Municipal Securities

• -Federal govt does not generally tax interest payments (Doctrine of Reciprocal Immunity states that a level of govt can only tax the interest of its own issues)
• 1)Interest on Muni Bonds is largely exempt from taxation, but not capital gains
• 2)Muni Bonds issued by the state in which they live often receive a special tax exemption
• -Generally pay lower interest rates becuase of the tax-advantaged status
• -Most appropriate for investors in high tax brackets and are not suitable for investors in low tax brackets

• All principal matures at a single date in the future
• -Sinking funds may be established to accumulate funds to pay off term bonds at or before the established maturity date
• -Quoted by price (like corporate bonds) and are called dollar bonds

Bonds within an issue mature on different dates according to a predetermined schedule

Quoted on a basis of their yield to maturity to reflect the diff in maturity dates within one issue

Price/Yield = 100%, indicates that yield to maturity is = coupon rate (bond is being offered @ par)

Issuer pays part of a bond's maturity before the final maturity date, but the largest portion is paid off at maturity

• 1)Voter Approval reqd if an issue would put it above the statutory limit
• 2)Tax Limits
• 3)Limited Tax GO - bond secured by a specific tax (more risky)
• 4)Overlapping Debt - Bonds issued by different muni authorities that tap the same taxpayer wallets are known as coterminous debt
• *Coterminous debt only occurs in property taxing situations

Revenue bonds that have characteristics of GO Bonds

Interest and principal are paid from a specified facility's earnings, but are also backed by the taxing power of the state or muni

Although backed primarily by revenues from that facility, double-barreled bonds are rated and traded as GOs

Issued to construct facilities or purchase equipment, which is then leased to a corporation

Under the Tax Reform Act of 1986, the interst on these nonpublic purpose bonds may be taxable bc the act reserves tax exemption for public purposes

Under a typical lease-rental (or lease-back) bond arrangement, a muni issues bonds to finance office constructuion for itself or its state or community

Example: Bonds issued to raise money to construct a school, which is then leased to the district. Lease payments come from funds raised through special taxes or appropriations, or revenues (school tuition and fees), or from the munis general fund

Taxes other than Property - ie. tobacco, alcohol, fuel, etc.

Public imporovements such as streets, sidewalks, sewers - issuer asses a tax only on the properties that benefit from the improvement

Develop & Improve low-income housing - backed by the full faith and credit of the US Govt

Sometimes called PHAs (Public Housing Authority)

Most secure of all muni bonds bc of their backing, and have an AAA rating

If revenues or tax collections backing the bond are not sufficient to pay the debt service, the state legislature has the authority to appropriate funds to make payments

Makes the bond more marketable, but the state's obligation is not required by law

The only way bondholders can be repaid if the bond goes into default

The issuer's legislature would have to apportion money to satisfy the debt, but is not legally bound to do so

Usually have less than 12-month maturities, but may range from 3 months to 3 years

• 1)TANs - Tax Anticipation Notes
• 2)RANs - Revenue Anticipation Notes
• 3)TRANs - Tax & Revenue Anticipation Notes
• 4)BANs - Bond Anticipation Notes
• 5)Tax Exempt Commercial Paper (often used in place of BANs and TANs for up to 270 days, though maturities are most often 30,60, and 90 days
• 6)CLNs - Construction Loan Notes
• 7)Variable Rate Demand Notes - have a fluctuating interest rate and are usually issued with a put option
• 8)GANs - Grant Anticipation Notes
• 9)PNs - Project Notes - issued in anticipation of a later issuance of New or Public Housing Authority Bonds

Offers interst payments tied to the movements of another specified interest rate

Sometimes called reset bonds, price remains neare par at all times bc their coupon is usually reset to the market rate of interest every 6 months

Long Term variable rate bonds, tied to short-term interest rates

Long-term maturities of 20-30 years, interest rates are determined using a Dutch auction method at predetermined short-term intervals, typically 7,28, or 35 days

Uses a competitive bid process where the lowest bid rate at which all of the bonds can be sold at part is used to establish the new or "reset rate"

Any customers that bid above the clearing rate receive no bonds and those that bid at or below the clearing rate receive the bonds at that rate

Interst paid in the current period is based on the interst rate reset on the prior auction

State and Local Government Securities Series

Bonds are often pre-refunded well before a call date if interest rates have fallen - in order to comply with the complex arbitrage restrictions imposed by the IRS, the proceeds of muni pre-refunding are placed in an escrow account that immediately invests in SLGS (these are US govt securities issued directly by the Treasury to muni issuers only in connection with pre-refundings

Muni issuer enters into a bond contract with the underwriters of, and prospective investors in, its securities

Includes a bond resolution or trust indenture, applicable state and federal law, and other legal documents pertaining to that particular issue and issuer

The municipality authorizes the issue and sale of its securities through the bond resolution - the authorizing resolution contains a description of the issue

Underlying Trust Indenture = Protective Covenant

Not required by law, but makes the bond more marketable

Indenture includes a flow of funds statement establishing the priority of payments made from a facility's revenues

Must be signed by an officer of the issuer, and is the equivalent of the corporate prospectus

Identifies the issue's purpose, the source from which the interest and principal will be repaid, and the issuer's and community's financial and economic backgrounds, and info relating to the issue's creditworthiness

• Typically includes:
• 1)Offering Terms
• 2)Summary Statement
• 3)Purpose of Issue
• 4)Authorization of bonds
• 5)Security of bonds
• 6)Description of bonds
• 7)Description of issuer
• 8)Construction Program
• 9)Project Feasability Statement
• 10)Regulatory Matters
• 11)Specific provisions of the indenture or resolution
• 12)Legal Proceedings
• 13)Tax Status
• 14)Appropriate appendixes, including consultant reports, legal opinion, and financial statements
• 15)Credit Enhancements

Includes most of the same information from the Official Statement, but excludes the issue's interest rate and noffering price

Determines interest in the issue

After the issuer meets with its attorneys and accountants to analyze each bid, it awards the muni bond issue to the syndicate that offers to underwrite the bonds at the lowest net interest cost (NIC) or true interest cost (TIC) to the issuer

Issuer then returns the good faith deposits to the syndicates not chosen

Difference between the winning bid and the next best bid is called the cover

Combines the amount of proceeds the issuer receives with the total coupon interest it pays

Provides the same type of cost comparison as Net Interest Cost, but is adjusted for the time value of money

TIC Weights early interest payments more heavily to give greater value to dollars of today over dollars to be paid in the future, consistent with present value calculations

The price at which the bonds are sold to the public

Syndicate's compensation for underwriting the new issue

Difference between the price the syndicate pays the issuer and the reoffering price

Each participant in the syndicate is entitled to a portion of the spread, depending on the role each members plays in the underwriting

Syndicate manager receives a per-bond fee for its work in bringing the new issue to market

Example: The manager might receive 1/8 point ($1.25) as a management fee from a total spread of 1 point ($10)

• Portion of the spread that remains after subtracting the management fee
• (Spread-Management Fee = Total Takedown)

Member that has purchased bonds at the takedown can sell its bonds either to customers at the offering price or to a dealer in the selling group below the offering price

Firms that are part of the selling group do not assume financial risk - their compensation for each bond sold = concession

• The discount the selling group receives from the syndicate member is called the concession
• Example: Firm sells bonds to a member of teh selling group @ $995; the discount the selling group received from the syndicate member is called the concession ($5)

Selling group members buy bonds from syndicate members at the concession. the syndicate member keeps the remainder of the total takedown, called the additional takedown ($3.75)

• Mangement Fee = $1.25
• Spread = $10
• *For these examples

MSRB requires syndicates to establish priority allocation provisions for orders

Time set by the manager during which the syndicate solicits customers for the issue and all orders are allocated without regard to the sequence in which they were received - usually runs for an hour on the day following the bid

• 1)Presale
• *entered before the date that the syndicate wins the bid, which means that a customer is willing to place an order without knowing the final price or whether the syndicate will even win the bid
• *Individual syndicates are not credited with any takedown on presale orders - takedown is split among all syndicate members according to participation
• 2)Group Net Order
• *Takedown is deposited in the syndicate account and upon completion of underwriting, it is split among all syndicate members according to particpation
• 3)Designated Order
• *Usually from institutions that wish to allocate the takedown to certain syndicate members
• 4)Member Order and Member-Related Order
• *Enters such an order for its own inventory or related accounts

*Highest priority given to those orders that benefit the most members, the lowest priority is given to orders that benefit a single member

Usually sold on a when-issued bassis, meaning the securities are authorized, but not yet issued

When bonds are ready, the syndicate manager gives notice of the settlement date. The syndicate members, in turn, give notice of teh settlement date to the purchasers. On the settlement date, the newly issued bonds are delivered to the underwriters witha final legal opinion and the underwriters pay for the bonds on delivery.

On or before the completion of the transaction (settlement date), final confirmations must be sent to investors who purchased bonds from the underwriters

Investors' confirmations disclose the purchase price adn settlement date of the transaction - the underwriters then deliver teh bonds, accompanies by the legal opinion to investors

dated date = date on which interest begins to accrue (investor must pay any interest that has accrued from the dated date up to, but not including the settlement date)

vs.

settlement date = date the investor starts receiving interest on the settlement date

• 1)General Wealth of the Community
• 2)Characteristics of the Issuer
• 3)Debt Limits
• 4)Income of the Municipality
• *Income and sales tax are major sources of state income
• *Real property taxes are the principal income source of counties and school districts; real property taxes are the largest source of city income
• *City income can include fines, license fees, assessments, sales taxes, hotel taxes, city income taxes, utility taxes, and any city personal property tax
• 5)Ad Valorem Taxes
• *GOs backed by the power to tax and seize property are considered safer than revenue bonds of the same issuer and therefore can be issued with a lower interest rate

• 1)Economic Justification - should be able to generate revenues
• 2)Competing Facilities
• 3)Sources of Revenue
• 4)Call Provisions - higher call premiums are more attractive to investors
• 5)Flow of Funds - revenues must be sufficient to pay all operating expenes and meet the debt service obligation

Ratios = GOs, except for debt service coverage ratio which analyzes revenues

Muni bond prices tend to fluctuate more than govt and corporate bond prices bc each issue is unique and may have few regular market makers - bc fewer mkt makers exist in the muni bond market than exist in the OTC equity market, the market for any specific muni bond is typically thinner than the market for comparable corporate or govt bonds

• MBIA (Municipal Bond Investors Assurance Corporation)
• AMBAC (AMBAC Indemity Corporation)
• FGIC (Financial Guaranty Insurance Company)

Insured bonds can be issued with lower coupon rates bc investors will accept lower rates of return for added safety - typically rated AAA

Insures teh securities' principal and interest payments

Muni bonds are bought and sold in the OTC market

Usually priced and offered for sale ona yield-to-maturity (YTM) basis, rather than a dollar price (this is called a basis quote)

Example: 6% bond quoted on a 6.5 basis means the coupon of the bond is 6% and its YTM is 6.5%. Because the YTM is higher than the coupon, the bond is trading at a discount

• Dollar Bonds = Term Maturities (bond quoted at 104)
• Basis Bonds = Serial Maturities

Some muni revenue bonds are quoted on a % of par dollar basis rather than basis - referred to as dollar bonds

Usually term bonds, callable before maturity

Dealer must be prepared to trade the security at the price specified in the quote and under the conditions and restrictions (if any) accompanying the quote

Must reflect the dealer's best judgment and have a reasonable relationship to the fair market value for that security

May reflect the firm's inventory and expectations of market direction

• 1)Workable Indication - reflects a bid price at which a dealer will purchase securities from another dealer
• 2)Nominal (subject) - indicates a dealer's estimate of securitys market value, provided for informational purposes only, permitted if the quotes are clearly labeled as such

Out-Firm with Recall Quote: quote a bond price that is firm for a certain time period - allows a dealer to try to sell bonds that it does not own, knowing that if it finds a buyer within the alloted time, it can buy the bonds at a fixed price from the firm providing the out-firm quote

Formed by a group of Investment Bankers to purchase large blocks of bonds from institutions and resell them

Joint account, when reselling the bonds, can only give one quote for teh bonds - participants must sell the bonds at the same price

Like syndicate accounts for new underwritings, settlement of secondary market joint or trading accounts is 30 days after teh securities purchased are delivered to teh secondary joint account members

Muni Securities Dealers must report trades with other dealers to the National Securities Clearing Corporation (NSCC). Must include teh 2 executing firms' names and the amount of accrued interest, if known.

Some muni brokers specialize in trading only with institutional customers, such as banks and other muni brokers, not with the retail public - these are called Broker's Brokers bc their business focuses on helping other muni dealers place unsold portions of new bond issues & Do not disclose the identities of the customers they represent; Act solely as agents and do not maintain an inventory of bonds

Dealer cannot solicit trades in muni securities from an investment company in return for sales by the dealer of shares or units in the investment company

Example: A muni bond fund makes a large # of trades every month in its portfolio, a muni dealer cannot be selected to execute the fund's portfolio trades only on the basis of the firm's promise that its account executives will increase sales of the bond fund's shares. The firm can be selected to execute those trades on the basis of the services the dealer offers to the fund, such as prompt execution and research

Suitability Test applies to discretionary accounts, as well as to other accounts

Churning is prohibited

Before an account is opened, must be approved in writing by a principal

If a customer refuses to disclose net worth, income, or both, teh account can still be opened - but recommendations cannot be made

Control relationships must be disclosed before it can effect any transaction in that security for the customer (ie. dealer controls, is controlled by, or is under common control with that security's issuer)

Commission = Agent (arranges trades for customers)

• Markup = Principal (sell securities from its own inventory)
• Markdown = Principal (buys securities from customers)

Each principal transaction is executed at a net price, which includes the markup or markdown

• Factors considered:
• 1)Dealer's best judgment of fair market value
• 2)Expense of effecting the transaction
• 3)Fact that the dealer is entitled to a markup or markdown (profit)
• 4)Total dollar amount of the transaction
• 5)Value of any security exchanged or traded

*Markups or Markdowns are not disclosed separately on a customer's confirmation

Each agency transaction is executed for a commission that is not in excess of a fair and reasonable amount, considering all relevant factors

• 1)Security's availability
• 2)Expense of executing the order
• 3)Value of services teh dealer renders
• 4)Amount of any other compensation received or to be received in connection with the transaction

• *when executing an order as agent, a dealer must make a reasonable effort to obtain a fair and reasonable price
• *Commissions are disclosed on customer confirmations

Must receive a written confirmation of each muni securities transaction entered

Must describe the security, list the trade date, settlement date, and amt of accrued interest, state the firm's name, address, and phone number, and indicate whether the firm acted as agent or principal in the trade

A confirm that does not include the time of execution must indicate that this information will be provided if the customer requests it

In disclosing yield on a customer confirm, the following rules apply:

Noncallable bond = actual life of bond is known with certainty = yield to maturity (YTM) shown

• Callable bond = uncertain actual life known = show the lower of the YTM or YTC
• *For discount bonds, YTM is lower
• *For premium bonds, YTC is lower

1)Variable Rate Bonds (Reset Bonds) - As the coupon adjusts periodically, a yield computation is impossible

2)Bonds in default - If a bond is no longer paying interest, a yield computation is impossible

3)Bonds sold at par - For bonds sold at part, no separate yield disclosure is required bc the yield cannot be anything other than the coupon rate. Remember: At par, all yields are the same

Issued at a deep discount from part and pays no current interest - confirmation must indicate an interest rate of 0% and state that accured interest is not calculated

• 1)In an agency transaction, the name of the party on the other side and the source and amount of any commission
• 2)The dated date if it affects the interest calculation
• 3)Are the securities fully registered, registered as to principal only, in book-entry form, or in bearer form
• 4)Are the securities called or pre-funded, as well as the date of maturity fixed by the call notice and the amount of the call price
• 5)Any special qualification or factor that might affect payment of principal or interest
• 6)Whether the bond interest is taxable or subject to the alternative minimum tax (AMT)

Restricted the fed income tax exemption of interest for muni bods to public purpose bonds

If a bond channels more than 10% of its proceeds to private parties, it is considered a private activity bond & is not authomatically granted tax exemption

• Calculate the tax-equivalent yield:
• Tax Free Yield/(100%-Investors Tax Rate%)

Example: 7% Muni Bond Yield, investor in the 30% tax bracket

7%/(100%-30%) = 10%

• To calculate the opposite, known as the tax-free equivalent yield:
• Corporate Yield X (110%-Tax %)

Example: 11% Corporate bond x (100-30) = 7.7%

Expenses associated with purchasing or holding muni bonds are not deductible

• -FRB enforces rules governing any nonnational banks that are members of the Federal Reserve System
• -FDCI enforces MSRB rules for non-national banks that are not members of the Federal Reserve System

A Bank that has a separately identifiable department or division engaged in any activity related to the muni securities busines is classified as a muni securities dealer & must comply with MSRB regulations

• Muni Securities-related activity includes:
• Underwriting
• Trading
• Selling Muni Securities
• Provide research or advisory services for muni securities investors
• Communicates with the public in any way about investing in Muni Securities

*Must register with MSRB

Principals, Financial & Operations principals, Muni Securities Reps must qualify by examiniation

• Rep = 52 or 7
• Principal = 53

• Excluded from Licensing Requirements:
• 1)Clearical or ministerial capacity who read approved quotes, provide trade reports, or record or enter orders

Requires Muni Broker/Dealers to maintain a blanket fidelity bond as mandated by the SRO to which a BD belongs - $amount varies according to the firms size. Banks not affected by this rule.

Must obtain and keep on file specific info about its associated persons - most of which is coontained on the U-4 & U-5

Written complaints must enter the complaint in a complaint file, indicating what action, if any the firm has taken; must also deliver a copy of the MSRB's Investor Brochure to that customer.

During the underwriting period, the syndicate must establish a priority for allocating orders & identify conditions that might alter the priority

Outlines the Procedures (Uniform Practices) for settling transactions between Muni Securities firms.

• Cash Trades - Settle on Trade Date
• Regular Way - Settle on 3rd biz day after trade date

Good Delivery Requirements

Dealers can publish quotes for only bona fide bids or offers. Nominal quotes are permissible if identified as such.

BD must be examined at least once every 2 calendar years to ensure the firm is in compliance with SRB regulations, SEC rules, and the Securities and Exchange Act of 1934

Each Muni Securities firm must designate a principal to supervise the firm's reps and must create & maintaina supervisory procedures manual

• Designated principal must approve in writing:
• 1)Opening of new customer accounts
• 2)Every muni securities transaction
• 3)Actions taken on customer complaints
• 4)Correspondence regarding muni securities trades

If a muni securities dealer employee opens an account with another muni securities firm, the MSRB rules require the firm opening the account to notify the employer in writing and to send duplicate confirmations to teh employer

the firm opening the account must comply with any other requests the employer makes

A new issue of muni securities delivered to the customer, must be accompanied or preceded by a copy of the official statement

For Negotiated: must disclose in writing to the customer the amount of the spread, and any fees received if the firm acted as agent, and the initial offering price for each maturity in the issue

For Competitive: No requirement to disclose the spread

Muni bonds, like corporates, use a 360-day year with 30-day months

Muni dealers must calculate accrued interest when a muni security trades with interest

Prohibits muni firms from engaging in muni securities business with an issuer for 2 years after any political contribution is made to an official of that issuer

Refers to negotiated underwritings, not competitive

Contributions up to $250 (for muni financial professionals) are allowed per election as long as these individuals are eligible to vote for the issuer official - exemption does not apply to firms!