, the municipal issuers are responsible for getting the best deal for the people living in their municipality. In order to get the best deal, they will post an advertisement known as a Notice of Sale in the Daily Bond Buyer (the main source of information about new municipal bonds) saying that they are accepting bids on a new issue of bonds. After a good faith deposit, the winner of the bid will be the underwriter that presents the lowest cost to the taxpayers backing the bond. The lowest could be the result of issuing the bond with a lower coupon rate and/or agreeing to pay more to purchase the bonds.

Marketability of GO bonds

Because they're backed by taxes rather than sales of good and services, GO bonds have different components to look at when analyzing their marketability and safety of the issue: 1. Quality (rating): the higher the credit rating, the safer the bond. 2. Maturity: the short the maturity, the more marketable the bond issue. 3. Call features: callable bonds are less marketable than noncallable bonds. 4. Interest (coupon) rate: bonds with higher coupon rates are more marketable. 5. Block size: the larger the block size, the more marketable the bond usually is. 6. Dollar price: the lower the dollar price, the more marketable the bond is. 7. Issuer's name (local or national reputation): bonds are more marketable when the issuer has a good reputation for paying off its bonds on time. 8. Sinking fund: if the issuer has put money aside to pay the bonds off at maturity, the bonds are more marketable because default risk is lower. 9. Insurance: if the bonds are insured against default, they're considered very safe and are more marketable. Bond insurance is considered credit enhancement.

Rule G-18

Best execution. A broker must use reasonable diligence to attempt to get the best price for the security (lowest buying price or highest selling price of the customer).

Triple tax-free municipal bonds

Bonds that U.S. territories (and federal districts) issue are triple tax-free (the interest is not taxed on the federal, state, or local level). These places include: Puerto Rico, Guam, U.S. Virgin Islands, American Samoa, and Washington D.C. Additionally, in most cases, if you buy a municipal bond issued within your own state, the interest will be triple tax-free. Remember: unless you see the U.S. territories or Washington, D.C., in a municipal bond question, don't assume that the bonds are triple tax-free. Also, the tax advantage of municipal bonds applies only to interest received, not capital gains if they sell the bond for more than their cost basis.

Rule G-34

CUSIP numbers, issue and market information requirements. For new issues of municipal bonds, the managing underwriters must apply to the Committee on Uniform Security identification Procedures (CUSIP) to receive identification numbers for the bonds for each maturity, if more than one.

Rule G-17

Conduct of municipal securities and municipal advisory activities. All securities professionals shall deal fairly with all persons and not engage in dishonest, deceptive, or unfair practices.

Rule G-10

Delivery of investment brochure

General Obligation bonds (GOs)

Essentially, these bonds are tax-backed because: 1. They fund nonrevenue-producing facilities. These bonds are not self-supporting because municipalities issue them to build or support projects that don't bring in enough (or any) money to help pay off the bonds. 2. They're backed by the full faith and credit (taxing power) of the municipality. The taxes of the people living in the municipality back these bonds. 3. They require voter approval. Since these bonds are paid by the taxes of the people living in the municipality, those same people have the right to vote on the project. The bonds fund schools, libraries, police departments, fire stations, etc.

Rule G-47

Time of trade disclosure. Brokers, dealers, and municipal securities may not trade a municipal security (buy from or sell to) with a customer (whether solicited or unsolicited) without providing all material information about the trade.

Legal opinion

The purpose of this document is to verify that the issue is legally binding on the issuer and conforms to tax laws. Remember: if a bond is stamped ex-legal, it does not contain a legal opinion.

Achieving a Better Life Experience (ABLE)

These accounts are designed for individuals with provable disabilities and their families. Because of the extra needs and expenses incurred in taking care of individuals with disabilities, these accounts allow people to invest after-tax dollars. The investments may be conservative, moderate, or aggressive and many states have annual contribution caps and max account balances. In order to be eligible, the onset of the disability must have been discovered before the individual reached age 26.

Local government investment pools (LGIPs)

These accounts are established by states to provide other gov't entities (cities, counties, school districts, etc.) with a short-term investment vehicle for investing in their funds. Since these are set up by state gov'ts for state entities, they are exempt from SEC registration.

Double-barreled bonds

These bonds are a combination of revenue and GO bonds. Municipalities issue these bonds to fund revenue-producing facilities (toll bridges, water and sewer facilities, etc.), but if the revenues taken in aren't enough to pay off the debt, tax revenues make up the deficiency.

Moral obligation bonds

These bonds are issued by a municipality backed by a pledge from the state gov't to pay off the debt if the municipality can't. Given this additional backing of the state, they're considered safe. These need legislative approval to be issued.

Public housing authority bonds (PHAs)

These bonds are issued by local housing authorities to build and improve low-income housing. These bonds are backed by U.S. government subsidiaries, and if the issuer can't pay off the debt, the U.S. government makes up any shortfalls. Because these are backed by the issuer and the U.S. gov't, they're considered among the safes municipal bonds.

Special assessment (special district) bonds

These bonds are issued to fund the construction of sidewalks, streets, sewers, and so on. These bonds are backed by taxes only on the properties that benefit from the improvements, so only the people benefiting from new sidewalks would be taxed for it.

Special tax bonds

These bonds are secured by one or more taxes other than ad valorem (property) taxes. The bonds may be backed by sales taxes on fuel, tobacco, alcohol, and so on.

Limited-tax general obligation bonds (LTGO)

These bonds are types of GO bonds for which the taxes backing the bonds are limited. These bonds are secured by all revenues of the municipality that aren't used to back other bonds. However, the amount of property taxes municipalities can levy to back these bonds is limited.

Section 529 Plans

These plans are specialized educational savings accounts available to investors. These plans are also known as qualified tuition plans because they are designed to allow money to be saved fo qualified expenses for higher education. As such, there is an owner and a beneficiary. Contributions are made from after-tax dollars. However, withdrawals of the amount invested plus interest received is tax free, meaning that the earnings grow on a tax-deferred basis and no tax is due if earnings are used for qualified educational expenses. 1. Contribution levels may vary from one state to another. 2. No income limits are placed on the investors of a 529 plan. 3. May investors contribute monthly, although this is not required. 4. Any account balance unused can be transferred to another related beneficiary. 5. The assets in the account always remain under control of the owner even after the beneficiary turns 18. 6. In some cases, plans can be set up as prepaid tuition plans (allowing investors to pay prepay college at a locked-in rate.

Tax-exempt commercial paper

These short-term notes are usually issued by organizations such as universities with permission of the gov't. This debt obligation usually lasts only a few months to help the organization cover its short-term liabilities.

Property taxes

These taxes (which local municipalities - not states - collect) and sales taxes are the driving force behind paying back investors. So, in general, the higher the property values and the larger the tax base, the safer the municipal bond issue. GOs are also backed by traffic fines, licensing fees, sales taxes, and so on. Remember: Municipal GO bonds are backed by the huge taxing power of a municipality, so GO bonds usually have higher ratings and lower yields than revenue bonds.

Date of sale

This is the date that the bids are submitted to the issuer for competitive offerings. For negotiated offers, it's the date that the final contract is signed by the syndicate.

Order period

This is the time established by the syndicate manager that allows the syndicate members to solicit customers.

Municipal Equivalent Yield (MEY)

This is the yield on a taxable bond after paying taxes. MEY = municipal yield x (100%-investor's tax bracket).

Notice of Sale

This notice contains all bidding information about new municipal issues. Besides just saying that it is taking bids, the issuer also gives bidding details, such as where to submit bids, the amount of the good faith deposit, whether it is expecting bids on an NIC (net interest cost) or TIC (true interest cost) basis, the amount of bonds to be issued, maturing date, etc. Remember: underwriters need to be able to sell the issue and still make a profit. So, the selling price and the coupon rate have to be attractive to investors. You should remember that the difference between the cost the issuer pays for the security and the amount if receives from investors is called the spread. The underwriter(s)' profit lies within that spread.

Underwriting period

This period begins when the first order is submitted to the syndicate or when the securities are purchased from the issuer, whichever happens first. This period ends when the issuer delivers securities to the syndicate or the syndicate sells all the securities purchased from the issuer, whichever happens last.

The bond resolution (indenture)

This provides investors with contract terms including the coupon rate, years until maturity, collateral backing the bond (if any), and so on. Although not required by law, almost every municipal bond comes with this. It makes bonds more marketable because it serves as a contract between the municipality and a trustee who's appointed to protect the investors' rights.

Allocation of orders

This states which bond orders are to be filled first (basically a priority provision) and must be supplied to customers who request it. It is in the syndicate agreement and must be signed by all syndicate members. The order is: 1. Presale orders: orders entered before the date the securities were officially available for sale. 2. Syndicate (group-net) orders: the syndicate member receiving the order will credit the sale to all of the syndicate members, so they all profit. 3. Designated orders: the buyer specifies which syndicate member is to profit from the sale. 4. Member orders: If there are any securities left after the presale, syndicate, and designated orders, syndicate members may purchase them for their own portfolios.

Insurance covenant

This type of covenant is a promise that the municipality will adequately insure the facility.

Maintenance covenant

This type of covenant is a promise that the municipality will adequately take care of the facility and any equipment so the facility continues to earn revenue.

Rate covenant

This type of covenant is a promise that the municipality will charge sufficient fees to people using the facility to be able to pay expenses and the debt service (principal and interest on the bonds).

Taxable Equivalent Yield (TEY)

This yield tells you what the interest rate of a municipal bond would be if it weren't federally tax-free. You need the following formula to compare municipal bonds and corporate bonds equally: TEY = municipal yield/100% - investor's tax bracket Because the investor's tax bracket comes into play with municipal bonds, they are better suited for investors in higher tax brackets.

Direct Payment BABs

When a municipality issues this type of BAB, it receives reimbursements from the U.S. treasury equal to 35% of the coupon rate. As such, this type of BABs tend to have a higher coupon rate that tax credit BABs.

Municipal notes

When municipalities need short-term (interim) financing, municipal notes comes into play. These notes bring money into the municipality until other revenues are received. Municipal notes typically have maturities of one year or less (usually three to five months).

Covenants

Wonderful little promises that protect investors by holding the issuer legally accountable. Remember: if you see the word "covenant", immediately think of revenue bonds.