Series 7 Unit 6
Which of the following municipal issues would least likely involve overlapping debt? A) An airport district B) A library district C) A school district D) A park district
A) An airport district 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
Which of the following statements regarding an official statement are true? I. It is required by the SEC for all new issues. II. It is required by the Municipal Securities Rulemaking Board (MSRB) for all new issues. III. It must be delivered to purchasers at or before settlement. IV. It is generally used by underwriters to help sell the issue.
A) III and IV An official statement is a document similar to a prospectus and is furnished, in most cases, to buyers of new issue municipal bonds. SEC rules require that an official statement be prepared for most—but not all—new municipal issues. The MSRB has no such requirement, as it does not regulate issuers. LO 6.a
A customer purchased a full faith and credit bond. This bond would be known as A) a general obligation bond. B) a revenue bond. C) a moral obligation bond. D) a sinking or surplus fund bond.
A) a general obligation bond. General obligation bonds are also known as full faith and credit bonds. LO 6.b
Alternative minimum tax (AMT) A) is assessed against high annual income earners and disallows some deductions and exemptions used to calculate adjusted gross income. B) is assessed against high annual income earners and gives them special deductions that lower income earners do not get. C) is assessed against low annual income earners and allows special deductions for them to be taken. D) is assessed against all self-employed individuals.
A) is assessed against high annual income earners and disallows some deductions and exemptions used to calculate adjusted gross income. The AMT is assessed against high annual income earners. When calculating adjusted gross income, some deductions and exemptions are disallowed, resulting in a higher taxable adjusted gross income. LO 6.f
An investor buys a GO bond with a coupon of 3½% that has a basis of 3¾%. If the bond is held until maturity, the investor's actual yield will be A) more than 3½% but less than 3¾%. B) more than 3¾% . C) 3½%. D) 3¾%.
A) more than 3½% but less than 3¾%. This is tricky, so follow along. With a coupon of 3½% and a basis (yield to maturity) of 3¾%, we know the bond was purchased at a discount. GO bonds are municipal bonds, and when a municipal bond is purchased in the secondary market at a discount, the accretion of the discount is taxed as ordinary income. Therefore, a portion of the investor's return will be taxable, making the actual return slightly less than the yield to maturity. LO 6.e
After an extensive feasibility study on the viability of a new shopping mall, the City of Mount Vernon decided to issue bonds that depend on the earning requirements of the facilities. All of the following statements are true except A) that the bonds are backed by the full faith and credit of the City of Mount Vernon. B) that the city is issuing revenue bonds. C) that investor risk depends on the specific characteristics of the project. D) that rental revenues collected from shop owners within the mall will pay the bonds' debt service.
A) that the bonds are backed by the full faith and credit of the City of Mount Vernon. These are revenue bonds that will be paid for by the users of the facility, not the taxing power of the municipality. The issuance of revenue bonds depends on the completion of a proper feasibility study. Such a study projects the revenues and costs associated with a project. If the feasibility study does not show sufficient earnings, then the bonds will not be issued. The risk level depends on the characteristics of each particular project. LO 6.b
The call provisions of a municipal issue would be detailed most completely in A) the bond resolution. B) the legal opinion. C) the official notice of sale. D) The Bond Buyer.
A) the bond resolution. 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
A city has issued bonds to construct a new sewage treatment facility. If the bonds are not backed by the full taxing authority of the city, all of the following statements about the bond issue are true except A) the disbursement of principal and interest payments must be approved semiannually by the state public service commission. B) if earnings fall short of the amount needed to make principal and interest payments, the debt service reserve can be used. C) the interest on these bonds is not considered a preference item for the alternative minimum tax. D) there is no debt limitation on the issue.
A) the disbursement of principal and interest payments must be approved semiannually by the state public service commission. As an exclusion question, we are looking for the false statement. The public service commission would have no approval power over revenue bond interest and principal payments. Because the bond is not backed by the taxing authority of the city, it is a revenue bond rather than a general obligation bond. The funds for payment of interest and repayment of principal are generated through the fees paid by those using the city's water and sewage facilities. Being a public, rather than private, facility, these would not be alternative minimum tax bonds. LO 6.b
Revenue bonds may be called for all of the following reasons except A) the issuer has reached a statutory debt limit. B) a provision in a sinking fund agreement is calling for a partial call. C) the facility has been destroyed. D) interest rates have fallen.
A) the issuer has reached a statutory debt limit. Statutory debt limits only apply to general obligation bonds. LO 6.b
All of the following sources of revenue could be used to service general obligation debt except A) user charges. B) fines. C) sales taxes. D) ad valorem taxes.
A) user charges. Historically, municipalities get most of their revenues from property taxes (ad valorem taxes). Other sources of revenue include sales taxes, income taxes, gasoline taxes, license fees, fines, and assessments. User charges would be used to service revenue bonds. LO 6.b
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
B) I and III 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
All of the following are useful tools for saving for a child's higher education except A) using a Section 529 plan. B) funding a Roth IRA in the child's name. C) opening an UTMA account. D) starting an education IRA.
B) funding a Roth IRA in the child's name. 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
If a customer purchases five newly issued municipal bonds for 101 and holds the bonds to maturity, the tax consequence is A) not possible to calculate with the information provided. B) $50 capital gain. C) $0 gain or loss. D) $50 capital loss.
C) $0 gain or loss. If a new issue municipal bond is bought at a premium, the premium must be amortized over the life of the bond. At maturity, no capital gain or loss would occur because the premium would have been fully amortized. LO 6.e
A resident of New York City purchases an Albany, New York, general obligation bond and receives $600 of interest from that bond during the year. How is that $600 taxed? A) Taxation is deferred until the bond matures. B) It is subject to federal income tax at ordinary rates. C) It is not subject to federal income tax. D) It is subject to state income tax at ordinary rates.
C) It is not subject to federal income tax. Interest from public purpose municipal bonds is exempt from federal income tax, and most states have chosen to make interest on their municipal bonds exempt from state income tax to residents of their states. LO 6.f
All of the following are allowable municipal dealer quotes except A) bona fide quotes. B) requests for bids only. C) an unidentified nominal quote. D) requests for offers only.
C) an unidentified nominal quote. Municipal Securities Rulemaking Board Rule G-13 requires municipal brokers and dealers to give bona fide bids and offers for municipal securities. (Bona fide quotes are those good for trading.) It also allows for requests for bids (BW = bids wanted) and requests for offers (OW = offers wanted). A nominal quote (those for informational purposes only) is permissible, but only if it is identified as such. LO 6.a
The date on which the interest on a new municipal issue begins accruing is A) the settlement date. B) the delivery date. C) the dated date. D) the closing date.
C) the dated date. New issues of municipal bonds begin accruing interest on the dated date. LO 6.e
All of the following statements regarding municipal revenue bonds are true except A) the interest and principal are paid from revenue received from the facility. B) no debt limitation is set by the issuing municipality. C) the maturity of the revenue bond will usually exceed the useful life of the facility being built. D) revenue bonds can be issued by inter- or intrastate authorities.
C) the maturity of the revenue bond will usually exceed the useful life of the facility being built. Revenue bonds are usually structured so their maturity is shorter than that of the facility they were issued to build. LO 6.b
Which of the following ratios is normally considered adequate coverage of interest and principal charges for a municipal revenue bond? A) 1:1 B) 7.5:1 C) 3:1 D) 2:1
D) 2:1 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
A municipal revenue bond indenture contains a net revenue pledge. The following are reported for the year: $30 million of gross revenues, $18 million of operating expenses, $4 million of interest expenses, and $2 million of principal repayment. What is the debt service coverage ratio? A) 3:1 B) 5:1 C) 9:1 D) 2:1
D) 2:1 Under a net revenue pledge, bondholders are paid from net revenue, which equals gross revenue minus operating and maintenance expenses. In this example, net revenue is $12 million ($30 million − $18 million). Debt service is the combination of interest and principal repayment. Here, debt service is $6 million ($4 million + $2 million). To compute the debt service ratio, divide net revenue by debt service: $12 million divided by $6 million equals a ratio of 2:1. LO 6.c
A customer buys $10,000 worth of new issue municipal bonds at a price of 104, and the bonds have 10 years to maturity. Four years after purchasing the bonds, she sells them at 99. What is the tax loss on these bonds? A) 500 B) 160 C) 400 D) 340
D) 340 To arrive at adjusted cost basis, the premium on a new issue municipal bond must be amortized (subtract). To amortize the premium annually, divide the premium amount (in this case, $400 on the total purchase of 10 bonds) by the number of years until maturity (10). Thus, the customer writes down the initial cost by $40 per year. After four years, the bonds purchased at a cost of $10,400 will be written down to $10,240 (4 years × $40 per year = $160). If the bonds are sold for $9,900, the tax loss is $340 ($10,240 − $9,900 = $340). LO 6.e
An abstract of a municipal securities issue official statement must be maintained on file for how long? A) 5 years B) There is no requirement to file abstracts of official statements. C) 12 months D) 4 years
D) 4 years The Municipal Securities Rulemaking Board requires firms to retain abstracts of official statements for four years—the same as all pieces intended to communicate with the public. LO 6.h
A 4% municipal bond maturing in 2040 has a current yield of 4.4% with a yield to maturity of 4.7%. What is the basis of this bond? A) 4.0% B) 4.4% C) 4.5% D) 4.7%
D) 4.7% The basis of a municipal bond is its yield to maturity (YTM). The terms are used interchangeably. Therefore, in this question, the basis is the 4.7% stated as the YTM. There will be some questions on the exam similar to this where no math is involved. Just be sure to know your definitions. LO 6.a
Which of the following would be of least concern to a registered representative recommending a municipal security to a customer? A) Customer's tax status B) Customer's state of residence C) Municipal security's rating D) Availability of the security
D) Availability of the security The customer's state of residence and tax status are essential when determining suitability of a municipal security. The security's rating is also important because it measures the bond's safety and quality and should align with the customer's risk tolerance. While the availability may pose a challenge for the broker-dealer and could potentially add to the cost of the transaction, it would be of the least concern regarding suitability unless the cost was in some way prohibitive. LO 6.c
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) Refunding C) Refinancing D) Catastrophe
D) Catastrophe Condemnation is considered a catastrophe and only applies to revenue bonds. LO 6.b
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) Treasury bond B) Industrial revenue bond C) Corporate bond D) General obligation (GO) bond
D) General obligation (GO) bond 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
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
D) I and III 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
Which of the following statements about municipal original issue premium bonds are true? I. The original issue premium must be amortized. II. If the bond is held to maturity, there will be no capital loss reportable. III. The cost basis of the bond is adjusted downward by the amortized amount.
D) I, II, and III Original issue premium municipal bonds (as well as those purchased in the secondary market) must be amortized by an amount each year so that, if held to maturity, there is no reported capital loss. LO 6.e
Which of the following taxes are considered sources of debt service for special tax bonds? I. Ad valorem tax II. License taxes paid by businesses III. Special liquor and tobacco taxes IV. Real estate taxes
D) II and III As described by the Municipal Securities Rulemaking Board, a special tax bond is "a bond secured by revenues derived from one or more designated taxes, other than ad valorem taxes." For example, bonds for a particular purpose might be supported by sales, cigarette, fuel, or business license taxes. General obligation bonds are backed by the full faith and credit (taxing power) of the issuer for payment of principal and interest. Their main source of debt service funding is ad valorem (real estate) taxes. LO 6.b
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) a capital gain. 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
Variable-rate municipal bonds are subject to all of the following risks except A) default. B) liquidity. C) market. D) interest rate.
D) interest rate. A variable-rate bond is one whose coupon is adjusted periodically (semiannually or annually) to reflect current interest rates. Therefore, if rates rise and force prices down, the coupon on a variable-rate bond will be adjusted upward, thereby tending to keep the bond's price at or near par. Therefore, no interest rate risk is associated with these bonds. However, if rates fall, the coupon will be adjusted downward, keeping the bond's price at or around par. Normally, a fall in rates will force prices up, but not with variable-rate bonds. LO 6.b
