Section 4: Municipal Debt

Capital Appreciation Bond

A Capital Appreciation Bond (CAB) is a municipal zero coupon bond with a "legal" twist to it. A conventional zero coupon G.O. bond is counted against an issuer's debt limit at par value because the discount is treated as "principal." If a new issue discount bond is legally crafted as a CAB, then the principal counted against the issuer's debt limit is the discounted principal amount and the discount earned is considered to be interest income.

General Obligation Bonds / Unlimited Ad Valorem Tax Backing For "Local" Issues

A general obligation bond is backed by the full faith, credit and taxing power of the issuer. The type of taxes which back general obligation bonds depends on the issuing entity. Local governments have the ability to collect property taxes, known as "ad valorem" taxes. It is unusual that local governments (towns and cities) collect income taxes, although New York City has an income tax. Therefore, local governmental issues are usually backed by "unlimited" ad valorem taxes. This means that the issuer promises to raise taxes without any limit in order to pay off the bondholders.

Revenue Bond / Not Backed By Taxing Power

A revenue bond is one backed by a specific source of revenue to which the full faith and credit of the issuer is not pledged. Such bonds do not allow bondholders to compel taxation or legislative appropriation for payment, as is true of G.O. bonds. Since only the specified revenues back a revenue bond, this is said to be a self-supporting debt. The types of revenue that back these bonds are revenues from the operation of the project, user fees, rents, grants, excise and other non-ad valorem taxes.

Debt Service Coverage Ratio

A test that would be used to evaluate safety is the Debt Service Coverage Ratio. Ideally, this ratio should be comfortably above 1, indicating there are sufficient revenues to meet debt service requirements. Using the Statement of Revenues and Expenses presented earlier in this section, the Debt Service Coverage Ratio, assuming a Net Revenue Pledge would be: Given a choice, every municipal issuer would like to see Moody's and Standard and Poor's rate the issue AAA. The agencies perform an analysis of the bonds, considering all the items just discussed. Issuers can get an AAA rating if the bonds are insured. Municipal bond insurers are: AMBAC: American Municipal Bond Assurance Corp. MBIA: Municipal Bond Insurance Association Corp. FGIC: Financial Guaranty Insurance Corporation FSA: Financial Security Assurance Corp.

Mill Rate

Ad valorem taxes back local G.O. bond issues. These taxes are assessed based on "millage." One mill = 1/10th of 1 percent or .001

Additional Bonds Covenant

Additional Bonds: A promise not to issue additional bonds against the facility unless specified "earnings tests" are met. If earnings are high enough, additional bonds of equal status (called "parity bonds") can be issued. This test is called an "additional bonds test." This is true if the bond contract has an "open end lien" - that is, more bonds can be issued. If the contract is "closed end lien," no additional bonds may be sold until the existing bonds are redeemed.

Bond Contract

All bonds are issued under a "bond contract" prepared by the bond counsel. The "contract" consists of various pieces, depending on the type of issue. Every bond contract has an "authorizing resolution" (bond resolution) which allows the sale of the securities. Each contract has a "security agreement" pledging an income source to back the issue, such as full faith, credit, and taxing power for a G.O. bond or specified revenues for a revenue bond. And most revenue bond contracts have a "Trust Indenture" - a contract between the issuer and a trustee for the benefit of the bondholders.

Legal Opinion / Bond Counsel

All municipal issues also have a legal opinion printed on the face of the bond. Before a bond can be issued, the municipality retains a bond counsel. The bond counsel examines the issue to make sure that it is legally binding on the issuer, is valid, and that the interest is exempt from Federal tax under current law.

Refunding

An issuer may issue new bonds and use the proceeds to retire old maturing bonds. This is a refunding, which was covered in Corporate Debt.

No Short Sales

Another factor that limits municipal trading is that most issues are "serial" maturities. Within a bond offering are multiple maturities, with each maturity having a relatively small principal amount. The small amount of each maturity available limits trading. For example, if a customer wants to buy a Chicago bond maturing in 2020, you can't give him a 2021 bond. This also limits short sales of municipal bonds. When a security is sold short, it is borrowed and sold on the condition that it be replaced later by purchasing the issue in the market. If one borrows and sells a 2020 bond, one must buy back the same 2020 bond (not a 2019 or 2021).

Municipal Broker's Broker

Another participant in the municipal market is the "municipal broker's broker." There are very few of these firms (12 at last count) which perform a specialized service, usually for large institutions. Assume that Citibank wants to sell a very large block of New York City G.O. bonds. If it listed the offering in Bloomberg, everyone would know that it wants to sell a large amount and pressure would be put on Citibank to drop the price.

Pre-Refunding

Assume the issuer has 20-year bonds outstanding, callable in 10 years. The issuer defeases the debt by escrowing 10-year Treasury Notes. Once this occurs, the bondholders know that the issue will be called. The bonds are said to be pre-refunded. They will not be paid at maturity, but rather will be called early. Also note that the tax law changes that took effect at the beginning of 2018 banned municipalities from doing any more advance refundings or pre-refundings. However, all the bonds that have been advance refunded remain outstanding until they reach their maturity date, while those that have been pre-refunded remain outstanding until their first call date.

Constitutional Debt Limit

Because local issues are backed by property taxes, and property owners are very unhappy when mill rates are raised, most municipalities have imposed a debt limit on the dollar amount of G.O. bonds that can be outstanding at any one time. This is either a statutory or constitutional limit which is expressed as a percentage of assessed valuation. If a municipality is at its limit, it cannot issue additional G.O. bonds. The only way to change the limit is through majority approval in a public referendum. Debt limits are also imposed by state constitutions on G.O. debt issued by each state, similar to the Federal debt limit.

Trust Indenture

Because revenue bonds are backed by a single source of funds, they have greater credit risk than G.O. bonds. As such, they trade at higher yields. Investors in revenue bonds demand greater protections than G.O. bond purchasers since there is no ability to collect if the project fails. Because of this, most revenue bonds are issued under a "Trust Indenture." A trust indenture is a legal requirement for corporate issues under the Trust Indenture Act of 1939, but municipal issues are exempt from this act. The use of a "Trust Indenture" is optional, but revenue issues are hard to sell without one.

Step-Up / Step-Down Notes

Because the interest rate can either be "stepped-up" or "stepped-down" at the reset date, these are sometimes referred to as "step-up" or "step-down" notes (or bonds).

BANs / Secured By General Obligation Pledge

Bond Anticipation Notes (BANs): Issued to start capital projects; the note is paid off by the placement of the final long term bond issue. BANs are used because the ultimate final cost of the project is unknown during the construction period. Once all the costs are tallied, a long-term bond financing is floated to pay off the BAN issue. Most BANs are secured by the general obligation pledge of the issuer.

Debt Statement

Bonded Debt, also called Overall Net Debt, is computed in two steps:

Firm Offer With A Recall

By giving the bonds "firm" for 1/2 hour, the New York dealer is allowing the California dealer to shop around for 1/2 hour, and will not change the stated price during that time period. This allows the California dealer to look for a better price, knowing that the New York dealer will not change his quote during that 1/2 hour. However, the New York dealer, by adding a 5 minute recall, is protecting himself in the following way. If someone else comes along during that 1/2 hour to the New York dealer, wishing to buy that same bond, the New York dealer will call the California dealer, and demand that a purchase decision be made within the next 5 minutes (the "5 minute recall"). If the California dealer does not accept within 5 minutes, the offer is null and void. Assume the following scenario: A customer from New York has moved to California. After moving, he realizes that he has some New York bonds that he wishes to sell. He contacts a dealer in California to sell the bonds. The dealer in California is familiar with local California issues, but not those of New York. The dealer in California must call dealers in New York, shopping around for the "best bid."

2-3 Year Length

CLNs are typically issued for periods of 2-3 years. Such notes are typically issued during periods when interest rates are high; the borrower is hoping that interest rates will have dropped by the time the take-out loan is issued. The second type of municipal short term note is used to "pull forward" an income source and use the monies before they are actually collected. For example, tax revenues come in on April 15th. On March 1st of that year, an issuer may sell Tax Anticipation Notes maturing on April 30th. The notes are paid off by the collected taxes, but the issuer has had use of the funds since March 1st.

Catastrophe (Calamity) Call Covenant

Catastrophe Call: A promise to call in the bonds if the facility is destroyed. Since the facility can no longer generate revenues, the bondholders should be happy to get their money back. The funds to call the bonds would come from the insurance proceeds.

Certificate Of Participation (COP)

Certificate Of Participation: As municipalities reached their debt limits with G.O. bond issuance, they found it hard to get voter approval to increase the limits so that more bonds could be issued. To get around this, the "COP" - Certificate of Participation - was invented by creative municipal bond attorneys. These allow state entities to issue a tax-exempt security that pledges the revenue (lease payments received) from a project, such as a university dormitory, prison, municipal office building, etc. The lease payment is made based on the governing body making an annual appropriation from tax collections. The governing body is not "legally" obligated to make the annual appropriation, so it is not legally a G.O. bond (however, the annual appropriation will be made, otherwise the issuer's credit rating would be destroyed).

CLNs / Take-Out Financing

Construction Loan Notes (CLNs): Issued to start the building of multifamily housing projects; the note is paid off by the placement of a final long-term bond issue. The final long-term bond issue is known as the "take-out" loan, since it replaces the CLN issue. The permanent financing plan is typically arranged for at the time of the CLN issuance, usually with GNMA.

New Issues Are Book Entry / Older Bonds Are Fully Registered Or Bearer

Currently, virtually all new municipal debt is issued in book-entry form. However, older bonds that have not matured still trade and come in fully registered form or bearer form (at least until all bearer bonds mature in the upcoming years). These bond forms were covered in Section 2 of this chapter.

Bloomberg For Quotes

Dealer offerings of municipal bonds are published by diversified quote providers like Bloomberg that electronically post government, corporate and municipal bond offerings; and also by the larger bond dealers who post their own bond offerings directly on their own websites. In Bloomberg, serial bonds are quoted on a yield basis while term bonds are quoted on a percentage of par basis. This is a wholesale listing of bonds offered dealer to dealer. If a public customer wants to buy a bond that the firm does not have, the firm uses Bloomberg to find the dealer offering the bond and calls to obtain a firm price. (Quotes in Bloomberg, while firm at the time of publication, can be changed at any time in response to market conditions). The dealer then buys the bond for the customer and charges him a commission for this service.

Debt Per Capita Is Used Widely

Debt Per Capita is the most common measure used to evaluate the relative debt burden of one municipality as compared to another. It is used because its components are computed consistently from one municipality to the next.

Debt Service Reserve

Debt Service Reserve Fund: A fund of "extra" monies (usually one year's worth) to pay bondholders if revenues are insufficient at any one time. If it is depleted, it must be refunded as soon as sufficient revenues are available.

Debt To Assessed Valuation Is Not Used Widely

Debt To Assessed Valuation is not as widely used because each municipality assesses property value based on differing methods. Because there is no consistency, this measure is not used as widely. To illustrate how the ratios are computed, following is the debt statement of the City of Kenosha, Wisconsin, a city with a population of 80,889 at the time this statement was issued.

Double-Barreled

Double-Barreled Bond: An issue backed by a revenue source other than ad valorem taxes but also backed by the faith, credit and taxing power of a municipal issuer. For example, a housing bond (revenue) may be backed as well by the issuer's ad valorem taxing power to improve its credit rating. This type of bond is treated as a G.O. bond since the ultimate source of payment is taxing power. Also note that the term "double-barreled" bond is sometimes, though erroneously, used in reference to bonds secured by any two sources of revenue. Do not do this on the exam!

Extraordinary Mandatory Redemption

Extraordinary Mandatory Redemption: The issuer must call the bonds if unusual events specified in the contract occur. For example, the issuer does not use the bond issue proceeds because the project is canceled; or the facility is destroyed in a disaster. This is also known as a "catastrophe call" covenant.

Extraordinary Optional Redemption

Extraordinary Optional Redemption: The issuer has the option of calling the bonds if an unusual event specified in the contract occurs. An example is a bond issue used to fund local housing by giving mortgages. If the mortgages are prepaid, the revenue source for the bond issue is reduced. The issuer can have the right to call in bonds by using the mortgage prepayments.

Variable Rate Demand Notes / Long-Term Debt Issued At Short-Term Rates

Finally, some issuers have sold "variable rate" demand notes. The issuer resets the interest rate daily or weekly based on a given index. At the reset point, the note holder has the option of redeeming the note at par or holding it for the next period (1 day or 1 week) at the new interest rate. This was the first attempt by issuers to sell long-term bonds (because there is no stated maturity date) at short-term interest rates (because the holder can redeem at each reset date).

Municipal Market Participants

Firms that trade in the municipal market include banks (such as J. P. Morgan Chase), full service brokerage firms (such as Raymond James), and firms that deal only in municipal bonds whose names are not as familiar (such as J. J. Kenny Drake or Stoever Glass and Co.).

Thin Market

Generally, this confines investor interest in municipal issues to residents of the state of issuance. In effect, the municipal market is a state by state market. People in Maine buy Maine bonds, not New York bonds; people in New York buy New York bonds, not Maine bonds, etc.

GANs

Grant Anticipation Notes (GANs): Issued in expectation of receiving grant monies, usually from the federal government for mass transit, energy conservation, and pollution control programs.

The components of Overall Net Debt are: Gross Direct Debt

Gross Direct Debt: All indebtedness of the issuer Sinking Fund Deposits and Self-Supporting Debt: Monies held on deposit in a sinking fund reduce the issuer's obligation, since these funds are earmarked to retire debt. Self-supporting debt (meaning debt other than G.O. bonds) is also deducted to arrive at the true amount of debt supported by taxpayers.

$1 Tax Due For Every $1,000 Of Assessed Value

If a municipality has a tax rate of 6 mills, a property with an assessed valuation of $100,000 would pay taxes of .006 x $100,000 = $600. This is the same as $1 of tax for every $1,000 of assessed value.

Gross Revenue Pledge

If this revenue bond issue included a "Gross Revenue Pledge" in the Trust Indenture, then the $110,000,000 of Gross Revenues (before Operation and Maintenance expenses have been paid) is the amount pledged to the bondholders.

Net Revenue Pledge

If this revenue bond issue included a "Net Revenue Pledge" in the Trust Indenture, then the $35,000,000 of Net Revenues (after Operation and Maintenance expenses have been paid) is the amount pledged to the bondholders.

BABs - Build America Bonds

In April 2009, Congress passed the "American Recovery and Reinvestment Act" which included a number of economic stimulus provisions to help the economy rebound after the market meltdown and "great recession" of 2008.

Limited Tax Bonds

In some cases, local issuers will sell bonds backed by "limited" taxing power. This means that there is a limit placed on the rate that the issuer uses to assess taxes. If the issuer is not collecting enough taxes to pay the bondholders and is at the maximum millage rate (defined below), then the bondholders are at risk. Obviously, limited tax bonds have more credit risk than unlimited tax bonds and sell at higher interest rates.

G.O. Holders Have Legal Right To Compel Tax Levy

In the event of a default, G.O. bondholders have the right to compel a tax levy or legislative appropriation to make payment on the debt. Because of this, G.O. bonds are generally considered the safest type of municipal credit. Of course, the actual rating of each issuer can vary and is provided by the ratings services.

Industrial Development Bond

Industrial Development Bond: Bonds issued by a state, city, or local agency to build an industrial facility that is leased to a private company. The lease payments of the company are the revenue source. IDBs are also guaranteed by the private user, take on its credit rating, and are considered the user's liability - not the issuer's.

Does Not Carry Inventory / Acts As Agent

Instead, Citibank can use a "broker's broker" to obtain bids for the bonds. The broker's broker will call up other dealers and offer small portions of the issue, keeping Citibank anonymous in the transaction. In this manner, the issue can be sold evenly into the market. Municipal broker's brokers do not deal with the public and do not carry an inventory of bonds. They handle large transactions for institutions.

Insurance Covenant

Insurance: A promise to insure the facility in an amount sufficient to pay off the bondholders if the facility is destroyed or inoperable.

Lease Rental

Lease Rental Bond: An issue used to finance office construction where the user is a state or city agency. The rents paid by the user are the revenue source and the user is generally obligated to appropriate the funds for the lease payments from general tax revenues.

Maintenance Covenant

Maintenance Covenant: A promise by the issuer to maintain the facility in good repair.

Books And Records Covenant

Maintenance of Books and Records: A promise to maintain proper record keeping of accounts. Generally, there is an annual audit requirement as well.

Mandatory Redemption

Mandatory Redemption: The issuer is required to call bonds on a schedule included in the bond contract. The contract specifies the dollar amount of bonds to be called but does not specify the particular bonds. These are drawn randomly on the redemption dates. The issuer is often allowed to buy the bonds in the open market if the price is better than the call price. The point is that as parts of the issue are called, the remaining bonds become more valuable, as the issuer demonstrates its creditworthiness.

Moral Obligation / Ultimate Payment By Legislative Apportionment

Moral Obligation Bond: Assume an issuer is at or above its statutory debt limit and cannot legally issue more debt backed by taxing power. Also assume that the issuer needs more financing, mainly to have the funds to "roll over" existing debt or it will default. This is the situation that New York City faced in 1975. The solution: issue a bond backed by the "promise" to pay, but not the legal obligation to pay. In New York City's case, the State assumed the moral obligation to pay if the city could not, with the State legislature authorized, but not obligated, to apportion the funds needed to service the debt, if necessary. This "moral obligation" bond is only issued in times of distress and has a higher level of credit risk.

Net Revenue Pledge / Gross Revenue Pledge

Most revenue bonds are issued under a "Net Revenue Pledge." The bondholders do not have claim to the "gross revenues," but rather the "net revenues" from the facility. Net revenues are gross revenues less operation and maintenance. After operation and maintenance are paid, then the bondholders are paid. Very few "gross lien" revenue bonds are issued where the bondholders are paid before operation and maintenance.

Municipal Bonds / Interest Exempt From Federal Income Tax

Municipal bonds are debt issues of state and local governments, territories, and political subdivisions (such as special districts, agencies or authorities). A principal feature of municipal bonds is the tax status of the interest income. Generally, it is exempt from Federal income tax, but subject to state and local tax (unless purchased by a resident of that state - this is covered at the end of this section).

DEBT RETIREMENT PROVISIONS

Municipal debt may be redeemed at maturity, or if call provisions are included in the bond contract, it may be retired prior to maturity. Municipal call features differ somewhat from those of corporate bonds. The call may be at par or may be at a premium, similar to corporate bonds. The call may be optional or mandatory.

Advance Refunding

Municipal issuers may also "advance refund" debt. Assume that a G.O. bond issuer believes that interest rates have bottomed and wants to sell long-term debt now, while rates are low. Also assume that the issuer believes that the sale of additional debt may reduce its credit rating at this time. The issuer can buy U.S. Government bonds and deposit them with a trustee. The interest payments from these bonds are earmarked to service the issuer's old debt. At maturity, the issuer uses the principal repayment to retire the old bonds. Since the source of revenues backing the issuer's old bonds is no longer taxing power, but rather the interest and principal from the U.S. Government bonds held in trust, the G.O. bonds are no longer considered a debt of the issuer. The issuer is free to issue new bonds at the current low interest rates.

Tender (Put) Option / Tender Offer

Municipal issues may also be sold with a tender option, allowing the purchaser to "put" the bonds to the issuer after a certain date. This was covered in Section 1. An issuer may also retire debt prior to maturity by making a tender offer for the bonds. Interested bondholders can "tender" their bonds for a stated cash price, but are under no obligation to do so. An issuer would only use this method if the bonds are non-callable.

Bid / Firm Bid / Nominal Bid

Municipal trading terminology is a bit unusual, to accommodate the fact that the market is quite illiquid and not actively traded. A dealer bidding for a bond is willing to buy at the stated price or yield. A "firm" quote means the dealer will honor that price. If the quote is "nominal," the dealer is giving an idea of the price, but not an actual price. Dealers can qualify their bids. A typical qualification is that the legal opinion must be printed on the bond (some older bonds have them on a separate piece of paper) or that delivery be made by a stated date. Assume the following scenario: A customer in California is moving to New York, and wants to buy some New York bonds prior to moving. He contacts a local dealer in California to buy the bonds. The dealer in California is familiar with California issues, but not those of New York. The dealer in California must call dealers in New York, shopping around for the "best offer."

Serial Bonds

Municipalities issue long term debt and short-term notes. Most long term issues are "serial maturities" - with the maturities spread over a sequence of years. These bonds are issued at par and pay interest semi-annually. Short- term notes are issued at a discount from par and mature at par value.

Usually Under 1 Year Maturity

Municipalities issue short term notes, usually with less than 12-month maturities, although it is not uncommon for notes to be issued with maturities as short as 3 months and for as long as 3 years. Notes are issued for 2 general purposes: For temporary financing of capital improvements To even out cash flows

Net Direct Debt

Net Direct Debt: The amount of debt of the issuer that is ultimately the responsibility of the taxpayers.

Total Net Direct And Overlapping Debt

Net Direct and Overlapping Debt: The true debt liability of the issuer to be paid from taxing power. Once Total Net Direct and Overlapping debt has been computed, ratio tests are performed to evaluate the issuer.

No Sale Covenant

No Sale or Encumbrance: A promise by the issuer not to sell the facility or to allow liens to be placed on the facility (e.g. obtain a mortgage which would jeopardize the bondholders' position in a liquidation).

All Offers Made In Dealer Publications Must Be "Bona-Fide"

Note that all offers of municipal securities made in dealer publications must be "bona-fide" - that is, the dealer must have been willing to sell those securities at the indicated prices at the time that the offer was made. Note that it is not required that the dealer actually own the securities at the time that the bona-fide offer is made - the only requirement is that the dealer must know where such securities can be obtained if the offer is accepted.

Level Debt Service

Note that with a serial structure, generally part of the issue is maturing each year, thus both interest on all outstanding bonds, and the principal repayment scheduled for that year, are due. If the issue is structured so that the combined annual payments of interest and principal equal the same total amount each year, then the issue is said to have "level debt service." (This is the same type of structure as a mortgage payment schedule for a homeowner.) Municipalities like level debt service bond issues because it allows them to budget the same annual dollar amount to pay debt service requirements. As long as they pay the level debt service amount yearly, the bond issue will be completely retired at maturity. Municipal issues are broadly categorized into general obligation bonds, revenue bonds, special types of bonds, and short-term notes.

Operation And Maintenance Fund

Operation and Maintenance Fund: Monies to run the facility are deposited in this fund from the Revenue Fund.

Optional Redemption

Optional Redemption: The issuer has the right to call bonds after a certain date, usually at a premium, but has no obligation to do so.

Overlapping Debt

Overlapping Debt: The issuer's share of debt of other governmental bodies which are wholly or partly within the same geographic boundaries. For example, a school district may consist of three separate towns. Debt issued in the name of the school district would be shared by the three towns. This is an "overlapping debt."

Rate Covenant

Rate Covenant: A promise by the issuer to maintain fees for using the facility at a high enough level to cover debt service. If fees are not sufficient, the issuer is obligated to raise rates.

Recent Moral Obligation Bond Issues Are Revenue Bonds

Recent moral obligation bond issues have been revenue bonds that are being used to build ever-more costly ball stadiums. The projected revenues from these super-expensive projects may not cover the debt service, so a state agency or authority secures the bond with a non-binding covenant that any deficiency in pledged revenues will be included in the budget recommendation made to the state legislature, which may appropriate the funds to make up the shortfall (but is not obligated to do so).

Renewal And Replacement

Renewal and Replacement Fund: Monies to pay for regularly scheduled major repairs and replacement.

Reserve Maintenance

Reserve Maintenance Fund: Monies to pay extraordinary maintenance or replacement costs.

RANs / Backed By G.O. Pledge

Revenue Anticipation Notes (RANs): Issued in anticipation of future revenue collections and tax collections other than ad valorem taxes. An example of an income source is intergovernmental capital construction grants such as Federal Highway Funds. The notes are paid off from those collections. Most RANs are also backed by the general obligation pledge of the issuer, making them very marketable.

Revenue Fund

Revenue Fund: All gross revenues from the facility are placed in this fund and all monies to be disbursed are taken from this fund.

Self-Supporting

Revenue bond issues are self-supporting. To ensure that a proposed project makes economic sense, the issuance of revenue bonds is dependent on the completion of a "feasibility study." For example, a town proposes to build a new hospital to be financed by a revenue bond issue. A report will be prepared showing the need for the facility, the projected costs of running and financing the facility, the expected revenues from the facility, an engineer's report on the costs of building the facility, the effect of competing hospitals, etc. If the report shows that the project is economically feasible, then the town will go ahead with the issue.

Segregation Of Funds Covenant

Segregation of Funds: A promise by the issuer to keep the revenues collected from and monies expended on running the facility separate from other municipal accounts.

Sinking Fund

Sinking Fund: Monies to meet debt service requirements are deposited to the sinking fund. The bondholders are paid from this fund.

Special Assessment

Special Assessment Bonds: To fund an improvement which does not benefit the general public, but rather a small portion of the community, a municipality will float a bond issue backed by a "special assessment" of increased taxes designed to pay for the improvement. For example, new street lights may be put in one area, and only that area is assessed higher taxes to pay for the improvement.

Special Tax

Special Tax Bonds: An issue secured by a tax other than an ad valorem tax, usually excise taxes such as cigarette, liquor, gasoline taxes. The tax source does not have to relate to the type of project.

State Issues Backed By Income And Sales Taxes

State issues are backed by a different source of taxing power. Most states do not assess property taxes; instead the revenue sources are income and sales taxes.

Surplus

Surplus Fund: Monies "left over" after all other uses are exhausted. It can be used in any legal way by the issuer.

TANs / Backed By G.O. Pledge

Tax Anticipation Notes (TANs): Issued in anticipation of future property (ad valorem) tax receipts; paid off from those receipts. TANs are secured by the general obligation pledge of the issuer.

TRANs

Tax and Revenue Anticipation Notes (TRANs): Issued in anticipation of both future tax collections and revenue collections. This is really a combination of a TAN and RAN offering.

Flow Of Funds

The "flow of funds" states the priority of collecting and disbursing pledged revenues. The normal flow of funds (from first to last) is: Revenue fund; Operation and maintenance fund; Sinking fund; Debt service reserve fund; Reserve maintenance fund; Renewal and replacement fund; Surplus fund.

Municipalities Can Sell Bonds In The Broader "Taxable" Bond Market

The "idea" is that the municipality would now be able to sell bonds to the larger investor base for taxable investments, including international investors that have no reason to buy "tax-free" municipal issues. With a larger pool of potential buyers, municipalities should be able to raise much needed funds during a recessionary period where falling tax revenues and other receipts have sharply limited their ability to finance new projects.

Unqualified Opinion / Qualified Opinion

The bond counsel prepares all the legal documentation necessary for the issue and renders an opinion. Issuers desire an "unqualified legal opinion." Here, the bond counsel says everything is "OK" - there are no problems. If the counsel does find a problem, he "qualifies" the opinion, stating that there is a legal uncertainty of which any purchaser should be aware. For example, new Federal tax rulings may make the interest taxable.

IRS Arbitrage Regulations

The excess of interest earned on these "taxable" investments, over and above interest owed on the issuer's outstanding "tax free" municipal debt is limited under IRS regulations that govern arbitrage on such transactions. Municipalities would not defease their debt with lower credit rated issues (corporates) or with lower yielding investments (i.e., other municipal bonds).

Feasibility Study

The feasibility study is usually prepared by outside consultants, who do not have a vested interest in seeing the facility built.

Firm Offer

The first dealer contacted in New York gives a firm price for the desired bonds. However, the California dealer is reluctant to make the purchase without further "shopping around" to see if this quote is the best price. The California dealer says "I can't buy yet because I want to get some other quotes." Upon hearing this, the dealer in New York states "I'll offer the bonds to you firm for 1/2 hour with a 5 minute recall."

BABs Could Only Be Used For Capital Projects That Would Be Funded With Tax-Free Bonds

The program ran through the end of 2010 and only permitted bond issues to be sold where the proceeds would be used for infrastructure improvements. Capital projects that could be funded with BABs included public buildings, courthouses, schools, roads, public housing, transportation infrastructure, government hospitals, public safety facilities, water and sewer projects, environmental projects, and public utilities. Essentially, the bonds could be used for any capital project that would normally be financed with a tax-free bond issue. This was a pure and simple economic stimulus program to encourage capital investment in 2009 and 2010, and thus, create jobs and growth. At the end of 2010, Congress chose not to extend the "BAB" program when it extended the lower "Bush-Era" income tax rates, but these bonds trade in the market.

Defeasance / Escrowed To Maturity / Acceptable Securities For Escrow

The technical term for the issuer's elimination of the G.O. debt as its liability is defeasance. The issuer has defeased its debt; the obligation rests with someone else (the U.S. Government bonds held in escrow). Defeased debt is also called "ETM"- escrowed to maturity - or advance refunded debt. Escrowed bonds are rated AAA and trade at low yields. Municipal issuers are typically permitted to defease their debt with U.S. Government bonds, agency bonds, and sometimes, bank certificates of deposit. Each of these represents security of the highest quality, satisfying the requirements of the existing bondholders and also yields a higher nominal amount than "tax-free" municipal debt, giving the municipality "extra" income.

Trust Indenture Protective Covenants

The trustee's job is to monitor the issuer's compliance with the bond contract and, more specifically, compliance with "protective covenants" specified in the contract. If the issuer is not living up to the contract, the trustee has legal power to enforce the contract on behalf of the bondholders by initiating court proceedings.

SPECIAL TYPES OF MUNICIPAL DEBT

The two largest types of municipal offerings, by far, are G.O. bonds and revenue bonds. Revenue bond financing accounts for about 45% of municipal issues, while G.O. bonds account for another 45%. The rest of the municipal market is composed of "special" types of bonds.

Tax-Exempt Commercial Paper - Backed By Bank Line Of Credit

There are two unusual forms of short term municipal financing. Some issuers have sold "tax-exempt commercial paper" with very short maturities (under 30 days). To make these marketable, they are sold backed by a bank line of credit. Thus, if the municipal issuer cannot pay, the bank is obligated to pay.

Rated "AAA"

These are private companies (e.g. MBIA is listed on the New York Stock Exchange) that insure both the timely payment of interest and the repayment of principal on a given issue, for which a fee (similar to an insurance premium) is paid by the issuer. Due to the better credit rating, as well as the cost of the insurance, insured issues typically yield about 1/2 percent less than similar uninsured issues.

Usually Issued At Par With A Stated Interest Rate

These notes usually are sold at par with a stated rate of interest and are redeemed at par plus accrued interest. However, some are sold at a discount and mature at par. Short-term notes can be categorized in types. The first type is used to obtain short-term financing for a building project, to be replaced by permanent financing at the completion of the project.

Federal Tax Credit On Interest Paid

Thus, if a municipality issues a 10% BAB, it will get a payment from the Federal Government equal to 3.5%, so the issuer's net interest cost is 6.50%.

ANALYZING MUNICIPAL DEBT

To analyze G.O. debt, one would look at the debt statement of the municipality. This will outline the issuer's total bonded debt, which is the total obligation outstanding at that time.

General Factors To Consider About G.O. Bonds

To evaluate a G.O. bond issuer, other factors also must be considered. These include the community's attitude towards its debt (if times are tough, will they do everything possible to pay off the debt or would they file for bankruptcy?); its tax base; the diversification of the local economy; its financial condition (including unfunded pension liabilities - a potentially large liability); population trends in the area; and tax collection ability as measured by its collection ratio. The collection ratio should be well above 90% - any lower ratio indicates that the municipality is not able to collect its taxes and is experiencing a high level of delinquencies. Also to be evaluated are the issuer's debt trend (is it going up?); its ratio of debt service to annual revenues; its future debt service requirements; and the anticipated life of any improvements (which should not be less than the bond issue life).

Build America Bonds Are Taxable But Issuer Gets 35% Interest Rate Credit

To help with an economic recovery, municipalities could issue "Build America Bonds," which are taxable bond issues. However, these bonds get a 35% interest rate credit from the Federal Government.

Municipals Trade Over-The-Counter / Intrastate Issues Triple Exempt

Trading in the municipal bond market is very limited. All trades take place over-the-counter. The cause of this is the fact that, in addition to the federal tax exemption that municipal interest enjoys, if a bond is purchased by the resident of a state, most states will also exempt the issue from state and local tax (a "triple" exempt issue - Federal, State and Local).

Revenue Pledge

Under the security agreement included in the bond contract, the issuer pledges the revenues of the facility to pay the debt service. The "revenue pledge" outlines exactly how the issuer will apply collected revenues. To understand what happens, we must look at the "flow of funds" stated in the contract.

Variable Rate Notes Have Almost No Market Risk

Unlike bonds with fixed interest rates, such "reset" bonds will show very little price fluctuation in response to market interest rate movements, since the interest rate is being reset to the prevailing market rate daily or weekly. Thus, the price tends to stay at, or close to, par.