Chapter 7: Municipal Debt

Municipal bonds are identified based on the circumstances surrounding their purchase. The following are the three different classifications of municipal issues:

1. Original Issue Discount Bonds 2. Secondary Market Discount Bonds 3. Premium Bonds

Certificates of Participation (COPs)*

A Certificate of Participation (COP) is a type of lease financing agreement that's usually issued in the form of a tax-exempt municipal revenue bond. COPs have been used as a method of monetizing existing surplus real estate. This financing technique provides long-term funding through a lease that doesn't legally constitute a loan and, therefore, eliminates the need for a public referendum or vote.

Ability to Collect Taxes

A community's tax limitations and budgetary considerations must also be reviewed. Attempts to limit the maximum amount of debt that a municipality may carry will positively influence general obligation bonds since the projected revenues will be directed to service the already-issued debt. In this way, fiscal responsibility is imposed and the creditworthiness of the issuer is enhanced. Since most general obligation issues are secured by property taxes, the tax collection record of the community is an essential component of quality analysis. A poor collection record may be a red flag that's indicative of an inefficient local government which may result in bonds with low credit ratings. Other red flags or negative trends that may affect an issuer's credit are property taxes that are increasing in the face of a declining population, an increasing tax burden on the community in comparison to other regions, or general obligation debt that's increasing while property values remain stagnant.

General Obligation (GO) Bonds

A general obligation bond is secured by the full faith, credit, and taxing power of the issuer. Therefore, only issuers that have the ability to levy and collect taxes may issue general obligation bonds. State or local governments are able to issue general obligation bonds based on their statutory or constitutional powers. However, prior to issuing general obligation bonds, issuers must obtain voter approval. Essentially, this requirement is due to the fact that taxpayer money is being used to pay debt service.

Parity Bonds*

A parity bond exists when two or more issues of revenue bonds are backed by the same pledged revenues.

Authority to Issue

A statutory power is a law passed by a state or local government which allows for the issuance of securities. These laws may be amended by legislative action. The constitutional powers to issue general obligation bonds are derived from the state constitution. These statutory and constitutional powers may also limit the amount of debt that an issuer is able to incur. This restriction is referred to as a debt ceiling or the municipality's debt limit.

529 ABLE Plans

Achieving a Better Life Experience (ABLE) plans (also referred to as 529A ABLE plans) are municipal fund securities that can be purchased to help support individuals with disabilities without jeopardizing their disability payments received from Social Security, Medicaid, or private insurance. The maximum contribution is $17,000 per year and front-loading is not permitted. The individual's other disability payments will continue if the account's value doesn't exceed $100,000. Distributions from the plans are tax-free if they're used to pay qualified expenses. - help support individuals with disabilities without affecting disability income - maximum annual contribution is $17,000 per year - front-loading is not permitted - disability payments will continue if the account value does not exceed $100,000 - tax free distributions if they are qaulified

Ad Valorem Tax

Ad valorem tax (property tax) is determined based on the assessed value of property multiplied by the tax rate levied (expressed in terms of mills). One mill expressed as a percentage is 0.1% or, if expressed as a decimal, it's 0.001. Ultimately, if a rate of one mill is used for tax purposes, it equates to a tax of $1 per $1,000 of assessed value. For example, a taxpayer owns property that's assessed at a value of $300,000 and is subject to a tax of 7 mills. This means that property tax of $2,100 is owed ($300,000 x .7% or $300,000 x .007). In addition to property taxes, sales taxes, and income taxes, other non-tax revenue, such as parking fees, park and recreational expenses, and licensing fees, may be used to pay the debt service on GO bonds.

Contribution Limits

Although current tax law allows a tax-free gift of up to $17,000 to any one person in any given tax year, a 529 plan may be front-loaded with an initial gift of $85,000 which is treated as if it's being made over a five-year period (five contributions of $17,000 each). Individuals may contribute these same amounts to 529 plans that are maintained for more than one beneficiary. In other words, if an individual has five grandchildren, she's able to contribute $85,000 to each grandchild's 529 plan without incurring federal gift taxes. This amount is doubled for a married couple funding multiple 529 plans. The aggregate amount able to be contributed to a 529 plan is determined by the state. Most states use a total that's sufficient to pay for an undergraduate degree. (In 2022, the maximum tax-free gift was $16,000 and the front-loading amount was $80,000.) - maximum of $85,000 a year to each person (treated as if paid over 5 years) or $17,000 a year - amount is doubled for married couples

*It's important to understand the difference between a VRDO and a municipal ARS...

Although they're both long-term securities with short-term trading features, only VRDOs have a put feature that permits the holder to sell the securities back to the issuer or third party. If an ARS auction fails, the investor may not have immediate access to his funds. ARSs use an auction process to reset the interest rate on the securities; however, VRDOs have an interest rate that's reset by the dealer at a rate that allows the security to be sold at par value. - only VRDOs have a put feature to sell the securities back to the issuer - ARSs use an auction process to reset the interest rate - VRDOs have an interest rate that is reset by the dealer at a rate that allows the security to be sold at par

Repayment Schedule: Serial versus Term

Another factor in the analysis of the debt is the schedule of debt repayment. A serial bond issue (one with maturities that are staggered) provides greater flexibility when meeting debt requirements than a term issue (one with a single maturity date). This flexibility is due to the fact that serial maturities may be organized to coincide with expected tax revenues. Future financing also plays a part in general obligation bond analysis. Issuers that borrow early to finance school improvements or new water systems for expected future increases may ultimately be better off than a municipality that waits until it's too late to support an overburdened infrastructure.

Unfunded Pension Liabilities*

Another factor which must be examined is a municipality's pension fund. The existence of unfunded pension liabilities (i.e., the financial reality that the money available may be less than the amount required to pay projected pensions) will have a negative impact on the quality of the issuer's debt.

Variable Rate Demand Obligations (VRDOs)

Another long-term security that's marketed as a short-term investment is a variable rate demand obligation (VRDO). A VRDO's interest rate is adjusted at specified intervals (daily, weekly, monthly) and, in many cases, this adjustment allows the owner to sell or put the security back to the issuer or a third party on the date that a new rate is established. If this is done, the investor will receive the par value plus accrued interest.

The order of the first three funds is very important*

As described earlier, if net revenues (gross revenues minus operating and maintenance expenses) are pledged to pay debt service, the bond is referred to as a net revenue issue. On the other hand, if gross revenues are pledged to pay debt service (debt service is paid before the operation and maintenance expenses), it's known as a gross revenue issue. (For exam purposes, a net revenue pledge is the assumed flow of funds method.)

Ratings for Municipal Notes

As explained in the Bond Fundamentals Chapter, Moody's and Standard and Poor's issue ratings for fixed-income securities. Both organizations also have a rating system for municipal notes. Moody's has four rating categories for municipal notes and variable rate demand obligations (VRDOs). The first three ratings are considered Municipal Investment Grade (MIG) ratings (also referred to as Moody's Investment Grade), with the fourth considered a speculative grade. VRDOs, which will be described below, receive ratings based on a variation of the MIG scale—the Variable Municipal Investment Grade (VMIG) system. MIG 1 (VMIG 1): Superior credit quality MIG 2 (VMIG 2): Strong credit quality MIG 3 (VMIG 3): Acceptable credit quality SG: Speculative grade credit quality Standard and Poor's has the following four rating categories for municipal notes: SP-1+: Very strong capacity to pay principal and interest SP-1: Strong capacity to pay principal and interest SP-2: Satisfactory capacity to pay principal and interest SP-3: Speculative capacity to pay principal and interest

Auction Rate Securities

Auction rate securities (ARSs) are long-term investments that have a short-term twist—the interest rates or dividends they pay are reset at frequent intervals through auctions. Investors who purchase ARSs are typically seeking a cash-like investment that pays a higher yield than available from money-market mutual funds or certificates of deposit. Generally, there are two types of ARSs, bonds with long-term maturities (20 to 30 years) and preferred shares with a cash dividend. Both the interest rate on the bonds and the dividend on the preferred shares will vary based on rates that are set through auctions for a specified short period that's usually measured in days—7, 14, 28, or 35. This is unlike a traditional bond that's issued with an interest rate that's set for its life or preferred stock that specifies the dividend rate for its life. Auction rate bonds are issued by entities such as corporations, municipalities, student loan authorities, and museums, while auction rate preferred shares are issued by closed-end funds.

The interest rate/dividend rate is determined through a Dutch auction process...

Before each auction, current ARS investors may request to 1. hold their existing position at the new interest/dividend rate that's established by the auction, 2. hold their existing position at a specified interest/dividend rate, 3. or sell their ARSs. The size of any given auction will depend on how many current ARS investors want to sell and how many want to hold at a certain minimum rate. Essentially, the auction procedures that are set forth in most offering documents allow for a variety of different types of auction orders to be placed with an auction dealer.

*Certain governmental entities, such as school districts, may have an imposed legal limit on the tax rate at which they may assess.

Bonds issued by these entities are called limited tax general obligation bonds since the taxing power of the issuer is limited to a specified maximum rate. Unlimited tax general obligation bonds are issued by government units that have no legal limitation on their taxing power. Most local general obligation bonds are unlimited tax bonds; therefore, the issuers have the ability to levy ad valorem taxes without limitation as to the rate or the amount.

Build America Bonds (BABs)*

Build America Bonds are taxable municipal bonds that were issued under the American Recovery and Reinvestment Act of 2009 (ARRA). Although the program officially ended in 2010, a student should still be aware of their fundamental characteristics. BABs were intended to help state and local governments finance capital projects at a substantially lower cost. Examples of capital projects include creating public infrastructure (e.g., public schools and roads) and transportation infrastructure (e.g., rail, bridges and ports, and public buildings). The objective was to broaden the appeal of municipal securities to taxable, fixed-income investors.

A potential buyer has the option to place a:

Buy order: this indicates a new investor's desire to buy a new position at a specified minimum rate (this order may be entered by new buyers or existing holders who are interested in adding to their position at a specified rate).

Net (After-Tax) Yield (examples included)*

Calculating a bond's net yield is especially important when an investor is considering the possibility of buying a taxable corporate bond and wants to know what she will be able to keep after taxes are paid. Since the interest on a corporate bond is taxable, the investor will realize a lower net (after-tax) return. To determine the net yield of a taxable investment, use the following formula: Net Yield = Taxable Yield x (100% - Tax Bracket%) Example 1: An individual who is in the 20% tax bracket purchases a 10% corporate bond at par. What's her bond's net (after-tax) yield? Net Yield = 10% x (100% - 20%) = 10% x 80% = 8.0% For this investor, the 10% corporate bond is equivalent to a municipal bond yielding 8.0%. Example 2: An individual who is in the 28% tax bracket purchases a 10% corporate bond at par. What's his bond's net (after-tax) yield? Net Yield = 10% x (100% - 28%) = 10% x 72% = 7.2% For this investor, the 10% corporate bond is equivalent to a municipal bond yielding 7.2%.

The State Tax Effect*

Depending on the situation, it may be necessary to adjust the taxable equivalent yield calculation if a question provides information about a customer's state income tax rate. The key to solving these more complicated taxable equivalent yield calculations is to adjust the divisor in the formula to account for any additional potential tax exemption. Since investors who purchase in-state municipal issues are exempt from both federal and state taxes, this combined tax liability is subtracted from 100% to calculate the divisor. Investors who purchase out-of-state municipal issues are still subject to state tax; therefore, only the federal liability is subtracted from 100% to calculate the divisor. Essentially, the divisor in the taxable equivalent yield calculation is 100% minus any tax liability from which the bond's interest is exempt for a given investor.

*The Debt Statement* A critical tool available to those analyzing the debt of a municipality is the debt statement. The various components of the debt statement are:

Direct Debt: All the debt (bonds and notes) that's been issued by the municipality Net Direct Debt: The direct debt (all issues) minus any self-supporting debt, such as revenue and note issues. In general, the net direct debt is only the general obligation debt (bonds supported by taxes). Overlapping Debt: This is the result of multiple authorities in a given geographic area having the ability to tax the same residents. Total Bonded Debt: The sum of both the long- and short-term debt of a municipality, plus its applicable share of overlapping debt.

Disclosure Requirement When promoting 529 plans, an RR is required to:

Disclose the risks and costs (both fees and maximum sales charges) involved with the different types of plans Provide a disclaimer stating that, prior to investing in a plan, customers should read the official statement (disclosure document) Recommend that clients check with their home state to discover if it offers tax benefits for investing in its plan. There's no requirement to provide the name and contact information of the Municipal Securities Principal who will approve customers' investments in the plan

Treasury Arbitrage Restrictions*

Due to the tax-exempt status of municipal bond interest, municipalities are normally able to issue bonds with coupon rates that are below those of Treasury securities. This could present an arbitrage opportunity since a municipality could borrow money at a low rate of interest and invest the funds in higher yielding, risk-free Treasury securities. Treasury Arbitrage Restrictions were enacted to prohibit state and local governments from refinancing their debt and placing the proceeds into an escrow fund that invests in Treasuries with yields above a certain rate.

The Auction Process*

Each bid and order size is ranked from the lowest to the highest minimum bid rate. The lowest bid rate at which all of the securities may be sold at par establishes the interest/dividend rate, otherwise referred to as the clearing rate. This is the rate that's paid on the entire issue for the upcoming period. Investors who bid a minimum rate above the clearing rate receive no securities; however, those whose minimum bid rates were at or below the clearing rate receive the clearing rate for the next period. ARS auctions may fail when supply exceeds demand or, put another way, when there are not enough bids to purchase all of the securities being offered for sale in the auction. When an ARS auction fails, existing holders will continue to hold their securities and will generally receive an interest/dividend rate that's set above market rates for the next holding period (up to a maximum that's disclosed in the offering documents). These securities are usually sold as an alternative to other short-term money-market instruments. A member firm must disclose to its clients that if the auction fails, the clients may not have immediate access to their funds. Member firms also have a duty to disclose to their clients all material facts relating to the specific features of the auction rate securities and must evaluate all customers' liquidity needs when recommending this type of product.

Legal Opinion

Every municipal issue must be issued with a legal opinion. The legal opinion is written by a recognized bond counsel that's hired by the issuer to attest to the validity and tax-exempt status of the bond issue. Essentially, the legal opinion assures investors that the issuer has the legal right to issue the bonds. If there are no existing situations that could adversely affect the legality of an issue, the bond counsel renders an unqualified legal opinion. Potential adverse situations include an issuer of a revenue bond not having a clear title to a property or an issuer that's violating local, state, or federal statutes when developing a project. Delivery of certificates without legal opinions or other documents that are legally required to accompany the certificates will not constitute good delivery unless they're identified as ex-legal at the time of the trade.

Nature of the Issuer's Debt

Examining the fiscal responsibility of the issuer's past attitudes toward debt is often an indicator of the issuer's present, and possibly future, ability to engage in fiscally sound behavior. Some important considerations include whether the issuer has maintained a balanced budget over the last five years and how well the issuer has maintained fund reserves. Any analysis must also review a municipality's debt trend. If a community has used debt to support the growth of its suburbs (such as building roads and schools that are needed to support that growth), the debt is not necessarily bad. Conversely, if debt has been issued to finance budget deficits or to increase spending in a weak local economy, this may be an indication of an unwise fiscal policy.

*The following examples illustrate the concept of overlapping debt:

Example 1) Broward County, Florida issues a general obligation bond that's secured by the assessed value (property tax) within Broward County. Since the city of Fort Lauderdale lies within Broward County, part of the assessed value that secures the county debt lies in Fort Lauderdale. Due to the fact that the county's debt overlaps Fort Lauderdale, Fort Lauderdale is ultimately responsible for a portion of the county's debt. Example 2) The debt of a school district is comprised of one or more cities or towns. If a city and school district lie within the same boundaries, they're said to be coterminous and, when examining the debt of the city, the school district's debt must be shown as overlapping debt.

*For example, a client who is in the 35% tax bracket and subject to the AMT is able to purchase an AMT municipal bond yielding 4.70% or a non-AMT municipal bond yielding 4.35%. Which bond will offer the highest after-tax yield?

For the AMT bond, the after-tax yield is calculated as follows: 4.70% x (1.00 - 35%) = 3.05%. For the non-AMT bond, the after-tax yield is 4.35% (and higher than the AMT bond).

*An existing holder of ARSs may choose to place the following orders:

Hold at Market: this order indicates the amount of the security he wishes to continue to hold regardless of the clearing rate that's set by the auction. Additionally, if an owner doesn't place an order, the assumption is that he has elected to continue to hold the securities regardless of the clearing rate. Hold at Rate or Bid: this order indicates the holder's bid to continue to hold an existing position at a specified minimum rate. Sell: this order indicates the holder's desire to sell an existing position regardless of the rate that's set by the auction.

Financial Condition

How well public officials manage in times of economic and financial stress is particularly important to the credit quality of an issuer. A sound financial condition indicates that the governmental entity is able to meet all of its obligations to creditors, employees, taxpayers, suppliers, and others, on a timely basis. Measuring the financial resources that are required to make payments will determine the issuer's financial condition.

Private Activity or Alternative Minimum Tax (AMT) Bonds*

If 10% or more of the bond proceeds will be used to finance a project for a private entity (e.g., a corporation or professional sports team) and if 10% or more of the bond proceeds will be secured by property used in the private entity's business, the bonds are referred to as private activity bonds. The interest earned on a private activity bond is taxable at the federal level unless the bond is deemed to be a qualified private activity bond. To be considered "qualified," the private activity bond must satisfy certain standards and must be publicly approved. If a bond is qualified, the interest is exempt from federal taxes, but subject to the AMT. Due to the potential tax implication, these bonds may trade with a higher yield than issues that are not subject to the AMT.

Other Considerations*

If a community is involved in a lawsuit, any liability that a municipality is obligated to pay will place a financial burden on the community. Such litigation will generally have a negative effect on the community's ability to pay the debt service on outstanding bonds. Conversely, the receipt of non-tax revenues, such as federal payments for education, may serve to enhance the community's ability to pay the required debt service. Tracking trends in real estate valuation provides a good indication of a community's health. Analysts often concentrate more on the market value of real estate as opposed to the assessed value. Estimating the revenues available to a general obligation bond includes the community's full evaluation, the percentage of assessed value that's taxable, and the tax (millage) rate. For example, a community that has a full valuation of $250,000,000, a 40% basis of assessment, and a millage rate of 20 will produce $2,000,000 in property tax (as calculated below): $250,000,000 (full valuation) x 40% (basis of assessment) = $100,000,000 $100,000,000 x .02 = $2,000,000 (Remember, 1 mill = .001 or 0.1%.)

2. Secondary Market Discount (SMD)*

If a municipal bond is purchased at a discount in the secondary market (a discount caused by market conditions) and held to maturity, there will be a taxable gain at maturity. The gain is reported as ordinary income. For example, a municipal bond was originally issued at par. A customer buys the bond in the secondary market for $920 with 8 years to maturity. The bond's value will be accreted upwards 1 point ($10) per year (8 points divided by the bond's remaining 8- year life).

OID Sold Prior to Maturity*

If an OID bond is sold prior to maturity, the cost basis (adjusted to reflect the accretion) is used to calculate gains or losses. For example, if an OID bond is purchased at 60 and it has 10 years to maturity, the bond's cost basis is accreted by 4 points each year. To determine the accretion amount, the 40-point difference between the purchase price and par is divided by the 10 years remaining until maturity. Since this annual accretion is not taxable, these issues are suitable for customers who don't wish to incur a tax liability. Based on the example above, if an investor buys an OID municipal bond at a price of 60 with 10 years to maturity, the bond will accrete by 4 points each year. Therefore, after three years, the bond's basis has accreted by 12 points to a basis of 72. If the bond's adjusted basis is 72: A sale at a market price of 75 creates a 3-point capital gain (75 market price - 72 adjusted cost). A sale at a market price of 70 creates a 2-point capital loss (70 market price - 72 adjusted cost). A sale at a market price of 72 creates no capital gain or loss (72 market price - 72 adjusted cost).

Trust Indenture Covenants (8 in total)*

In addition to the debt service coverage ratio, there are various provisions that are found in the bond's indenture that should be examined when analyzing revenue bonds. The indenture is also referred to as the bond resolution or trust agreement The indenture is a contract between the issuer and the trustee that has been appointed to represent the bondholders' interests. The indenture includes a variety of provisions that establish the issuer's responsibilities and the bondholders' rights. Since the indenture describes the legal protections that are afforded to bondholders, it's essential to analyze some of the various covenants (promises). The typical covenants include: Rate Covenant The issuer's pledge to maintain rates at a level that's sufficient to meet operation and maintenance costs, debt service, and certain reserve funds. Maintenance Covenant The issuer's pledge to maintain the project in good working order. Insurance Covenant The issuer's pledge to carry insurance on the property. Financial Reports and Audits The issuer's pledge that it will maintain proper records and that an accounting firm will be retained to do an outside audit. This pledge is designed to avoid the possibility of funds being misused. Issuance of Additional Bonds If there's a closed-end indenture, no additional bonds that have an equal claim on the pledged revenues may be issued against the same security. However, if there's an open-end indenture, additional bonds may be issued in the future for expansion of the project. Revenue bonds with an additional bonds covenant must meet a certain earnings test before news bonds can be issued. This ensures that the issuer will be able to pay its obligations to both new and existing bondholders Non-Discrimination Covenant This represents the issuer's pledge that

*Taxable Municipal Bonds

In certain cases, a municipality may not be able to issue bonds that are exempt from federal income tax. This may occur when the bonds are issued to finance projects that don't provide a significant benefit to the general public. Some examples of situations in which a bond may lose its tax exemption include 1) an offering where the proceeds are being used to build a sports facility or certain types of housing, or 2) an offering designed to allow an issuer to borrow funds in order to replenish its unfunded pension liabilities. Since these bonds will have higher yields, they may be suitable for investors who are unconcerned about the tax status of the investment (e.g., pension funds and retirement accounts).

Municipal Bonds—The Target Market*

In many cases, corporate bonds and Treasury securities have a higher coupon than municipal bonds of similar maturity. An investor must have a way of comparing the taxation differences between these security types. The main reason that this is important is the fact that investors are most concerned with determining how much money they will be able to keep after paying all of the taxes that are due. The benefit of investing in tax-exempt securities increases along with an investor's tax bracket. A high tax-bracket investor usually pays a greater percentage of his earnings in taxes; therefore, the higher the investor's marginal rate, the greater the benefit of receiving a tax-free coupon. -wealthier investors should consider municipal securities over other securities because their tax bracket is higher Conversely, municipals are unsuitable for investors who receive special tax considerations. For example, since the earnings in a pension fund accrue on a tax-deferred basis, the fund doesn't derive any additional benefit from investing in tax-exempt municipal bonds. Municipal bonds are also generally unsuitable investments for an individual's IRA and 401(k) accounts.

Capital Gains and Losses on Municipal Issues

It's important to understand the differences between the taxation of interest on municipal bonds and the potential capital events associated with these securities. Securities such as stocks, bonds, and options are considered capital assets and, if a capital asset is sold for less than its cost, the result is considered a capital loss. On the other hand, if a capital asset is sold for more than its cost, it's considered a capital gain Although the interest on municipal bonds is exempt from federal taxation, any resulting capital gain from the sale or redemption of a municipal bond is subject to tax. In some cases, the gain is reported as ordinary income.

Local Government Investment Pools (LGIPs)

LGIPs are investment pools that are created by state and local governments to provide municipal entities a place to invest funds. Although municipalities are generally prohibited from investing in money market funds, these pools are structured in a manner that's similar to money market funds. The pools provide both liquidity and minimal price volatility, but are not open to the public. - created by state and local governments to provide municipal entities a place to invest funds - not open to public

Types of Municipal Bonds

Municipal bonds are classified into two major categories—general obligation bonds (GOs) and revenue bonds. GO bonds may be issued to meet any and all needs of the issuer. In a sense, GO bonds are issued for general purposes. Unlike a revenue issue, the source of the funds that the GO issuer uses to back the bonds may come from various sources. Conversely, revenue bonds are typically issued to fund a specific project or facility, such as a bridge or road. For revenue bonds, the cash flows generated by the specific project (e.g., tolls, usage fees) are used to repay bondholders.

Summary

Municipal bonds are issued by states, territories, and possessions of the United States, as well as other political subdivisions (e.g., counties, cities, or school districts) and public agencies (e.g., authorities and commissions). Unlike U.S. Treasury securities, these debt instruments carry some level of default risk since municipal bonds are not backed by the U.S. Treasury. Municipal issues are exempt from the filing provisions of the Securities Act of 1933 and are exempt from state and federal registration requirements. However, municipal issues are not exempt from antifraud provisions of any securities law. For most investors, the primary advantage of municipal bonds is that the interest received is typically exempt from federal tax. Another advantage is that most states don't tax the interest from bonds that are issued within their borders. For this reason, investors tend to buy in-state bonds to avoid potential federal, state, and (in some cases) local taxes.

Municipal Notes*

Municipal notes are short-term issues that are normally issued to assist in financing a project. As is true for long-term municipal bonds, short-term municipal notes and commercial paper provide investors with tax-exempt interest. The notes may also be issued to help a municipality manage its cash flow. Municipal notes are interest-bearing securities that ultimately pay interest at maturity.

Debt Service Coverage (net revenue vs gross revenue pledge)*

Nearly all revenue issues pledge a project's net revenue to pay the bondholders their debt service. A net revenue pledge indicates that operating and maintenance expenses are deducted from the gross project revenues before the revenues are applied to debt service. On the other hand, a gross revenue pledge indicates that debt service is paid prior to operating and maintenance expenses being deducted.

Taxable Equivalent Yield (examples included)*

Now, let's examine the issue from the other point of view. If a customer is considering the possibility of purchasing a tax-free bond and wants to calculate what he needs to earn on a taxable issue to achieve an equivalent return, the taxable equivalent yield calculation is used. To determine the taxable equivalent yield of a tax-exempt investment, the formula is: Taxable Equivalent Yield = Municipal Yield / (100% - Tax Bracket%) Example 1: An individual who is in the 25% bracket purchases a 6% municipal bond at par. What will the individual need to earn on a fully taxable instrument (e.g., a corporate bond) to equal the tax-free yield on the municipal bond? Taxable Equivalent Yield = 6% / (100% - 25%) = 6% / 75% = 8% In other words, if a client buys the 8% taxable bond, but is required to pay 25% of his earnings in taxes, he will be left with a net (after-tax) return of 6%. For this investor, an 8% taxable issue and the 6% tax-free issue are equivalent. Example 2: An individual who is in the 35% tax bracket purchases the same 6% municipal bond at par. What's the bond's taxable equivalent yield? Taxable Equivalent Yield = 6% / (100% - 35%) = 6% / 65% = 9.23% This example shows that the same 6% bond is more attractive to an individual who is in a higher tax bracket. This 35% tax-bracket investor will need to find a taxable bond that yields 9.23% to be equivalent to the 6.00% tax-free issue.

Revenues that are generated by the project fill each of the funds to a prescribed level and then flow to the next fund. The flow of funds described below is typical of most revenue bonds.

Revenue Fund This is the account into which all receipts and income (gross revenues) are deposited and recorded. Operating and Maintenance Fund This is the account into which a prorated amount of the revenue is deposited to meet the costs of operating and maintaining the project. Occasionally, there's an excess of funds which allows for the creation of a reserve fund. Debt Service (Bond Service) Fund This is the fund into which an amount of revenue is deposited that will be sufficient to pay semiannual interest and maturing principal. Debt Service Reserve Fund This is the fund into which revenue is deposited after annual debt service is ensured. These funds are only used if the debt service fund itself is insufficient to meet annual payments. Reserve Maintenance Fund This is the fund into which revenue is directed in order meet any unexpected maintenance expenses. Replacement and Renewal Fund In the event that there's a demand based on an engineer's report, this is the fund into which revenue is deposited to meet new equipment and repair costs. Sinking Fund This is the fund into which revenue is accumulated to retire bonds prior to maturity. If there's a mandatory sinking fund provision in the indenture, this fund will receive money prior to the replacement fund. An offering with a mandatory sinking fund will retire a portion of the debt prior to its stated maturity. Since the entire offering will not reach maturity, it will have an average life that's shorter than the stated maturity. Surplus Fund This is the fund into which excess money will be placed for use in emergencies. Construction Fund This is the fund into which money is allocated to use for future construction.

Types of Revenue Bonds

Revenue bonds are generally characterized by the project the bond is financing or by the source(s) backing the bond. The following list represents some of the more common types of revenue issues.

Revenue Bonds*

Revenue bonds may be issued when voter approval for general obligation bonds cannot be obtained. Also, revenue bonds may be issued to finance capital projects when statutory or constitutional debt limitations prevent a municipality from issuing general obligation bonds. Revenue bonds are issued for either projects or enterprise financings in which the issuer pledges to repay the bondholders using the revenues generated by the financed project. Issuers of revenue bonds may be authorized political entities (e.g., state or local governments), an authority (e.g., the Port Authority of New York and New Jersey), or a commission created to issue bonds for purposes of building and operating a project. Revenue bonds may be used to finance airports, water and sewer systems, bridges, turnpikes, hospitals, and many other facilities. Concessions, tolls, and user fees that are associated with the use of these facilities are used to make interest and principal payments on the bonds. Revenue bonds are generally considered riskier than GO bonds since the generated revenues may prove to be insufficient to fund debt service. Another source of revenue could originate from rental or lease payments. For example, a state may create a non-profit authority to issue revenue bonds in order to build a school. The local government using the school will lease the facility from the authority and the lease payments will be used by the issuer to pay interest and principal.

OID Held to Maturity*

Since the accreted amount of a municipal OID is treated as interest, this upward adjustment in the bond's value is tax-exempt. Each year, the bondholder's cost basis is increased and, at maturity, the cost basis reaches par. At maturity, since the cost basis is equal to the redemption price (par), there's no capital gain.

Consider the following examples (State Tax Effect): Example 1: A California resident who is in the 25% federal bracket and is subject to a 3% state income tax purchases a 4% City of Sacramento municipal bond at par. What will this investor need to earn on a fully taxable instrument to equal the tax-free yield on the municipal bond? Example 2: A Wisconsin resident who is in the 25% federal bracket and is subject to a 3% state income tax purchases a 4% City of New York municipal bond at par. What will this investor need to earn on a fully taxable instrument to equal the tax-free yield on the municipal bond?

Since the bond was purchased by a resident of California, its interest is also exempt from California state tax. Therefore, the state tax rate is factored into the equation (25% + 3%). Taxable Equivalent Yield = 4% / (100% - 28%) = 4% / 72% = 5.55% Since the bond was not purchased by a resident of the state of issuance (i.e., New York), interest is subject to Wisconsin state tax. Therefore, the state tax rate is NOT included in this calculation. Taxable Equivalent Yield = 4% / (100% - 25%) = 4% / 75% = 5.33%

1. Original Issue Discount Bonds*

Some bonds that are initially issued at a deep discount are classified by the IRS as original issue discount (OID) securities. The appreciation in the value of an OID (the amount of the discount) is treated differently for tax purposes than a municipal bond that's purchased in the secondary market at a discount. The discount on an OID must be accreted. Therefore, each year a portion of the discount is treated as interest for tax purposes and is added to the bondholder's cost basis. For example, if an OID bond is purchased at 60 and it has 10 years to maturity, the bond's cost basis is accreted by 4 points each year. To determine the accretion amount, the 40-point difference between the purchase price and par is divided by the 10 years remaining until maturity. Since this annual accretion is not taxable, these issues are suitable for customers who don't wish to incur a tax liability.

Backing

State general obligation bonds are usually secured by income tax, sales tax, and other taxes collected at the state level. For local jurisdictions, such as counties and cities, the most common source of tax revenue is from levies on real property (ad valorem tax). School taxes are also assessed at the local level and are normally a significant portion of a person's real estate tax assessment.

Expanded Use of 529 Plans

Tax law has expanded the use of 529 plans. Originally, 529 withdrawals were permitted for qualified higher education expenses. These include, tuition, room and board, as well as some books and supplies. However, travel expenses and room and board for studying abroad are nonqualified expenses. Rules were updated and funds in these plans may also be used for expenses related to elementary and secondary schools at public, private, or religious institutions Individuals can take annual distributions of up to $10,000 from their 529 plans to pay for private school tuition and books for grades K through 12—in addition to using their account proceeds for college costs. Additionally, individuals are now permitted to withdraw up to $10,000 (lifetime limit) on a tax-free basis (a qualified withdrawal) to repay qualified student loans as well as expenses for certain apprenticeship programs. If a non-qualifying distribution is taken, the amount withdrawn is added to ordinary income and subject to a 10% penalty. The assets in plans may be transferred to another family member (a change in beneficiary) if the original beneficiary doesn't need or use the funds for qualifying education expenses. - can be used for k-12 institutions - travel expenses and room and board abroad are not covered - one time withdrawal of $10,000 to repay qualified student loans and apprenticeship programs - if distribution is non qualified, there is a 10% tax penalty and the amount of the distribution is added to ordinary income - assets can be transferred to another family memeber

Section 529 College Savings Plans

The Economic Growth and Tax Relief Reconciliation Act of 2001 expanded the federal tax treatment of state-run 529 plans, which are also referred to as municipal fund securities. As with Coverdell ESAs, 529 plans are not retirement accounts; instead, they're savings vehicles created to meet the expenses of higher education. The beneficiary, who may include the donor, is able to be changed in the future. Under federal law, contributions are made with after-tax dollars, but any earnings grow on a tax-deferred basis. If withdrawals are used to pay for higher education, they're considered qualified withdrawals and are tax-free. States that offer 529 plans are responsible for determining the specific plan rules such as allowable contributions, investment options (e.g., mutual funds), and the deductibility of contributions for state tax purposes. - 529 plans are also referred to as municipal fund securities - beneficiary may include the donor and can be changed in the future - contributions are made with after-tax dollars and earnings grow on a tax-deferred basis - if withdrawals are used to pay for school, they are considered qualified and are tax-free

Alternative Minimum Tax*

The alternative minimum tax is a method of calculating a return to ensure that wealthy taxpayers pay at least a minimum amount of tax. When calculating the AMT, various adjustments are made. Some income is added which may not have been subject to regular tax, while some deductions are adjusted downward or eliminated entirely. One of the factors that may trigger an AMT liability is the receipt of interest on qualified private activity municipal bonds, where the proceeds of municipal offerings go to benefit or finance a facility for use by a private business. Since the purchase of a qualified private activity bond leads to AMT liability, the MSRB requires an RR to disclose the bond's details on a confirmation. For any client who's subject to the AMT, an RR must ensure that any recommendations being made are suitable.

Flow of Funds

The flow of funds establishes the order and priority of handling, depositing, and disbursing pledged revenues, as set forth in the bond contract. Generally, when received, pledged revenues are deposited into a general collection account or revenue fund that's established under the bond contract for subsequent disbursement into the other accounts that are established under the bond resolution. These other accounts provide for payment of the costs of debt service, debt service reserve deposits, operation and maintenance costs, renewal and replacement, and other required amounts.

Triple-Tax-Exempt Issues*

The interest earned on bonds that are issued by a territory or possession of the U.S., such as Puerto Rico, the U.S. Virgin Islands, Guam, and American Samoa, are not subject to federal, state, or local taxes. These securities are referred to as triple-tax-exempt bonds.

Demographics

The make-up of the population of the issuing municipality is an important indicator of a bond's quality. Since many general obligation bonds are dependent on property tax revenues, a growing population is a sign of economic strength; however, a declining population is most likely a sign of a deteriorating tax base. Keep in mind, although a city may lose some of its population to its suburbs, it still may retain its economic strength as a place of employment. The specific industries that constitute a community's employment is another important demographic factor to examine. Diversification of economic activity signals economic strength and also indicates that a municipality is not dependent on any one industry (e.g., computer technology). When analyzing a general obligation issue, a mixture of new, growing companies along with reliable, established companies is a desirable combination.

Bond Taxation

The manner in which income is taxed is often a function of the source of that income. Some of the sources of income include earned, passive, deferred, and investment (portfolio) income. Most income is taxed as ordinary income and is based on the individual's particular tax bracket. Ordinary income includes wages, interest, and qualified withdrawals from retirement plans. Assets that are bought and subsequently sold result in either capital gains or capital losses and have separate tax implications. Remember, interest earned on corporate securities is subject to federal, state, and local taxes (fully taxed). On the other hand, interest earned on U.S. government obligations is subject to federal tax, but is exempt from state and local taxes.

Feasibility Study

The municipality must hire a consulting engineer to study the project and present a report to identify whether the project will be able to bring in the necessary revenues. This report examines the need for the proposed project and whether the project is a sound economic investment. Other factors involved in the feasibility study include comparing the cost of using the proposed service to other alternatives available within the project's area to ensure that the project will be competitive and generate revenue. An accounting firm is usually retained to help determine if the revenues will be sufficient to cover expenses and debt service.

Constant Yield Method*

The preceding diagram used the straight-line accretion method, which is the same process used for questions on the examination. However, the actual method of accretion used by accountants is referred to as the constant yield method or constant interest method. Students are not expected to perform this more difficult calculation.

Preference for Local Issues

The primary benefit of purchasing a municipal security is the fact that the interest is either fully or partially tax-free to the investor. If an investor buys an in-state municipal bond, the interest earned is exempt from federal, state, and local income taxes. However, if an investor buys an out-of-state municipal security, the interest earned is still exempt from federal tax, but usually subject to state and local taxes.

Fiscal Responsibility

The soundness of the budget process is critical because it shows how well a particular governmental entity is managing its fiscal affairs. Fiscal responsibility may be shown in a variety of ways such as: balancing the budget, creating rainy-day funds for use in business cycle downturns when fewer tax receipts are collected, having a string of budget surpluses over five years, and reducing expenditures by monitoring the conditions on which services are provided.

Double-Barreled Bonds

These are backed by a specific revenue source (other than property taxes) as well as the full faith and credit of an issuer with taxing authority (a GO issuer). Essentially, a combination of tax dollars and revenue dollars from the project being constructed will be used to pay the debt service on the bonds.

Tax and Revenue Anticipation Notes (TRANs)

These are created when TANs and RANs are issued together.

Construction Loan Notes (CLNs)

These are issued by municipalities to provide funds for construction of a project that will eventually be funded by a bond issue.

Housing Revenue Bonds

These are issued by state or local housing finance agencies in an effort to help fund single family or multifamily housing and are normally for low or moderate income families. In some cases, the proceeds of the bond offering are lent to the real estate developers that are constructing the property. In other situations, the money being raised through the offering is used to support the mortgage markets

Revenue Anticipation Notes (RANs)

These are issued for the same purpose as TANs except that they will be paid from future revenues. Like TANs, they're usually general obligation securities.

Grant Anticipation Notes (GANs)

These are issued in expectation of receiving funds (grants) from the federal government.

Dormitory Bonds

These are issued to build housing for students at public universities and are repaid from a portion of student tuition payments.

Tax Anticipation Notes (TANs)

These are issued to finance current municipal operations in anticipation of future tax receipts from property taxes. They're usually general obligation securities.

Utility Revenue Bonds

These are issued to finance gas, water and sewer, and electric power systems that are owned by a governmental unit. The bonds are normally backed by the user fees that are charged to customers. When assessing the credit risk, important considerations include environmental factors and the growth rate of the area being served by the utility.

Bond Anticipation Notes (BANs)

These are issued to obtain financing for projects that will eventually be financed through the sale of long-term bonds.

Health Care Revenue Bonds

These are used for the construction of non-profit hospitals and health care facilities. These bonds typically pay their debt service out of gross revenue. With a gross revenue payment process, all revenues received will be used to pay debt service prior to deductions being taken for any costs or expenses. In some cases, the existence of nearby competing facilities will influence the quality of the bonds.

Transportation Bonds

These are used to finance projects such as bridges, tunnels, toll roads, airports, and transit systems. User fees (e.g., tolls) are used to pay the debt service on these bonds. When analyzing bridge, tunnel, or turnpike bonds, the availability of fuel and the existence of competing nontoll facilities are factors that must be investigated. In addition, for airport revenue bonds, an examination of the level of tourism in an area, fuel costs, and competing airports must be conducted.

Special Tax Bonds

These bonds are backed by special taxes (e.g., excise taxes on tobacco, liquor, gasoline, hotel/motel stay) for a specific project or purpose, but not by ad valorem taxes. For example, highway bonds that are payable from an excise tax on gasoline are considered special tax bonds.

Moral Obligation Bonds*

These bonds are first secured by the revenues of a project; however, if revenues are insufficient to pay debt service requirements, the state (or a state agency) is morally obligated (but not legally required) to provide the needed funds. Prior to issuing the bonds as moral obligation bonds, the legislative approval of the state government must be obtained.

Special Assessment Bonds

These bonds are payable only from an assessment on those who directly benefit from the facilities. Examples include bonds issued to develop/improve water and sewer systems, sidewalks, and streets.

Escrowed-to-Maturity (ETM) Bonds*

These bonds are secured in the same manner as refunded bonds (are outstanding debt obligations that have been collateralized by U.S. government securities); however, they don't have a call feature. Due to the fact that they're not callable, these bonds will remain outstanding until their maturity. Similar to advance-refunded bonds, ETM bonds have high credit ratings

Industrial Development Bonds (IDBs)

These bonds, also referred to as Industrial Development Revenue bonds (IDRs), are issued by a municipality and secured by a lease agreement with a corporation. The purpose for the offering is to build a facility for a private company. The security's credit rating is based on the corporation's ability to make lease payments since the municipality doesn't back the bonds. An important potential detail is that if the holder of an IDB is a substantial user of the facility, then the federal tax exemption on the interest earned will not apply.

Advance-Refunded Bonds (also referred to as prerefunded or defeased bonds)*

These bonds, also referred to as prerefunded or defeased bonds, are outstanding debt obligations that have been collateralized by U.S. government securities. These bonds will usually be paid off on their next available call date and carry high credit ratings.

Education Bonds

These may be secured by the repayment of loans by students, by the money contained in a fund that was required to be established by the bond's indenture, or by insurance payments made by the state or federal government.

Lease Rental Bonds

These offerings involve one municipal entity that leases a facility from another. For example, a state building authority may issue bonds to build a college dormitory and then the authority will lease the dorm to the college. The bond issued by the building authority will be paid from the revenues generated through lease payments received from the college. If the lease payment is subject to an annual budgeting process, credit risk is tied to the willingness of the issuer to budget these payments annually.

When analyzing a revenue issue, one of the most important factors is the debt service coverage ratio (example included)*

This ratio measures the amount of available revenue compared to the amount of revenue needed to satisfy the debt service requirement. For example, a revenue issue shows the following financial data: Annual Gross Revenue: $8,000,000 Annual Debt Service: $3,000,000 Annual Operating and Maintenance Expenses: $2,000,000 To determine the net revenue, subtract operating and maintenance expenses from the gross revenue ($8,000,000 revenues - $2,000,000 O/M expenses = $6,000,000 net revenue). The debt service coverage ratio is then found by dividing the net revenue by the debt service ($6,000,000 net revenue ÷ $3,000,000 debt service). Therefore, the debt service coverage ratio is 2 to 1, which is considered adequate coverage.

Bank-Qualified (BQ) Issues*

To encourage banks to invest in municipal securities, some issues are specified as being bank-qualified. Banks that invest in these bonds are permitted to deduct 80% of the interest cost being paid to depositors on the funds that are used to purchase the bonds. In addition, the interest income on the bonds is tax-free. One limitation is that bank-qualified issues may not be private activity bonds. Issuers may designate bonds as being bank-qualified if they reasonably anticipate that the amount of such obligations will not exceed $10,000,000 in a calendar year.

*One form of BAB is a Direct Payment bond which was issued by municipalities to raise capital for all the traditional purposes except for refundings, private activities, and 501(c)(3) borrowers.

To help defray the cost of borrowing, the Direct Payment BABs provided issuers with a reimbursement (subsidy) from the U.S. Treasury for 35% of the interest paid on the bonds For example, if a municipality issues a BAB at a taxable rate of 6.25%, the issuer will receive 2.19% (6.25% x 35%) annually from the U.S. Treasury. Therefore, the net amount of interest being paid by the issuer is 4.06% (6.25% - 2.19%). Although taxable, BABs were issued by municipal governments and subject to MSRB rules. Brokerdealers involved in the underwriting of these bonds were required to provide official statements to purchasers and all sales activities were supervised by Municipal Securities Principals.

*To assist analysts in comparing the debt of different communities, the ratio of debt to a number of different factors may be used

Typically, the analyst will use the ratio of net direct debt plus overlapping debt (net overall debt) to assessed value or to population (debt per capita). An analyst might also use the ratio of annual debt service to tax and other income to assess the quality of a GO issue. In this case, a high ratio is indicative of a decreasing margin of safety in the issuer's ability to repay principal and interest. If the debt service increases and tax and other income remains stagnant or decreases, there are less funds available to pay the debt service.

Rollovers*

Under IRS rules, a rollover of a 529 plan is permitted once every rolling 12 months. In rolling over funds from this plan, an investor is moving the funds to another state's plan. Conveniently, there are generally no residency requirements for a 529 plan. A 529 plan may not be rolled over to a Coverdell ESA. In a 529 plan, the donor is not permitted to choose the individual securities to own; instead, the donor chooses among the investment options that are stipulated in the plan. The donor may change the selected investment option no more than twice every 12 months (based on calendar year). - a rollover is permitted once every rolling 12 months into another state plan - no residency requirements for rollover - cannot be rolled into a Coverdell ESA - donor cannot choose which securities to own, but can choose among different investment options - donor may change investment options twice a year

Analyzing General Obligation Bonds

Unlike U.S. Treasury debt, municipal securities do carry a level of default risk. When evaluating the risk of default for a general obligation bond, analysts will consider the following factors: The overall economic health of the community including changes in property values, its largest employers, average income, and demographic factors The tax burden and source of payments The budgetary structure and financial condition of the issuer The issuer's existing debt using measures such as debt per capita and overlapping debt

Analyzing Revenue Bonds

When analyzing a revenue bond issue, it's not necessary to examine the tax base or the tax collection record of the issuer because taxes are not the source of payments to the bondholders. Remember, for revenue bonds, investors are repaid from the cash flows generated by the project that was constructed. Therefore, for revenue bond analysis, a key factor is the comparison of the money being collected from users of a facility to the amount of debt service that must be paid to the bondholders.

Tax Considerations

When engaging in securities transactions, it's important to consider the tax implications of any particular investment. Since tax consequences differ from one investment to another, and the level of tax aversion differs from one customer to another, registered representatives must make recommendations that suit their customers' overall tax situations. U.S. tax laws are complex and constantly changing. In addition to being subject to federal tax, individuals may also be required to pay taxes to the state, county, and/or city in which they live. The final section of this chapter will primarily focus on the areas of the tax code that affect municipal bonds and municipal bond transactions. This will include the taxation of interest and the capital events that are associated with these instruments. Before examining how to determine whether a municipal bond is an appropriate choice for a client based on her tax situation, let's address some larger tax issues.

Note: If an exam question references a zero-coupon municipal bond,

it should be considered an OID. Therefore, the discount is treated in the same manner as previously described.

*Investors who are interested in short-term investments may also purchase other tax-free money-market instruments such as...

tax-exempt commercial paper and tax-free money-market funds. Tax-exempt commercial paper has a maximum maturity of 270 days and is normally backed by a bank line of credit.