copyright © 2010 pearson education, inc. publishing as prentice hall 8-1 chapter 8 municipal...

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-1

Chapter 8

Municipal

Securities


Learning ObjectivesAfter reading this chapter, you will understand the two basic security structures: tax-backed debt and revenue bonds the flow of funds structure for revenue bonds municipal bonds with hybrid structures and special bond security structures such as refunded bonds and insured municipal bonds the different types of tax-exempt short-term municipal securities what municipal derivative securities are


Learning Objectives (continued)

After reading this chapter, you will understand the two basic security structures: tax-backed debt and revenue bonds how municipal inverse floaters are created the tax risk that investors face when investing in municipal securities yield spreads within the municipal market the shape of the municipal yield curve the primary and secondary markets for municipal securities the taxable municipal bond market


Types and Features of Municipal Securities

There are basically two different types of municipal bond security structures:

i. tax-backed bonds

ii. revenue bonds There are also securities that share

characteristics of both tax-backed and revenue bonds.


Types and Features of Municipal Securities (continued)

Tax-Backed Debt Tax-backed debt obligations are instruments issued

by states, counties, special districts, cities, towns, and school districts that are secured by some form of tax revenue.

Tax-backed debt includes general obligation debt, appropriation-backed obligations, and debt obligations supported by public credit enhancement programs.



Tax-Backed Debt The broadest type of tax-backed debt is general

obligation debt. An unlimited tax general obligation debt is the

stronger form of general obligation pledge as it is secured by the issuer’s unlimited taxing power.

A limited tax general obligation debt is a limited tax pledge because for such debt there is a statutory limit on tax rates that the issuer may levy to service the debt.



Tax-Backed Debt Agencies or authorities of several states have

issued bonds that carry a potential state liability for making up shortfalls in the issuing entity’s obligation.

However, the state’s pledge is not binding. Debt obligations with this nonbinding pledge of

tax revenue are called moral obligation bonds.



Revenue Bonds The second basic type of security structure is found in a

revenue bond. Such bonds are issued for either project or enterprise

financings in which the bond issuers pledge to the bondholders the revenues generated by the operating projects financed.

For a revenue bond, the revenue of the enterprise is pledged to service the debt of the issue.

The details of how revenue received by the enterprise will be disbursed are set forth in the trust indenture.



Revenue Bonds There are various restrictive covenants included in the trust

indenture for a revenue bond to protect the bondholders. A rate, or user charge, covenant dictates how charges will be

set on the product or service sold by the enterprise. Other covenants specify thati. the facility may not be soldii. the amount of insurance to be maintainediii. requirements for recordkeeping and for the auditing of the

enterprise’s financial statements by an independent accounting firmiv. requirements for maintaining the facilities in good order



Revenue Bonds Examples of revenue bonds include:i. Airport Revenue Bondsii. Higher Education Bondsiii. Hospital Revenue Bondsiv. Single-Family Mortgage Revenue Bondsv. Multifamily Revenue Bondsvi. Public Power Revenue Bondsvii. Resource Recovery Revenue Bondsviii.Student Loan Revenue Bondsix. Toll Road and Gas Tax Revenue Bondsx. Water Revenue Bondsxi. Pollution Control Revenue and Industrial Development

Revenue Bonds



Hybrid and Special Bond Securities Some municipal bonds that have the basic

characteristics of general obligation bonds and revenue bonds have more issue-specific structures as well.

Some examples arei. insured bondsii. bank-backed municipal bondsiii. refunded bonds structured/asset-backed securitiesiv. “troubled city” bailout bonds



Hybrid and Special Bond Securities Insured bonds, in addition to being secured by the issuer’s

revenue, are also backed by insurance policies written by commercial insurance companies.

Because municipal bond insurance reduces credit risk for the investor, the marketability of certain municipal bonds can be greatly expanded.

There are two major groups of municipal bond insurers.i. The first includes the monoline companies that are primarily in the

business of insuring municipal bonds.ii. The second group of municipal bond insurers includes the multiline

property and casualty companies that usually have a wide base of business, including insurance for fires, collisions, hurricanes, and health problems.



Hybrid and Special Bond Securities Since the 1980s, municipal obligations have been increasingly

supported by various types of credit facilities provided by commercial banks.

There are three basic types of bank support: letter of credit, irrevocable line of credit, and revolving line of credit.

i. A letter-of-credit agreement is the strongest type of support available from a commercial bank.

Under this arrangement, the bank is required to advance funds to the trustee if a default has occurred.

i. An irrevocable line of credit is not a guarantee of the bond issue, although it does provide a level of security.

ii. A revolving line of credit is a liquidity-type credit facility that provides a source of liquidity for payment of maturing debt in the event that no other funds of the issuer are currently available.



Hybrid and Special Bond Securities Although originally issued as either revenue or general obligation

bonds, municipals are sometimes refunded. A refunding usually occurs when the original bonds are escrowed

or collateralized by direct obligations guaranteed by the U.S. government.

The escrow fund for a refunded municipal bond can be structured so that the refunded bonds are to be called at the first possible call date or a subsequent call date established in the original bond indenture.

Such bonds are known as prerefunded municipal bonds. Although refunded bonds are usually retired at their first or

subsequent call date, some are structured to match the debt obligation to the retirement date.

Such bonds are known as escrowed-to-maturity bonds.



Hybrid and Special Bond Securities There are three reasons why a municipal issuer may

refund an issue by creating an escrow fund.i. Many refunded issues were originally issued as revenue

bonds.ii. Some issues are refunded in order to alter the maturity

schedule of the obligation.iii. When interest rates have declined after a municipal security

has been issued, there is a tax arbitrage opportunity available to the issuer by paying existing bondholders a lower interest rate and using the proceeds to create a portfolio of U.S. government securities paying a higher interest rate.



Redemption Features Municipal bonds are issued with one of two debt

retirement structures, or a combination. Either a bond has a serial maturity structure or it has a

term maturity structure. A serial maturity structure requires a portion of the debt

obligation to be retired each year. A term maturity structure provides for the debt obligation

to be repaid on a final date. Municipal bonds may be called prior to the stated

maturity date, either according to a mandatory sinking fund or at the option of the issuer.



Redemption Features The municipal market has securities with various features. These are zero-coupon bonds, floating-rate bonds, and putable bonds

in the municipal bond market. For this market, there are two types of zero-coupon bonds.i. One type is issued at a very deep discount and matures at par.o The difference between the par value and the purchase price represents a

predetermined compound yield.o These zero-coupon bonds are similar to those issued in the taxable bond

market for Treasuries and corporates.ii. The second type is called a municipal multiplier.o This is a bond issued at par that has interest payments.o The interest payments are not distributed to the holder of the bond until

maturity, but the issuer agrees to reinvest the undistributed interest payments at the bond’s yield to maturity when it was issued.


Municipal Money Market Products

Tax-exempt money market products include:

i. notes

ii. commercial paper

iii.variable-rate demand obligations

iv.a hybrid of the last two products


Municipal Money Market Products (continued)

Municipal notes include tax anticipation notes (TANs), revenue anticipation notes (RANs), grant anticipation notes (GANs), and bond anticipation notes (BANs).

These are temporary borrowings by states, local governments, and special jurisdictions.

Usually, notes are issued for a period of 12 months, although it is not uncommon for notes to be issued for periods as short as three months and for as long as three years.

TANs and RANs (also known as TRANs) are issued in anticipation of the collection of taxes or other expected revenues.

These are borrowings to even out irregular flows into the treasuries of the issuing entity.

BANs are issued in anticipation of the sale of long-term bonds.



Tax-Exempt Commercial Paper As with commercial paper issued by corporations, tax-exempt

commercial paper is used by municipalities to raise funds on a short-term basis ranging from one to 270 days.

The dealer sets interest rates for various maturity dates and the investor then selects the desired date.

Variable-Rate Demand Obligations Variable-rate demand obligations (VRDOs) are floating-rate

obligations that have a nominal long-term maturity but have a coupon rate that is reset either daily or every seven days.

The investor has an option to put the issue back to the trustee at any time with seven days’ notice.

The put price is par plus accrued interest.



Commercial Paper / VRDO Hybrid The commercial paper/VRDO hybrid is customized to

meet the cash flow needs of an investor. As with tax-exempt commercial paper, there is

flexibility in structuring the maturity, because the remarketing agent establishes interest rates for a range of maturities.

Although the instrument may have a long nominal maturity, there is a put provision, as with a VRDO.


Municipal Derivative Securities (continued)

In recent years, a number of municipal products have been created from the basic fixed-rate municipal bond.

This has been done by splitting up cash flows of newly issued bonds as well as bonds existing in the secondary markets.

These products have been created by dividing the coupon interest payments and principal payments into two or more bond classes, or tranches.

The name derivative securities have been attributed to these bond classes because they derive their value from the underlying fixed-rate municipal bond.



Floaters / Inverse Floaters A common type of derivative security is one in which two classes

of securities, a floating-rate security and an inverse-floating-rate bond, are created from a fixed-rate bond.

The coupon rate on the floating-rate security is reset based on the results of a Dutch auction.

Inverse floaters can be created in one of three ways:i. A municipal dealer can buy in the secondary market a fixed-rate

municipal bond and place it in a trust with the trust issuing a floater and an inverse floater.

ii. As illustrated in Exhibit 8-1 (see Overhead 8-24), the municipal dealer uses a newly issued municipal bond to create a floater and an inverse floater.

iii. Using the municipal swaps market, one creates an inverse floater without the need to create a floater.


Exhibit 8-1Creation of a Municipal Inverse

Floater

Municipal floating-rate bond Municipal inverse-floating-rate

Fixed-rate municipal bond (newly issued or seasoned)



Strips and Partial Strips Municipal strip obligations are created when a municipal

bond’s cash flows are used to back zero-coupon instruments. The maturity value of each zero-coupon bond represents a cash

flow on the underlying security. Partial strips have also been created from cash bonds, which

are zero-coupon instruments to a particular date, such as a call date, and then converted into coupon paying instruments.

These are called convertibles or step-up bonds. Other products can be created by allocating the interest payments

and principal of a fixed-coupon-rate municipal bond to more than two bond classes.


Credit Risk Although municipal bonds at one time were considered

second in safety only to U.S. Treasury securities, today there are new concerns about their credit risks.

i. The first concern came out of the New York City billion-dollar financial crisis in 1975.

ii. The second reason for concern about municipal securities credit risk is the proliferation in this market of innovative financing techniques to secure new bond issues.

What distinguishes these newer bonds from the more traditional general obligation and revenue bonds is that there is no history of court decisions or other case law that firmly establishes the rights of the bondholders and the obligations of the issuers.


Credit Risk (continued)

As with corporate bonds, some institutional investors in the municipal bond market rely on their own in-house municipal credit analysts for determining the credit worthiness of a municipal issue.

Other investors rely on the nationally recognized rating companies.

The two leading rating companies are Moody’s and Standard & Poor’s, and the assigned rating system is essentially the same as that used for corporate bonds.

Although there are numerous security structures for revenue bonds, the underlying principle in rating is whether the project being financed will generate sufficient cash flow to satisfy the obligations due bondholders.


Risks Associated with Investing in Municipal Securities

The investor in municipal securities is exposed to the same risks affecting corporate bonds plus an additional one that may be labeled tax risk.

There are two types of tax risk to which tax-exempt municipal securities buyers are exposed.

i. The first is the risk that the federal income tax rate will be reduced.

ii. The second type of tax risk is that a municipal bond issued as a tax-exempt issue may eventually be declared to be taxable by the Internal Revenue Service.


Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Yields on Municipal Bonds A common yield measure used to compare the yield on a

tax-exempt municipal bond with a comparable taxable bond is the equivalent taxable yield, which is computed as:

Example: Suppose that an investor in the 40% marginal tax bracket is considering the acquisition of a tax-exempt municipal bond that offers a yield of 6.5%. What is the equivalent taxable yield? 6.5%/(1-40%)

1

tax-exemptequivalent taxable yield

marginal tax rate

0.065

0.1083 or 10.83%1 0.04

equivalent taxable yield

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-308-30

Yields on Municipal Bonds (continued)

Because of the tax-exempt feature of municipal bonds, the yield on municipal bonds is less than that on Treasuries with the same maturity. The yield on municipal bonds is compared to the yield on Treasury bonds with the same maturity by computing the following ratio:

Yield spreads within the municipal bond market are attributable to differences between credit ratings (quality spreads), sectors within markets (intramarket spreads), and differences between maturities (maturity spreads).

yield on municipal bondyield ratio

yield on same maturity Treasury bond


Municipal Bond Market Primary Market Municipal obligations are brought to market weekly. A state or local government can market its new issue by offering

bonds publicly to the investing community or by placing them privately with a small group of investors.

When a public offering is selected, the issue usually is underwritten by investment bankers and/or municipal bond departments of commercial banks.

Most states mandate that general obligation issues be marketed through competitive bidding, but generally this is not required for revenue bonds.

An official statement describing the issue and the issuer is prepared for new offerings.

Municipal bonds have legal opinions that are summarized in the official statement.


Municipal Bond Market (continued) Secondary Market Municipal bonds are traded in the over-the-counter

market supported by municipal bond dealers across the country.

Markets are maintained on smaller issuers (referred to as local general credits) by regional brokerage firms, local banks, and by some of the larger Wall Street firms.

Larger issuers (referred to as general names) are supported by the larger brokerage firms and banks, many of whom have investment banking relationships with these issuers.


Municipal Bond Market (continued) Secondary Market The convention for both corporate and Treasury bonds

is to quote prices as a percentage of par value with 100 equal to par.

Municipal bonds, however, generally are traded and quoted in terms of yield (yield to maturity or yield to call).

The price of the bond in this case is called a basis price.

The exception is certain long-maturity revenue bonds. A bond traded and quoted in dollar prices (actually, as

a percentage of par value) is called a dollar bond.


The Taxable Municipal Bond Market Taxable municipal bonds have their interest taxed at the federal level. Because there is no tax advantage, an issuer must offer a higher yield

than for another tax-exempt municipal bond. There are three reasons why a municipality would want to issue a

taxable municipal bond and thereby have to pay a higher yield than if it issued a tax-exempt municipal bond:

i. Some activities do not benefit the public at large and municipalities have to finance these restricted activities in the taxable bond market.

ii. The U.S. income tax code imposes restrictions on arbitrage opportunities that a municipality can realize from its financing activities.

iii. Municipalities do not view their potential investor base as solely U.S. investors.

When bonds are issued outside of the United States, the investor does not benefit from the tax-exempt feature.


The Taxable MunicipalBond Market (continued)

The most common types of activities for taxable municipal bonds used for financing are:

i. local sports facilities

ii. investor-led housing projects

iii.advanced refunding of issues that are not permitted to be refunded because the tax law prohibits such activity

iv.underfunded pension plan obligations of the municipality.


All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.

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