Series 7 Unit 6

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

A

Which of the following debt instruments generally present the least amount of default risk? A) Municipal general obligation bonds B) Municipal revenue bonds C) High-yield corporate bonds D) Convertible senior debentures

A Because the full taxing power of the municipality backs a general obligation municipal bond, it will exhibit the least amount of default risk. A corporate debenture is an unsecured bond with a greater degree of risk, as is a junk or high-yield corporate bond

The unqualified legal opinion on a municipal bond states that A) the issuer has the authority to issue bonds that are legal, valid, and enforceable obligations of the issuer. B) the bond has passed the additional bonds test (parity test). C) the issuer is creditworthy. D) the bond is marketable.

A Bond counsel attests that, to the best of its knowledge, the issuer has the legal right to issue the securities in question. In the case of tax-exempt bonds, the interest the issuer will pay on the bonds is exempt from federal taxation, and the bonds are exempt from federal registration requirements. The legal opinion does not go to the issue's marketability—or safety—debt service requirements.

When a securities professional refers to a bond as a full faith and credit issue, it is A) a general obligation bond. B) a special tax bond. C) a revenue bond. D) a moral obligation bond.

A General obligation bonds are payable from general funds, including taxes, and are often referred to as backed by the "full faith and credit" of the governmental entity.

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

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

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

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

In rating a general obligation (GO) bond, all of the following factors would be considered by an analyst except A) the tax collection ratio. B) the flow of funds. C) the public's attitude toward debt. D) the total outstanding debt.

B GO bonds are backed by the full faith and credit of a municipal issuer, which is based on its ability to levy and collect taxes. Therefore, among the considerations for an analyst, total outstanding debt, the tax collection ratio, and the public's attitude toward more municipal debt are prominent. The flow of funds is one of the protective covenants associated with municipal revenue bonds.

Which of the following municipal securities are backed by the full faith and credit of the U.S. government? A) Tax assessment bonds (TAs) B) Public Housing Authority bonds (PHAs) C) Industrial revenue bonds (IRBs) D) General obligation bonds (GOs)

B PHA bonds are backed by the full faith of the U.S. government, which guarantees rent payments on these low-income properties.

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) 9:1 B) 2:1 C) 3:1 D) 5:1

B 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.

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

B bank simply holding municipal securities as custodian for public customers need not register as a municipal securities broker-dealer with FINRA

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

C Do not combine revenue bonds with GOs to determine overlapping debt. Overlapping debt occurs in real estate taxing situations. Only GOs are backed by real estate taxes.

All of the following information is included in a municipal bond resolution except A) restrictive covenants that are binding on the issuer. B) any call provisions that allow the issuer to redeem the bonds before their scheduled maturity. C) compensation paid to the underwriters. D) an authorization to sell the securities.

C The bond resolution is the document in which the issuer authorizes the issuance of municipal securities. Among other things, the resolution describes the characteristics of the proposed issue and the issuer's duties to the bondholders. Compensation paid to the underwriters would be found in the official statement.

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

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

For an investor in the 37% federal income tax bracket, the tax-equivalent yield of a general obligation municipal bond with a coupon rate of 4.17% is A) 2.63%. B) 11.27%. C) 5.72%. D) 6.62%.

D The computation for tax-equivalent yield is done by dividing the coupon rate by (100% - tax bracket). In this question, that is 4.17% ÷ (100% - 37%) = 4.17% ÷ 63%. That equals 6.62%.

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

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

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

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

A quotation on a municipal security between dealers is assumed to be A) a nominal quote. B) an indication of interest. C) a workable quote. D) a bona fide quote.

D

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

D

Your client is considering two bonds: an ABC Corporation mortgage bond with a yield to maturity of 9% and a municipal bond issued by the state that she resides in. If your client is in the 32% tax bracket, what is the tax-free equivalent yield for the corporate mortgage bond so that she will be able to compare it to the tax-free municipal bond she is considering? A) 4.10% B) 13.24% C) 2.88% D) 6.12%

D The tax-free equivalent yield is calculated as follows: corporate rate × (1 − investor's tax bracket). In this case, 0.09 × (1 − 0.32) = 0.0612, or 6.12%. Or, just subtract the 32% tax from 9%. That would be 9 minus 2.88 equals 6.12.

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

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

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) 3½%. B) more than 3¾% . C) 3¾%. D) more than 3½% but less than 3¾%.

D 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.

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

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

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

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

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

B The original premium was $60 for eight years, which means that after four years, the remaining premium is half that amount.

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

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

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

B Quotes, dealers, and sales representatives are regulated by the MSRB, but issuers are not

An investor purchases an original issue discount municipal bond on the offering at 80. The bond matures in 25 years. Eight years later, the investor sells the bond for 84. The tax consequence of this transaction is A) ordinary loss of $24. B) long-term capital loss of $24. C) tax-free income of $24 and long-term capital gain of $40. D) long-term capital gain of $40.

B The 20 point ($200) discount accretes over the 25-year life of the bond. That makes the annual accretion $8 per year ($200 divided by 25 years). After 8 years, there has been $64 of accretion ($8 times 8 years). That means the cost basis of the bond is $864. The sale at $840 represents a loss of $24 and has a long-term holding period.

All of the following statements regarding industrial revenue bonds (IRBs) are true except A) interest is paid from rental payments received from corporations that have leased the property or equipment from the municipality. B) they can be issued by municipalities to provide local industries with funds for expansion. C) the credit rating of the bonds is dependent on the credit rating of the municipality. D) they can be issued by municipalities to build facilities that will be owned by the municipality but leased to a local corporation

C The debt service for IRBs is derived from the lease payments made by the leasing corporation to the issuing municipality. Therefore, the credit rating of the bonds is dependent on the credit worthiness of the leasing corporation, not the issuing municipality.

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

D

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

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

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

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

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

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

Whether funds should be allocated to support the debt service on a moral obligation bond in default is usually determined by A) the trustee. B) the state governor. C) the state legislature. D) the courts.

C Legislation authorizing the issuance of moral obligation securities usually grants the state legislature the authority to apportion money to support debt service payments on such securities but does not legally require the legislature to do so. This is called legislative apportionment.

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

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

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

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

State and local government securities (SLGS) are purchased by A) commercial banks. B) institutions. C) state and local governments. D) accredited investors.

C SLGS securities are purchased by municipal issuers that are subject to IRS yield restrictions when they invest the proceeds of a prerefunding. The monies placed in escrow are invested in SLGS, which are government securities whose interest rates are arranged to comply with IRS restrictions.

New Housing Authority (NHA) bonds are a relatively safe investment because A) banks buy these bonds. B) they are backed by the full faith and credit of the issuing municipalities. C) rental income provides a hedge against inflation. D) the U.S. government guarantees a contribution to secure the bonds.

D

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

D

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

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

A client is trying to decide between a par value corporate bond carrying a coupon rate of 6.25% per year and a par value municipal bond that pays an annual coupon rate of 4.75%. Assuming all other factors are equal, and your client is in a 28% marginal income tax bracket, which bond do you tell the client to purchase and why? A) The corporate bond because the after-tax yield is 4.5%. B) The municipal bond because its equivalent taxable yield is 6.3%. C) The corporate bond because the after-tax yield is 6.25%. D) The municipal bond because its equivalent taxable yield is 6.6%.

D This is calculated using the tax-equivalent yield formula: municipal yield / (100% − investors tax bracket) 4.75 / (1 − 0.28) = 6.6%. By comparison, the 6.6% tax-equivalent yield of the municipal bond is higher than the 6.25% yield of the taxable corporate bond, making the municipal bond the higher yielding investment, given the investor's 28% tax bracket. Alternatively, you could solve this by simply deducting the taxes due on the corporate bond and comparing that to the coupon on the tax-free municipal bond. It would go like this: 6.25% minus 28% tax equals 6.25 minus 1.75 equals 4.50%. That is less than the 4.75% received after taxes (because there are no taxes) on the municipal bond. So, either way, the municipal bond is a better deal for this client.

Moody's Investment Grade (MIG) ratings are applied to A) municipal notes. B) corporate bonds. C) municipal bonds. D) money market instruments.

A

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

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

Which of the following statements regarding an official statement are true? It is required by the SEC for all new issues. It is required by the Municipal Securities Rulemaking Board (MSRB) for all new issues. It must be delivered to purchasers at or before settlement. It is generally used by underwriters to help sell the issue. A) III and IV B) I and II C) II and III D) I and IV

A 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.

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

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

One of the benefits of adding a sinking fund provision to a municipal bond issue is that the bond will generally A) receive more favorable tax treatment. B) carry a higher coupon. C) receive a higher rating. D) have a longer maturity.

C Adding a sinking fund provision to a bond issue invariably results in a higher rating for the security. The fact that money is put aside to repay the principal on a regular basis offers greater safety. A higher rating results in a lower coupon. Although the sinking fund itself does not change the maturity date, having a sinking fund enables the issuer to use partial calls to redeem the bond ahead of the final maturity date. A sinking fund has nothing to do with tax treatment.

Purchasers of municipal revenue bonds are interested in knowing the priority of their claim on the revenues generated by the project. In general, the most senior position is held by A) an inverted revenue pledge. B) a GO revenue pledge. C) a net revenue pledge. D) a gross revenue pledge.

D The simplest way to think about this question is to look at our paycheck. What is the higher number - your gross pay or your net (take-home) pay? You could also say, "Who has the first claim on my earnings?" The government and that is why the taxes come out of your gross paycheck rather than your net check. The concept is the same here. In a gross revenue pledge, interest to the bondholders is paid out of the gross revenues before any other deductions. In a net revenue pledge, certain expenses are paid first, and then, from what remains, the bondholders receive their due.

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) no taxable result at this time. B) taxable interest income. C) a capital loss. D) a capital gain.

D 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.