MUNICIPAL SECURITIES, also known as MUNICIPALS and MUNIS, are state and local debt issues. Local issues may include those of cities, counties, or other local agencies and authorities. The proceeds from municipal securities are often directed toward financing specific public projects in the municipality or state for which the bond is issued. Such projects may include highways, environmental clean-up efforts, housing projects, or even sports stadiums.
Municipal securities offer a higher degree of security and safety to investors than do corporate bonds. Municipals also tend more to be held to maturity. They are not as susceptible to market fluctuations as stock, but their prices do fluctuate with changes in their risk characteristics or in interest rates.
TYPES OF MUNICIPAL SECURITIES
Municipalities issue the following three basic types of securities (listed in order from least risky to most risky):
General obligation bonds
Remember that all bonds are called FUNDED DEBT
MUNICIPAL NOTESare short-term securities issued in multiples of $1,000, although most are now issued to institutional investors (banks and insurance companies) in multiples of $1 million.
GENERAL OBLIGATION BONDS, or GO BONDS, are long-term debt securities backed by the taxing power of the entity issuing the bond. GO bonds are also issued in multiples of $1,000.
REVENUE BONDSare long-term debt securities issued to generate funds to build public projects. Revenue bonds are backed only by the revenues earned from the facility that was built with the proceeds gained from the bond issue. Revenue bonds are issued in multiples of $1,000.
When a local agency is in need of short-term financing, it can issue short-term notes, called MUNICIPAL NOTES. Municipal notes are the least risky of municipal securities because their time to maturity is short. Thus, there is lower risk of the municipality defaulting on the interest and/or principal
Five different types of municipal notes can be issued, depending on the needs of the issuing entity. They are:
•Construction Loan Notes (CLNs) or Project Notes (PNs) — issued to start a housing project in a low-income area of a city. These can be known as either a CLN or a PN.
•Tax Anticipation Notes (TANs) — issued in anticipation of incoming taxes
•Revenue Anticipation Notes (RANs)— issued in anticipation of revenues from a specific project
•Bond Anticipation Notes (BANs) — issued in anticipation of the proceeds from a bond issue
•Grant Anticipation Notes (GANs) — issued in anticipation of receiving money from a grant to the municipality
CLNs, formerly called PNs
Are issued for the purchase and construction of property for new, low-income housing projects. They are also issued for the renewal of existing projects or the building of urban housing. They are nothing more than a “construction loan” to get a housing project started. Although municipalities issue the project notes, they are actually backed by the U.S. government. This is because when the project is complete, the Public Housing Authority (PHA), a government agency, issues a PHA BOND, whose proceeds will be used to pay off the construction loan note/project note.
•CLNs are the SAFEST of all municipal securities because they are paid from the proceeds of public housing authority bonds.
•CLNs can be issued for up to three years duration, and usually have very low interest rates due to being tax-free. They are short term, issued at a discount, with the appreciation tax-free.
•The rates for CLNs are the LOWEST RATES for debt securities since they are short-term, tax-free, and BACKED by a U.S. government agency.
TAX ANTICIPATION NOTES (TANs)
Are issued by a local agency of a municipality to generate temporary money to finance current expenses until taxes are collected. Tax anticipation notes are issued with the understanding that the agency will receive tax revenue in the near future. Example: School districts often use tax anticipation notes because their budgets usually run from July 1 to June 30, yet they do not receive any tax money until the following December when tax payments are due.
Interest payments received on tax anticipation notes are always exemptfrom federal income tax, and are usually exemptfrom local and state income tax as well.
REVENUE ANTICIPATION NOTES (RANs)
Are issued by municipalities anticipating the receipt of future revenues.
These anticipated revenues are in the form of money that will be coming in from the use of a facility.The facility has not brought in sufficient revenues, but they are anticipated to increase in the near term. By issuing revenue anticipation notes, the municipality obtains money to continue operating the facility, with the knowledge that much of their needed revenues will be received shortly from the users. Interest payments received on revenue anticipation notes are always exemptfrom federal income tax, and are usually exemptfrom local and state income tax as well.
BOND ANTICIPATION NOTES (BANs)
Are issued by a municipality in anticipation of the issuance of a bond that has been passed for some project in the community.
The issuance of these notes allow the project to get started while waiting for the receipt of the funds from the new bond issue.
Since the bonds to be issued are the only source of income to build the project, the bond anticipation notes are only as good as the municipality’s ability to issue and sell those bonds. Therefore, the bond anticipation note is considered the LEAST SECURE of the municipal notes.
Interest payments received on a bond anticipation note are exemptfrom federal income tax and are usually exemptfrom state and local taxes in the state in which they are issued. Interest paymentsreceived on the bond that will be issued to pay the bond anticipation note are also exempt from federal income tax and are usually exemptfrom state and local taxes in the state in which they are issued.
GRANT ANTICIPATION NOTES (GANs)
Are issued by a municipality for a project that is being funded by a grant.
Usually, the grant is by the U.S. government or the state government, but it can also be by a private entity that bestows grants for projects that will benefit a community or other public service. When a grant has been bestowed on a city or county for a project, it requires the project to be finished, or at least in the finishing stages, BEFORE the money will be forthcoming. With the issuance of the GANs, the project can be built. When paid, the grant money then pays off the GAN, and the investors are paid their principal and interest.
Keep in mind that with TANs, RANs, BANs, and GANs
Their interest payments are usually exempt from state and local taxes in the state in which they are issued. HOWEVER, if they are purchased by investors outside of the state of issue, their interest payments aresubject to state taxes like any other municipal security
MIG ratings measure the risk of an issuer defaulting on the payments of interest and principal for a municipal note, such as BAN, GAN, TAN, or RAN. CLNs or PNs are not rated since they are backed by the issuance of a government-housing bond.
MIG stands for MOODY’S INVESTMENT GRADE. This is a system developed by Moody’s Rating Service for rating municipal notes. There are four ratings: MIG 1, MIG 2, MIG 3, MIG 4, with MIG 1 being the highest (best) rating and MIG 4 being the lowest (worst) rating.
All of the following are short-term municipal notes, except:
(A) Banker’s acceptances. Banker’s acceptances are not short-term municipal notes. Project notes, revenue anticipation notes, and tax anticipation notes are all short-term municipal notes. Banker’s acceptances are corporate short-term securities. All of the other notes listed are municipal notes.
GENERAL OBLIGATION BONDS
GENERAL OBLIGATION BONDS (GO Bonds) are municipal bonds that are backed by the "full faith and credit" of the issuer. Principal and interest payments are paid from the tax revenue generated by the issuing state or municipal entity.
GO bonds have a LOWER RISK of default than do revenue bonds; THEREFORE, they usually have lower yields and higher ratings than revenue bonds.
There is a limit on the tax rate a municipality is allowed to charge on assessed property. This limit is set either by voter referendum or by a statutory provision in the charter of the municipality. If the municipality wants to issue any debt (bonds) that will cause it to exceed this debt limit, it must first have a vote of the people.
AD VALOREM TAXES
Taxes imposed to raise money for GO bonds are called AD VALOREM TAXES. "Ad valorem" refers to the "at value" or "assessed value" of the real estate property upon which the tax rate is based.
Most cities and counties have both residential and commercial buildings, and the ad valorem taxes from these properties go to pay the debt service on the bonds.
Municipalities raise most of their revenues from property taxes. Property tax amounts are expressed in MILS PER THOUSAND, where one mil is equal to 1/10th of one cent (or .001 dollars).
The ad valorem tax is computed either on the assessed valuation or on the total valuation, depending on the rules of the taxing entity
Example: AD VALOREM TAXES
If a tax of seven mils on property that is worth $8 million were based on a 25% assessment, the property would have an assessment value of $2 million for tax purposes. A tax of $14,000 (25% of $8 million × .007 for seven mils) would be imposed. Counties raise most of their money through ad valorem taxes. States raise most of their money through income taxes, sales taxes, license fees, and excise taxes. Most states do not impose ad valorem taxes.
LIMITED TAX BOND
Municipalities can also issue a LIMITED TAX BOND that is only backed by a special tax, not the full taxing power of the issuer.
A municipal GO bond is paid by all of the following, except:
(A) Ad valorem taxes
(B) Personal property taxes
(C) Delinquent ad valorem taxes
(D) Sales taxes
(D) Sales taxes. A municipal general obligation bond is not paid by sales taxes. Sales taxes are revenues, for revenue bonds, while ad valorem taxes
are real estate taxes, which pay for the general obligation bonds. Personal property taxes also go into the general obligation bond fund.
Are issued to obtain funds to construct bridges, tunnels, streets and infrastructure, rapid transit, harbors, and parks. Principal and interest for revenue bonds are paid from fees imposed on the users of the facility for which the bond was issued.
Property taxes are not used to pay for revenue bonds, with the exception of special assessment bonds, so a vote of the citizens is not required. In fact, there is no effect on the municipality, its revenues, its taxes and tax limits, or any other concern regarding the municipality. A revenue bond stands on its own.
A feasibility study is conducted before a revenue bond is issued to determine whether a project is necessary and whether it can pay for itself. In a specific municipality, a revenue bond is more risky than a GO bond and thus has a higher coupon because the only source of payments for principal and interest is the revenues of the facility.
Revenue bonds are classified according to the method by which revenue is generated to pay off them off. The classifications are:
•User-fee revenue bonds
•Tolls and fees bonds
•Special tax bonds
•Special assessment bonds
•Industrial development bonds (also known as IDBs and IDR bonds, for industrial development revenue bonds)
•Public housing authority bonds (PHA bonds)
•Moral obligation bonds
USER FEE REVENUE BONDS
Fees charged for water and sewer usage pay off USER FEE REVENUE BONDS
TOLLS AND FEES BONDS
Fees charged for the usage of highways, toll bridges, airports, and other projects pay off TOLLS AND FEES BONDS.
SPECIAL TAX BONDS
Are issued for specific purposes, such as building or renewing roads or rapid transit systems. Principal and interest is paid from the revenues generated from a special tax placed on certain items.
For example, a highway bond may be paid by a gasoline tax.
SPECIAL ASSESSMENT BONDS
Are issued to generate money either to purchase specific property or to construct facilities, such as infrastructure in new housing areas, for a specific group of users.
Special assessments are imposed only on certain people in the area. Special assessment rates stay the same even if property taxes or interest rates increase. This is because the assessment is based on the original amount needed, not including any cost increases due to inflation.
Example of Special Assessment Bonds:
A new housing area is built in a city. Special assessment bonds are issued to pay for new infrastructure (e.g., streets, sidewalks) in the new housing area. This assessment will be imposed only on people living in the new housing area (and not on the entire city as a tax would be).
INDUSTRIAL DEVELOPMENT BONDS (IDBs) or INDUSTRIAL DEVELOPMENT REVENUE BONDS (IDRs)
Are issued by a municipalityfor acorporation for financing construction of such projects as pollution control facilities, industrial parks, sports stadiums, airports, or educational facilities.
The municipality issues the bond to investors as a municipal bond, tax-exempt, and sells the proceeds of the bond to the corporation (usually for $1). The corporation is responsible for paying the interest and the principal. The revenues to pay for the bonds come from the company’s revenues. These bonds are issued for private use, such as for equipment purchases or the construction of buildings,but not for land. The bond receives municipal status, regarding tax-free interest, because the bond is issued for the "best interest of the populace."
In some cases, the corporation gets laws passed that allow the municipality to issue bonds with municipal status, but most often, the bonds are for stadiums, convention centers, and so forth, The municipality issues the bonds for the corporation, which make the payments. Since these bonds are an obligation of the corporation, they take on the ratings of the corporation and not the rating of the municipality under which the bonds are issued.
Are issued to generate funds to pay for a specific facility. A double-barreled bond is both a revenue bond and a general obligation bond. The bond’s interest and principal payment is first paid by the revenues generated by the users of the facility, and if those revenues are insufficient, the bond is subsequently secured by property taxes.
Accordingly, the bond is backed by an additional source of revenue, which usually includes the full taxing power of the municipality.
In many large cities, double-barreled bonds were issued to build football and/or baseball stadiums. These bonds were first backed by the revenues generated from the use of the stadium, and then backed by the taxes of the community, if such taxes were needed.
MORAL OBLIGATION BONDS
Are paid from revenues of a facility, which is built by money from the bonds. These bonds pay for facilities that are needed in a community, state, or other district.
The revenues generated from the facilities are expectedto be sufficient to make all bond interest and principal payments.
If there are not enough revenues from the facility to pay the debt service, the local council (or state legislature) can make an annual appropriation to have the debt service covered.
If the local taxing body does not have the money or does not consider the facility a necessity, the issue’s debt service would not be paid at that time.
Which of the following bonds is issued by a municipality but will have interest and principal payments paid by the revenues from a corporation?
(A) Special assessment bond
(B) School district bond
(C) Bridge district bond
(D) Industrial development revenue bond
(D) Industrial development revenue bond. A municipality issues an industrial development revenue bond for a corporation for the benefit of the municipality. The income the company earns is used to make the bond’s interest and principal payments, so the bond assumes the corporation’s credit ratings instead of the municipality’s credit rating.
BUILD AMERICA BONDS BABS
Build America Bonds, also known as BABs, are issued by municipalities. However, the interest paid is subsidized by the U.S. government.
Two types of BABs are available — the first version and the second version. Both versions have been oversubscribed at the offerings (more purchasers than bonds available).
•Since institutional investors are not limited to the amount they can purchase (as in most municipal bond offerings), the only way that an individual investor can get them is in the secondary market.
•The BABs are presently being issued with maturities of 30 years.
In the first BAB version, the government subsidizes 35% of the interest that the municipality pays for the bond issue.
•This lowers the cost of the bonds to the municipality, allowing for higher interest rates.
•The higher interest rates make this version more desirablefor those purchasers who do not pay income tax, or who pay only a small amount of income tax, and want a long source of steady income.
•These investors are typically older people looking for income and institutional investors not necessarily looking for tax-free income, but wanting the highest yielding issues they can find with a long period to maturity.
In the second BAB version, the buyers/holders of the bonds receive a tax credit equal to 35% of the interest on the bond each year.
•However, if the investor’s tax liability is not sufficient enough to use the tax credit, it may be carried over to future years with no time limit
BABs are susceptible to a variety of risks. In mid-2010, the bonds were trading at a premium in the secondary market; however, this could change with fluctuating interest rates and/or with the solvency of the municipality or availability of the government to keep on funding the issues.
The greatest risk is liquidity, since there is not a large secondary market for them at the present time (third quarter of 2010) and the market has already been saturated.
• Their long period to maturity also makes them less desirable to those unwilling to commit to a 30-year investment.
The long maturities pose yet another risk — the solvency of the municipality that is issuing the bonds.
-In 30 years, the municipality could be bankrupt.
The interest on the bonds is subject to Federal income tax, since the bonds are subsidized by the U.S. government.
The money being raised by the issuers is for capital expenditures such as upgrading buildings, highways, and other infrastructures.
The money cannot be used for wages or other ongoing expenses.
SERIES BONDS, SERIAL BONDS, & TERM BONDS
All municipal bonds are either a SERIAL BOND or a TERM BOND. All notes and bonds canbe a series bond or a series note, but they are not required to be a series bond. Be familiar with the following three descriptions of bonds:
It is important to remember the differences between these three descriptions!
SERIES BONDS are issued at different times, either at different dates within one yearordifferent dates over a period of years. A series bonds can have one common maturity, the term, or each series bond can have its own serial maturity period.
Series bonds can be issued as serial bonds or as term bonds, or they can even be issued as serial bonds with a term bond at the end. Most municipalities have numerous issues outstanding, and each is considered a series bond since they were issued on different dates.
Example: Series Bonds
In January 2001, San Francisco issued Series 2001-A, a $20 million serial bond maturing in 2016, for eliminating the cancer-causing soundproof ceilings found in most of its schools.
In March 2001, San Francisco issued Series 2001-B, a $15 million term bond maturing in 2007, for improvement of the infrastructure in its business district, as well as the final part of the Embarcadero project.
In July 2001, San Francisco issued Series 2001-C, a $52 million serial and term bond with final maturity in 2031, for updating the city’s swimming pools and parks.
These are all series bonds.
SERIAL BONDS mature over a number of years and can be easily confused with SERIES BONDS. When a bond is issued so that parts of the bond MATURE in different years, the bond is called a serial bond. It can be a series bond, or it could be the only bond issued by that municipality. Most municipalities issue their bonds in serial form.
The various maturities in a serial bond issue have different prices, expressed not in dollar amounts, but in basis form. This means the price is given as a yield.
Either a BASIS BOOK or a software program is then used to change yields to dollars, or if dollars are given, change dollars to yields. Note: The test previously used questions right out of the basis book, but now only asks questions about the basis book itself. Therefore, simply remember it is used for this conversion.
It is also important to note that since a serial bond has an amount of principal mature each year, the interest cost to the issuer decreases each year.
Serial bonds are issued so the municipality has money coming in over a period of time, either from taxes or from revenues from a facility.
Example of Serial Bonds
In January 2001, San Francisco issued series 2001-A, a $20 million school bond that had $500,000 of the bond mature on March 1 each year in 2002, 2003, 2004, and 2005. Then $1 million would mature on March 1 in each year from 2006 through 2012. Then, $2 million will come due on March 1 in 2013 through 2015, with $5 million due in 2016, the final year. The interest for each maturity year increased from 5.2% up to 6.5%. This is an example of a series bond, 2001-A, which had serial maturities.
Issued by corporations and municipalities, all mature at one time. By having the whole issued bond come due on one date, corporations can either refund (refinance) the bond or they can anticipate having the money to pay it off. Municipalities, on the other hand, tend to issue term bonds only when they do not anticipate having funds available in the early years and but do anticipate having the funds by the time the issue matures. Since they do not have a large amount of funds in the early years, the municipality issues the bond as a term bond. If there would be ample funds in the early years, the municipality would prefer to issue the bond as a serial bond to reduce interest costs.
Please note that REFUNDING THE BOND is when one bond is issued to pay off another bond, commonly referred to as refinancing.
-It is called refunding the bond because the municipality has funded the debt over again, or “refunded” its debt.
-This is done only if the issuer can reduce its interest cost.
Example Term Bond
The 2001-B San Francisco bond discussed above was a term bond with a 6% coupon rate for the whole bond.
The 2001-C San Francisco bond was a 30-year bond, where $27 million of the $52 million is spread out, and part of it comes due each year until 2021, and then a $10 million term bond comes due in 2026, and a $15 million term bond in 2031. Each maturity year had a different interest rate, starting at 5.10% and increasing to 6.25%.
Which of the following bonds has decreasing interest costs each year?
(A) Serial bonds
(B) Term bonds
(C) Series bonds
(D) Zero bonds
(A) Serial bonds. Serial bonds have part of the issue mature each year. Therefore, fewer and fewer bonds are outstanding each year, so there is less interest cost to the issuer with each passing year. Series bonds have different issuing dates. Term bonds all mature at one time so the interest cost is the same each year. Zero-coupon bonds pay no interest and simply mature at face value.
For any of the previously mentioned notes or bonds the issuer can add a PUT FEATURE that is beneficial to the investor. (Note terms are normally too short to take advantage of a put feature.)
PUT BONDS can be redeemed prior to maturity without being called by the issuer. This is a good feature for investors when interest rates rise, because they can redeem the bonds and then reinvest the money in higher-interest bonds.
Issuers add the put feature to bonds so they can issue them with lower interest rates. There is a limited time period during which the investor can put the bond to the issuer.
•During this PUT PERIOD, the market price of the bonds is never below the PUT price, so the YIELD never exceeds the coupon.
A municipality has issued a 6%, 20-year term bond that has a put feature. Which of the following is true of the put bond during the put period?
(A) The yield will never be lower than 6%.
(B) The yield will never be higher than 6%.
(C) The yield will never be equal to 6%.
(D) The bond will never be called.
(B) The yield will never be higher than 6%. Since a put bond allows the holder to put the bond back to the issuer (in other words, redeem it without the issuer calling it), the bond never sells for less than par. If the bond were selling at discount during the put period, the holder could force the issuer to buy the bond back at par. Since the bond will never be selling for less than par, the yield will never be greater than the coupon, which in this case is 6%.
TYPES OF BOND OWNERSHIP
In the past, municipal bonds have been purchased in any one of three forms of ownership. Within a few years, however, only one predominant form of ownership may be available — book-entry (much like how the U.S. government issues bonds). This is due to the high cost of lost and stolen bonds. However, be familiar with the three forms of ownership for municipal bonds for the exam:
All three forms of ownership for municipal bonds are issued in increments of $5,000, although the minimum denomination is $1,000.
BEARER BONDS (also known as COUPON BONDS) are owned by the person who holds (or bears) them. With bearer bonds, possession is 100% of the law. Owners of bearer bonds do not have their names registered on the books of the issuer. The holder of the bond is thus the
owner. As of January 1, 1983, bearer bonds could no longer be issued. However, some are still in the marketplace, and the occasional question on bearer bonds may appear on your exam. The owner collects interest by cutting off the interest coupons and presenting them to a bank. The owner collects the principal by presenting the bond on or after the maturity date at one of the paying banks. Bearer bonds used to be issued in $1,000 or $5,000 increments. They were most commonly issued in $5,000 increments. If the exam asks for the minimum denomination for a bearer bond, the answer is $1,000.
With REGISTERED BONDS, the owner is registered with the issuer. All interest payments are sent to the person whose name is registered with the company.
Registered bonds are issued in denominations of $5,000 with increments of $5,000. They are most commonly issued in $5,000 denominations. However, if the test asks for the minimum denomination of registered bonds, the answer is $1,000.
BOOK-ENTRY BONDSare bonds whose ownership is registered in electronic form by the issuer or, more often, by the trustee on behalf of the issuer. In these cases, the issuer makes all principal and interest payments to the bondholders via the trustee. The actual owner of the bond never sees a certificate. Book-entry bonds are most commonly sold in denominations of $5,000 with increments of $5,000. However, the minimum denomination may be as high as $100,000 for some issues.
The good part about book-entry bonds is that they can never be lost. The bad thing is that investors must keep their confirmation slip to show they have ownership. Some people dislike this form of ownership, because they feel that the broker/dealers may sell the bonds without informing them or that someone could electronically steal the bonds. Some investors simply prefer the feel of the certificate in their hands.
Since 1983, any newly issued bonds must be in fully registered or book-entry form only, with most using the book-entry form of ownership. The Municipal Securities Rulemaking Board (MSRB) rules have changed and now require that, "For good delivery, all bonds must state if delivery of the bond will be in book-entry form." The type of delivery need not be given if the bonds are in bearer or registered form.
However, because of the number of bonds and the amount of money lost over time, soon only one method of ownership will be available: Book-entry. All U.S. government T-bills, T-bonds, and T-notes are already issued exclusively in book-entry form.
Example Book Entry Bonds
The City of New York issues a $20 million bond. The city does so by issuing one $20-million certificate to a trustee. The underwriter then sells $20 million in bonds to a large number of investors. Once the entire $20 million is sold, the names of the investors are given to the trustee, who then distributes interest and principal on the bonds when due. When investors sell their bonds, the names of the new owners are sent to the trustee to replace the names of the old owners. The new owners now receive interest and principal when due.
Which of the following describes a book-entry bond?
(A) The owners of the bonds are on the books of the trustee, but they have no certificate to show for the bonds.
(B) The owners of the bonds are on the books of the trustee, but they have a certificate to show for the bonds.
(C) The owners of the bonds have entered the bonds on their books, and they have a certificate to show for the bonds.
(D) There are no records to show who owns the bonds; as owners buy the bonds, they enter their name into the books of the issuer and show their certificate.
Answer (A) The owners of the bonds are on the books of the trustee, but they have no certificate to show for the bonds. This is the definition of book-entry, which is how T-bills have always been issued. In 2000, more than 90% of all bonds were issued in book-entry form.