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General Obligation (GO) Bonds

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Secured by the full faith, credit, and taxing power of the issuer. Only those issuers have the ability to levy and collect taxes may issue them. State/local governments are able to issue GO bonds on a statutory or constitutional basis

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GO Bonds: Authority to Issue

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Statutory power- law passed by a state or local government allowing the sale of the security. Can be amended by legislative action. Constitutional- derived from the state constitution- a law or statue does not need to be passed first.

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Debt ceiling

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limits to the amount of debt an issuer is able to incur

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Backing

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State GO bonds- secured by income, sales, gasoline, excise, and other taxes on state level. Counties/Cities- most common source of tax revenue is levies on real property. School taxes are also assessed and collected at the local levee and are normally a major portion of the real estate tax assessment.

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Ad Valorem Tax

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Property tax on the assessed value of real estate is the source of funds the local government uses to support its expenses and debt. Property tax is based on the ASSESSED value of property and the tax rate levied. It is expressed in mills (1 mil = .1% or $1 for every $1,000).

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GO Bonds: Non-tax revenue

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Parking fees, park and recreational expenses, and licensing fees can be used to pay the debt service on GO bonds Debt service - total interest and principal owed to bondholders. Level debt service- exists when each year's debt service payments are equal. Limited tax bond- a municipal bond issue secured by a pledge of taxes but where the tax rate is capped. Unlimited tax GO bonds- issued by government unites that have no legal limitation on their power to tax (most local GO bonds)

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Analyzing GO Bonds: Demographics

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A growing population is a sign of economic strength whereas a declining population most likely signals deterioration in the tax base. Diversification of economic activity would signal economic strength A mixture of new, growing companies and reliable established companies is a desirable combination when analyzation a GO issue.

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Analyzing GO Bonds: Nature of the Issuer's Debt

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Fiscal responsibility of the issuer's past attitudes toward debt is an indicator of the issuer's present/future ability to engage in behavior. Important indicators are whether the issuer has maintain a balanced budget over the last five years and how well the issuer has maintain fund reserves.

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Analyzing GO Bonds: Fiscal Responsibility

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Such as balancing the budget, carrying a rainy day fund for use in business cycle downturns, a string of budget surpluses over five years, and reducing expenditures by monitoring the conditions which services are provided should be considered

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Serial vs Term

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Serial (maturities are staggered) provides greater flexibility to meet debt requirements than a term issue (one maturity date) because serial matures can be organized to coincide with expected tax revenue.

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Analyzing GO Bonds: Financial Condition

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A sound financial condition means that the governmental entity is able to meet all its obligations to creditors, employees, taxpayers, suppliers, and others, as they come due.

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Analyzing GO Bonds: Unfunded Pension Liabilities

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The existence of unfunded pension liabilities will have a negative impact on the quality of the issuer's debt. Unfunded pension liabilities - money available is less than the amount required to pay projected pensions.

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Analyzing GO Bonds: Ability to Collect Taxes

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Attempts to limit a municipality's taxing power positively influence GO bonds, since projected revenues will service the already issued debt. A poor tax collection record may be a red flag indicating an inefficient local government, resulting in bonds with low credit ratings.

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Analyzing GO Bonds: Other Considerations

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Litigation can negatively affect the community's ability to pay the debt service on outstanding bonds and is a relevant factor to consider. The receipt of non tax revenues such as federal payments for education may well enhance the community's ability to pay the required debt service. Tracking trends in real estate valuation provides a good indication of community's health Analysts concentrate more on the market value of real estate as opposed to the assessed value.

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Analyzing GO Bonds: The Debt Statement

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Direct Debt- all the debt (bonds/notes) issued by the municipality Net Direct Debt- Direct debt minus any self supporting debt, such as revenue issues and note issues. Net direct debt is the only GO debt Overlapping Debt- Debt of a political entity, such as a country or school district, where its tax base overlaps the tax base of another political entity Total bonded debt- Sum of both long term and short term debt of a municipality plus its applicable share of overlapping debt. Usually, analyst will use the ratio of net direct debt plus overlapping debt to assessed value or to population (Debt per capita) Might also use the ratio of annual debt service to tax and other income (high ratio would indicate decreasing margin of satefy to repay P&I)

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Revenue Bonds

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Issued for either projects or enterprise financings in which a bond issuer pledges to bondholders the revenues generated by the financed project. Can be used to finance airports, water/sewer systems, bridges, turnpikes, hospitals, etc. Concessions, tolls, and user fees associated with the use of these facilities are used to make P&I payments on the bond. Considered riskier than GO bonds Another source of revenue could originate though rental or lease payments. Can be issued when voter approval for GO bonds cannot be obtained. Can also be used to finance capital projects when statutory or constitutional debt limitations prevent a muni from issuing GO bonds

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Housing Revenue Bonds

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Issued by state or local housing finance agencies to help fund single family or multifamily housing, normally for low or moderate income families.

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Dormitory Bonds

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Issued to build housing for students at public universities

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Health Care Revenue Bonds

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Used for the construction of nonprofit hospitals and health care facilitiles

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Utility Revenue Bonds

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Used to finance gas, water/sewer, and electric power systems owned by a governmental unit

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Transportation Bonds

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Used to finance such projects as bridges, tunnels, toll roads, airports, and transit systems

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Special tax bonds

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Payable only from the proceeds of a special tax

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Special Assessment Bonds

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Payable only from an assessment on those who directly benefit from the facilities

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Moral Obligation Bonds

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secured by the revenues of a project, but if revenues are not sufficient to pay debt service requirements, state is morally obligated to provide the funds needed.

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Education Bonds

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Secured by the repayment of loans by students, money contained in the fund established by the bond's indenture, and insurance payments made but he state or federal government

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Lease Rental Bonds

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Involve one municipal entity leasing a facility from another.

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Certificates of Participation (COPs)

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Type of lease financing agreement, usually issued int he form o fa tax empt of municipal revenue bond. Used as a method of monetizing existing surplus real estate

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Industrial Development Revenue (IDR) and Pollution Control Revenue (PCR)

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Used by a municipality and are secured by a lease agreement with a corporation. Issued to build a facility for a private company.

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Private Activity Bonds, also called AMT Bonds

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classified as such if 10% or more of the bond proceeds will be used to finance a project that will be used by a private entity and if 10% or more of the bond proceeds will be secured by property used in the private entity's business Interest on a private activity bond is subject to the AMT AMT requires that a taxpayer make adjustments to his income, including interest on private activity municipal bonds, where the proceeds of municipal offerings benefit or finance a facility for use by a private business (MUST DISCLOSE). LEAST suitable for client subject to the AMT.

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Taxable Municipal Bonds

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May be be able to issue bonds that are exempt from federal income tax. May occur if the use of the proceeds doe snot meet federal tax law requirements. Have higher yields and may be suitable for taxable investors such as pension funds and foreign investors

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Build America Bonds (BABs)

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Issued under the American Recovery and Reinvestment Act of 2009. They are designed to assist municipal issuers in raising funds for certain infrastructure projects Interest on these bonds is taxable, but the Treasury offers a tax incentive to either the issuer or the bondholder depending on whether the bond is a direct pay or tax credit bond. BDs involved with the underwriting of these bonds must provide official statements, and all sales activities must be supervised by a municipal securities principal.

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Double Barreled Bonds

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Backed by a specific revenue source (other than prop taxes) as well as the full faith and credit of an issuer that has taxing powers

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Advance-Refunded Municipal Bonds

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Outstanding obligations that have been collateralized by US government securities. Will usually be paid off on their next call date

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Escrowed to Maturity Bonds

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Secured in the same manner as refunded bonds, but they do not have a call feature. Remain outstanding until their maturity.

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Parity Bonds

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Exists when two or more issues of revenue bonds are backed by the same pledged revenues.

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Analyzing Revenue Bonds

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One of the most important factors to consider when analyzing revenue issues is the comparison of the money collected from uses of a facility to the amount of debt service due. Investors must also analyze the issue to see if there are any competitive projects that may cut into the CF of the financed project

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Debt Service Coverage

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Operating and maintenance expense are first deducted form the gross project revenues before being applied to debar service. Gross revenue- means that bondholders are paid prior to operating and maintenance expenses. Ratio of net revenue to debt service is known as the debt service coverage ratio. One of the most important factors in analyzing a revenue issue. TO FIND NET REVENUE: Subtract operating and maintenance expenses form the gross revenue. TO FIND DEBT SERVICE COV RATIO: Divide net revenue by debt service

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Trust Indenture Covenants

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The indenture includes a variety of provision that establish the issuer's responsibility and the bondholders' rights.

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Rate Covenant

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Issuer pledges to maintain rates at a level sufficient to meet operation and maintenance costs, debt service, and certain reserve funds

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Maintenance Covenant

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Issuer pledges to maintain the project in good working order

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Insurance Covenant

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Issuer pledges to carry insurance not the property

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Financial Reports and Audits

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An accounting firm will be retained to do an outside audit and the issuer pledges to maintain proper records. Avoids the possibility of misuse of funds.

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Issuance of Additional Bonds

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Closed End- no additional bonds that have an equal claim on the pledged revenue may be issued against the same security. Open End - additional bonds may be issued int he future for expansion of the project

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Nondiscrimination Covenant

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Issuing body pledges not to grant special rates to any person or group

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Insurance Covenant - Catastrophic Calls

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Issuing body pledges to maintain insurance sufficient to repay bondholders in the event the project is destroyed in a natural disaster. All bondholders would be repaid principal and accrued interest

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Flow of Funds

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Describes the priority for disbursing the revenues generated by the facility. To accomplish this, the indenture will establish accounts into which monies will be deposited. Revenues generated by the project fill each of the funds to a prescribed level and then flow to the next fund.

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Revenue Fund

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Account where all receipts and income are deposited and recorded

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Operating and Maintenance Fund

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Prorated amount is deposited to meet costs of operating and maintaing the project. Sometimes there are enough funds deposited to set up a reserve

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Debt Service (Bond Service) Fund

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Amounts are deposited that will be sufficient to pay semiannual interest and maturing principal

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Debt Service Reserve Fund

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Money is apportioned here after annual debt service is ensured. Fund safe tapped only if the debt service fund itself is insufficient to meet annual payments

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Reserve Maintenance Fund

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Money allocated to this fund to meet unexpected maintenance expenses

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Replacement an Renewal Fund

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Based on engineer's reports, obey is deposited in this fund to meet new equipment and repair costs

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Sinking Fund

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Money is accumulated to retire bonds prior to maturity Fund will receive money prior to the replacement fund Will retire a portin o the issue prior to maturity Issue will have an average life that is less than the stated maturity

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Surplus Fund

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Excess money will be placed int his fund and can be used in emergencies

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Construction Fund

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Money si allocated here for the use of future construction

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Gross Revenue vs Net Revenue Issues

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Net revenue- if net revenues are pledged toward paying debt service Gross revenue- gross revenues are pledged to pay debt service

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Municipal Notes

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Short term issues that are normally used to assist in financing a project or to help a muni manse its cash flow

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Tax Anticipation Notes

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Issued to finance current municipal operations in anticipation of future tax receipts from property taxes. Usually GO securities

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Revenue Anticipation Notes

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Issued for the same purpose as TANs except that the anticipated revenues are typically federal or state subsidies Usually GO securities

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Tax and Revenue Anticipation Notes

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Created when TANs and RANs are issued together.

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Bond Anticipation Notes

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Issued to obtain financing for projects that will eventually be financed through the sale of long-term bonds

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Grant Anticipation Notes

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Issued in expectation of receiving funds from the federal government

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Construction Loan Notes

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Issued by municipalities to provide funds for construction of a project agh will eventually be funded by a bond issue

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Rating for Municipal Notes

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Moody's has four rating categories for muni notes, known as MIG ratings -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 S&P has 3 categories -SP-1: Strong capacity to pay P & I -SP-2: Satisfactory capacity to pay P & I -SP-3: Speculative capacity to pay P & I

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Auction Rate Securities

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Securities with a variable interest or dividend rate that is set periodically though a single price or Dutch Auction process. Long-term securities that are marketed as short-term investments. There interest/dividend rate is reset at established intervals, usually 7,28, or 35 days All investors that are able to purchase the securities receive the same rate, referred to as the clearing rate.

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Types of Auction Orders: Hold Order

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May indicate to the auction dealer the amount of the security he wishes to continue to hold regardless of the clearing rate that is set by the auction. If a holder of securities does not place an order, the auction procedures generally provide that the holder will be considered to have elected to continue to hold the securities regardless of the clearing rate.

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Types of Auction Orders: Bid

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Prospective holder/owner may indicate to the auctions dealer that she wishes to acquire a specified amount of the security, at or above a desired interest or dividend rate. Current holder may indicate her desire to continue to hold only if the rate is set at or above a specified rate.

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Types of Auction Orders: Sell Order

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If a holder desires to sell a specified amount of the security in the auction without regard to the clearing rate that is set in the auction, they place a sell order with the auction dealer.

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Exposed for sale

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Total amount of securities that is subject of sell orders and roll at rate orders. If the quantity of bids is insufficient to meet the quantity that is exposed for sale, the auction is considered to have failed.

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Variable Rate Demand Obligations

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Long term security marketed as a short-term investment Will adjust its interest rate at specified intervals, allowing the owner to sell or put the security back to the issuer or a third party not he date that a new rate is established The investor will receive the par value plus accrued interest. Only VRDOs have a put feature that permits the holder to sell the securities back to the issuer or third party.

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Preference for Local Issues

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The primary benefit of purchasing a municipal security is that the interest is wholly or partially tax free to the investor If a state resident earns interest form an out of state municipal security, that interest is ually subject to state and local taxation

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Triple Tax Exempt Issues

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Bonds issued by a territory or possession of the US are not subject to federal, state, or local taxes

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Bank Qualified Issues

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Permitted to deduct 80% of the interest cost being paid to depositors on the funds used to purchase the bonds. Interset income on the bonds is tax-free.

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Treasury Arbitrage Restrictions

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Prohibit state and local governments from refinancing debt and placing the proceeds into an escrow fund that invests in Treasuries with yields above a certain rate.

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Bond Taxation

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SEE 11-16 Chart

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Who should buy Municipal Bonds?

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Investors in high tax bracket Not suitable for IRA, 401(k), pensions, or acts already receiving tax considerations

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Net Yield

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What a customer will get to keep after taxes TO FIND: Taxable Yield x (100% - Tax Bracket)

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Taxable Equivalent Yield

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Wants to calculate what he would need to earn on a taxable issue to earn an equivalent return TO FIND: Municipal Yield / (100% - Tax Bracket)

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Capital Gains and Losses on Municipal Issues

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If a capital asset is sold for less than its cost, the result is considered a capital loss. If a capital asset is sold for more than its cost, it is considered a capital gain. A capital gain resulting from the sale of redemptions of a muni bond is subject to tax

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Original Issue Discount Bonds

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Initially issued at a deep discount Appreciation in value is treated differently than in the case of a municipal bond purchased int he secondary market at a discount Discount on an OID must be accreted, meaning each year a portion of the disc out is treated as interest for tax purposeless and is added to the bondholder's cost basis Annual accretion is not taxable making these issues suitable for customers who do not wish to incur a tax liability

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OID Held to Maturity

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Since the accreted amount is treated as interest, this upward adjustment in the bond's value is tax-exempt

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OID Sold Prior to Maturity

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The cost basis reflecting the accretion is used to calculate gains or losses.

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Secondary Market Discount

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If a muni bond is purchased ta discount in the secondary market and held to maturity, there will be a taxable gain at maturity. The gain is reported as ordinary income.

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SMD Held to Maturity

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Accreted amount is treated as ordinary income and is taxable.

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SMD Sold Prior to Maturity

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The cost basis reflecting the accretion is used to calculate gains or losses

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Premium Bonds

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If a bond is purchased at a premium, the premium amount must be amortized each year. Means that the premium must be written off over the remaining life of the bond.

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Premium Bond Held to Maturity

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Amortized amount is subject rated from the bondholder's cost basis each year. Amortization on a muni bond is not tax deductible.

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Premium Bond Sold Prior to Maturity

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A premium bond's cost basis each year will be adjusted to reflect amortization. If the bond is sold prior to maturity, the adjusted cost basis is used to calculate gain or loss.

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Tax Swaps

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Some investors who hold municipal bonds that have decline in value wish to sell them to realize the loss, but do not wish to change the overall nature of their portfolio. In order to avoid the wash sale rule, investor must repurchase bonds that have material differences from the bonds sold at a loss. Relevant factors include the bond's issuer or coupon rate or maturity date. Swapping can be done for non tax reasons. Swap can be used to change a portfolio's maturity or to enhance its quality or yield.

Chapter 11: Municipal Debt Securities – Bond Types and Tax Treatments – Flashcards

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