CHAPTER
ELEVEN
MUNICIPAL BONDS

SYLVAN G. FELDSTEIN, PH.D.

Director
Investment Department
Guardian Life Insurance Company of America

FRANK J. FABOZZI, PH.D., CFA, CPA

Professor of Finance
EDHEC Business School

ALEXANDER GRANT

Portfolio Manager
RS Tax-Exempt and RS High Yield Municipal Bond Funds

DAVID RATNER, CFA

Industry Consultant

The U.S. bond market can be divided into two major sectors: the taxable bond market and the tax-exempt bond market. The former sector includes bonds issued by the U.S. government, U.S. government agencies and sponsored enterprises, and corporations. The tax-exempt bond market is one in which the interest from bonds that are issued and sold is exempt from federal income taxation. Interest may or may not be taxable at the state and local levels. The interest on U.S. Treasury securities is exempt from state and local taxes, but the distinction in classifying a bond as tax exempt is the tax treatment at the federal income tax level.

It should be noted that over the years some taxable municipal bonds have been issued. As an example of the largest issuance program, under the Federal Build America Bond (BABS) program, between 2009 and 2010, almost $190 billion of BABS were issued. Interest on these bonds was federally taxable and the federal government is to pay 35% of the interest payments.

The Federal Reserve Board estimates that the overall size of the municipal bond market as of the end of September, 2010 was $2.86 trillion. According to Barclays Capital Indices, by 2011 municipals represented 7.9% of their fixed income universe—which is made up only of the larger bond issues. The municipal sector is certainly one of the larger components of the domestic bond market, but it is clearly different from the taxable bond market.

The majority of tax-exempt securities are issued by state and local governments and by their creations, such as “authorities” and special districts. Consequently, the terms municipal market and tax-exempt market are often used interchangeably. Although not all municipal bonds are tax-exempt securities, most are.

The major motivation for investing in tax-exempt municipal bonds is their tax advantage. The primary owners of municipal bonds are individual investors; the remainder of the investors consists of mutual funds, commercial banks, and property and casualty insurance companies. Although certain institutional investors such as pension funds have no need for tax-advantaged investments, there have been instances in which such institutional investors have crossed into the municipal bond market to take advantage of higher yields. These investors also have purchased municipal bonds when municipal bonds were expected to outperform taxable bonds. Institutional investors who are natural purchasers of taxable bonds but at times purchase municipal debt are known as crossover buyers.

The industry has many new buy-side participants. In addition to the traditional bank trust departments, mutual funds, property and casualty insurance companies, and high-net-worth individuals, buyers now include hedge funds, arbitrageurs, life insurance companies, crossover buyers, and foreign banks, among other relative value buyers. There are now municipal bond exchangetraded funds (ETFs) that cater to investors.

Traditionally, the household sector has owned the largest portion of the municipal bond market. Another substantial owner has been the mutual fund industry. However, examination of Federal Reserve Board data indicates that there have been three major changes among holders. First, the percentage holdings of commercial banks have dropped significantly since 1986. In general, the Tax Reform Act of 1986 reduced the benefits commercial banks received by owning municipal bonds. Commercial banks responded to this change by reducing their municipal bond holdings and investing in assets that provided greater benefits.

Households account for the next substantial ownership change. In 1990, household ownership of municipal bonds reached a peak of 49% for the 20-year period. However, by the end of September 2010, household ownership was at 41%. If commercial banks and households both decreased their holdings, then other groups had to increase their ownership. Federal Reserve Board data indicate that mutual funds, money market funds, and closed-ended funds dramatically increased their holdings. In 1979, they held only 1% of the municipal market; by the end of September, 2010, their combined share was 33%.

Insurance companies and personal bank trust accounts have had relatively stable ownership of municipal bonds. Insurance companies typically adjust their holdings of municipal bonds according to profitability and the relative value municipal bonds offer compared with taxable bonds. Trust accounts are relatively stable purchasers of municipal bonds. A typical trust account will purchase bonds near par, collect the tax-exempt income, and hold the bonds to maturity.

It should be noted that when municipal bond yields are attractive compared with taxable bonds, traditional bond buyers, hedge funds, and arbitrageurs are active and at times have become significant participants in the municipal market.

In the past, investing in municipal bonds was considered second in safety only to that of U.S. Treasury securities; however, there have now developed among investors ongoing concerns about the credit risks of municipal bonds. This is true regardless of whether or not the bonds are given investment-grade credit ratings by the commercial rating companies. There are several reasons for this: (1) the financial crisis of several major municipal issuers beginning with the City of New York billion-dollar financial crisis in 1975 and the bankruptcy filing in 1994 of Orange County, California; (2) the federal bankruptcy law (which became effective October 1979) that makes it easier for municipal bond issuers to seek protection from bondholders by filing for bankruptcy; (3) the proliferation of innovative financing techniques and legally untested security structures, highlighted by the default of the Washington Public Power Supply System (WPPSS) in the early 1980s; (4) the cutbacks in federal grant and aid programs that will affect the ability of certain municipal issuers to meet their obligations; and (5) fundamental changes in the American economy that may cause economic hardship for municipal issuers in some regions of the country and thus difficulty in meeting their obligations.

More recently, beginning in December of 2007 when the latest recession began, the well-publicized bond defaults of Vallejo, California and Harrisburg, Pennsylvania as well as the budgetary stresses of several large states and cities, highlighted credit concerns about municipal bonds. Vallejo utilized Chapter 9 of the U.S. Bankruptcy Code to avoid paying bondholders. And Harrisburg just didn’t appropriate debt service.

FEATURES OF MUNICIPAL SECURITIES

In Chapter 1, the various features of fixed income securities were described. These include call and refunding provisions, sinking-fund provisions, and put provisions. Such provisions also can be included in municipal securities. In one type of municipal structure discussed below, a revenue bond, there is a special call feature wherein the issuer must call the entire issue if the facility is destroyed.

Coupon Features

The coupon rate on a municipal issue can be fixed throughout the life of the issue, or it can be reset periodically. When the coupon rate is reset periodically, the issue is referred to as a floating-rate or variable-rate issue. In general form, the coupon reset formula for a floating-rate issue is

Percent of reference rate ± spread

Typically, when the reference rate is a municipal index, the coupon reset formula is

Reference rate ± spread

Reference rates that have been used for municipal issues include the Securities Industry and Financial Markets Association (SIFMA), LIBOR, and Treasury bills. The coupon rate on a floating-rate issue need not change in the same direction as the reference rate. There are derivative municipal bonds whose coupon rate changes in the opposite direction to the change in the reference rate. That is, if the reference rate increases from the previous coupon reset date, the coupon rate on the issue declines. Such issues are referred to as inverse floating-rate issues. Some municipal issues have a fixed coupon rate and are issued at a discount from their maturity value. Issues whose original-issue price is less than its maturity value are referred to as original-issue discount bonds (OIDs). The difference between the par value and the original-issue price represents tax-exempt interest that the investor realizes by holding the issue to maturity.

Two types of municipal issues do not distribute periodic interest to the investor. The first type is called a zero-coupon bond. The coupon rate is zero, and the original issue price is below the maturity value. Zero-coupon bonds are therefore OIDs. The other type of issue that does not distribute periodic interest is one in which a coupon rate is stated but the coupon is not distributed to the investor. Instead, the interest is accrued, and all interest is paid to the investor at the maturity date along with the maturity value. Later in this chapter we will discuss the important aspects an investor should be aware of when considering the purchase of OIDs in the secondary market.

Maturity Date

The maturity date is the date on which the issuer is obligated to pay the par value. Corporate issuers of debt generally schedule their bonds to mature in one or two different years in the future. Municipal issuers, on the other hand, frequently schedule their bonds to mature serially over many years. Such bonds are called serial bonds. It is common for a municipal issue to have 10 or more different maturities.

After the last of the serial maturities, some municipal issues lump together large sums of debt into one or two years—much the way corporate bonds are issued. These bonds, called term bonds, have become increasingly popular in the municipal market because active secondary markets for them can develop if the term issue is of sufficient size.

The Legal Opinion

Municipal bonds have legal opinions. The relationship of the legal opinion to the safety of municipal bonds for both general obligation and revenue bonds is threefold. First, bond counsel should check to determine if the issuer is indeed legally able to issue the bonds. Second, bond counsel is to see that the issuer has properly prepared for the bond sale by having enacted the various required ordinances, resolutions, and trust indentures and without violating any other laws and regulations. This preparation is particularly important in the highly technical areas of determining if the bond issue is qualified for tax exemption under federal law and if the issue has not been structured in such a way as to violate federal arbitrage regulations. Third, bond counsel is to certify that the security safeguards and remedies provided for the bondholders and pledged either by the bond issuer or third parties, such as banks with letter-of-credit agreements, are actually supported by federal, state, and local government laws and regulations.

The popular notion is that much of the legal work done in a bond issue is boilerplate in nature, but from the bondholder’s point of view, the legal opinions and document reviews should be the ultimate security provisions. The reason is that if all else fails, the bondholder may have to go to court to enforce security rights. Therefore, the integrity and competence of the lawyers who review the documents and write the legal opinions that are usually summarized and stated in the official statements are very important.

It should be noted that by 2011, there were thousands of attorneys in the business. They were located throughout the country and listed in the The Bond Buyer’s Municipal Marketplace directory of municipal bond attorneys. They presented themselves as being experts in municipal finance law and provided various security structure and tax opinions. Sorting out quality distinctions in their work and who is well grounded in the law, and who is not, is challenging.

TYPES OF MUNICIPAL OBLIGATIONS

The number of municipal bond issuers is remarkable. One broker-dealer’s estimate places the total at 60,055. Even more noteworthy is the number of different issues. As of 2011, Interactive Data Pricing and Reference Data1 provides daily prices for over 1.4 million individual issues in its database of over 2.6 million records. The Bloomberg Financial Markets’ (Bloomberg) database,2 as of 2011, contained over 4.8 million CUSIPS (including matured bonds). Of the 1.19 million CUSIP numbers still active, Bloomberg updates them on a regular basis.

The number of different issues to choose from is staggering. Considering all the different types of issuers in the market—states, state agencies, cities, airports, colleges and universities, hospitals, continuing care retirement communities (CCRCs), school districts, toll roads and bridges, public power facilities, seaport facilities, water and sewer authorities, solid waste facilities, and other special purpose districts—the investment choices are overwhelming. Some of the issuers are extremely large and issue billions of dollars of debt. Some are extremely small and may only have $1 to $2 million in outstanding debt. Obviously, the characteristics of these issuers and their debt are very different, and both require independent and careful analysis. However, municipal bonds can be categorized into two broad security structures. In terms of municipal bond security structures, there are basically two different types. The first type is the general obligation bond, and the second is the revenue bond.

General Obligation Bonds

General obligation bonds are debt instruments issued by states, counties, special districts, cities, towns, and school districts. They are secured by the issuer’s general taxing powers. Usually, a general obligation bond is secured by the issuer’s unlimited taxing power. For smaller governmental jurisdictions, such as school districts and towns, the only available unlimited taxing power is on property. For larger general obligation bond issuers, such as states and big cities, the tax revenues are more diverse and may include corporate and individual income taxes, sales taxes, and property taxes. The security pledges for these larger issuers such as states sometimes are referred to as being full faith and credit obligations.

Additionally, certain general obligation bonds are secured not only by the issuer’s general taxing powers to create monies accumulated in the general fund, but also from certain identified fees, grants, and special charges, which provide additional revenues from outside the general fund. Such bonds are known as being double barreled in security because of the dual nature of the revenue sources. Also, not all general obligation bonds are secured by unlimited taxing powers. Some have pledged taxes that are limited as to revenue sources and maximum property-tax millage amounts. Such bonds are known as limited-tax general 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. Below are examples of the specific types of revenue bonds that have been issued over the years.

Airport Revenue Bonds

The revenues securing airport revenue bonds usually come from either traffic-generated sources—such as passenger charges, landing fees, concession fees, and airline apron-use and fueling fees—or lease revenues from one or more airlines for the use of a specific facility such as a terminal or hangar.

Charter School Bonds

These bonds are for publicly funded private schools that offer more institutional and academic flexibility than local public schools. State-aid funding usually follows the student who goes from a traditional public school to a charter school. Bond proceeds go for capital improvements.

College and University Revenue Bonds

The revenues securing college and university revenue bonds usually include dormitory room rental fees, tuition payments, and sometimes the general assets of the college or university as well.

Continuing Care Retirement Community Bonds

Life care or continuing care retirement community (CCRC) bonds are issued to construct long-term residential facilities for older citizens. Revenues usually are derived from initial lump-sum payments made by the residents and operating revenues.

Higher Education Bonds

Debt is often issued by institutions of higher education to finance the costs of building/renovating facilities or purchasing land for expansion. These bonds are secured by revenues of the given project, student charges, and/or a general obligation of the college or university.

Hospital Revenue Bonds

The security for hospital revenue bonds is usually dependent on federal and state reimbursement programs (such as Medicaid and Medicare), third-party commercial payers (such as Blue Cross and private insurance), health maintenance organizations (HMOs), and individual patient payments.

Industrial Development and Pollution Control Revenue Bonds

Bonds have been issued for a variety of industrial and commercial activities that range from manufacturing plants to shopping centers. They usually are secured by payments to be made by the corporations or businesses that use the facilities.

Land-Secured “Dirt” Bonds

Public infrastructure costs associated with new development projects on raw land are often financed by land-secured bonds, also known as “dirt” bonds. Revenue from the additional tax or assessment placed on the properties benefitting from these improvements is the primary security for the bondholders.

Multifamily Revenue Bonds

These revenue bonds usually are issued for multifamily housing projects for senior citizens and low-income families. Some housing revenue bonds are secured by mortgages that are federally insured; others receive federal government operating subsidies, such as under Section 8, or interest-cost subsidies, such as under Section 236; and still others receive only local property-tax reductions as subsidies.

Public Power Revenue Bonds

Public power revenue bonds are secured by revenues to be produced from electrical operating plants and distribution systems. Some bonds are for a single issuer, who constructs and operates power plants and then sells the electricity. Other public power revenue bonds are issued by groups of public and private investor-owned utilities for the joint financing of the construction of one or more power plants. This last arrangement is known as a joint power financing structure. During the past several years, this sector started to undergo the most dramatic changes since electricity was invented. In many states the electric utility industry is transforming to a deregulated industry. In a deregulated environment, customers will have the ability to choose an electric provider; therefore, electric providers will face competition. This means that this sector will experience new and different challenges, and investors will need to analyze this sector differently.

Public-Private Partnerships (PPPs)

Privatization is a form of municipal financing where a private company pays a large payment to operate, and often build or improve, a governmental asset (e.g., usually toll roads). The purchaser issues debt to help finance this large upfront cost, and the operating revenues are pledged to repay bondholders.

Resource Recovery Revenue Bonds

A resource recovery facility converts refuse (solid waste) into commercially salable energy, recoverable products, and a residue to be landfilled. The major revenues for a resource recovery revenue bond usually are (1) the “tipping fees” per ton paid by those who deliver the garbage to the facility for disposal; (2) revenues from steam, electricity, or refuse-derived fuel sold to either an electrical power company or another energy user; and (3) revenues from the sale of recoverable materials such as aluminum and steel scrap.

Seaport Revenue Bonds

The security for seaport revenue bonds can include specific lease agreements with the benefiting companies or pledged marine terminal and cargo tonnage fees.

Sewer Revenue Bonds

Revenues for sewer revenue bonds come from hookup fees and user charges. For many older sewer bond issuers, substantial portions of their construction budgets have been financed with federal grants.

Single-Family Mortgage Revenue Bonds

Single-family mortgage revenue bonds usually are secured by the mortgages and mortgage loan repayments on single-family homes. Security features vary but can include Federal Housing Administration (FHA), Federal Veterans Administration (VA), and private mortgage insurance.

Sports Complex and Convention Center Revenue Bonds

Sports complex and convention center revenue bonds usually receive revenues from sporting or convention events held at the facilities and, in some instances, from earmarked outside revenues such as local motel and hotel room taxes.

Student Loan Revenue Bonds

Student loan revenue bonds usually are issued by state agencies or not-for-profit organizations and are used for purchasing student loans for higher education. Depending on the security structure, bondholders’ payment can include student loan repayments and federal payments.

Tax-Allocation Bonds

These bonds are usually issued to finance the construction of office buildings and other new buildings in formerly blighted areas. They are secured by property taxes collected on the improved real estate.

Tobacco Revenue Bonds

Some tobacco bonds are solely secured by revenues in the Master Settlement Agreement (MSA) annually paid to states by cigarette companies.

Toll Road and Gas Tax Revenue Bonds

There are generally two types of highway revenue bonds. The bond proceeds of the first type are used to build such specific revenue-producing facilities as toll roads, bridges, and tunnels. For these pure enterprise-type revenue bonds, the pledged revenues usually are the monies collected through the tolls. The second type of highway bond is one in which the bondholders are paid by earmarked revenues outside toll collections, such as gasoline taxes, automobile registration payments, and driver’s license fees.

Tribal Casino Bonds

Native American governments in general finance the construction of their casino gaming facilities by issuing debt. Tribal casino bonds derive their revenues from the gaming operations of these facilities.

Water Revenue Bonds

Water revenue bonds are issued to finance the construction of water treatment plants, pumping stations, collection facilities, and distribution systems. Revenues usually come from connection fees and charges paid by the users of the water systems.

Hybrid and Special Bond Securities

Although having certain characteristics of general obligation and revenue bonds, the following types of municipal bonds have more unique security structures as well.

Refunded Bonds

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 either by direct obligations guaranteed by the U.S. government or other types of securities. The maturity schedules of the securities in the escrow fund are such that they pay when due the bond’s maturity value, coupon, and premium payments (if any) on the refunded bonds. Once this cash-flow match is in place, the refunded bonds are no longer secured as either general obligation or revenue bonds. The bonds are now supported by the securities held in the escrow fund. Such bonds, if escrowed with securities guaranteed by the U.S. government, have little if any credit risk. They are the safest municipal bond investments available.

Usually, an escrow fund is an irrevocable trust established by the original bond issuer with a commercial bank or state treasurer’s office. Government securities are deposited in an escrow fund that will be used to pay debt service on the refunded bonds. A pure escrow fund is one in which the deposited securities are solely direct or guaranteed obligations of the U.S. government, whereas a mixed escrow fund is one in which the permitted securities, as defined by the trust indenture, are not exclusively limited to direct or guaranteed U.S. government securities. Other securities that could be placed in mixed escrow funds include federal agency bonds, certificates of deposit from banks, other municipal bonds, and even annuity policies from commercial insurance companies. The escrow agreement should indicate what is in the escrow fund and if substitutions of lower-credit-quality investments are permitted.

Still another type of refunded bond is a crossover refunded bond. Typically, proceeds from crossover refunding bonds are used to purchase securities that are placed in an escrow account. Usually, the crossover refunding bonds are secured by maturing principal and interest from the escrowed securities only until the crossover date, and the bonds to be refunded continue to be secured by the issuer’s own revenues until the crossover date, which is usually the first call date of the bonds to be refunded. On that date, the crossover occurs, and the bonds to be refunded are redeemed from maturing securities in the escrow fund, which could include U.S. government securities or other investments, such as certificates of deposit. In turn, the security for the refunding bonds reverts back to the issuer’s own revenues.

Here we focus primarily on the pure escrow-backed bonds, not the mixed escrow or crossover bonds. The escrow fund for a refunded municipal bond can be structured so that the refunded bonds are to be called at the first possible date or a subsequent call date established in the original bond indenture. The call price usually includes a premium of from 1% to 3% above par. This type of structure usually is used for those refundings that either reduce the issuer’s interest payment expenses or change the debt maturity schedule. Such bonds are known in the industry as prerefunded municipal bonds. Prerefunded municipal bonds usually are to be retired at their first or subsequent respective callable dates, but some escrow funds for refunding bonds have been structured differently. In such refundings, the maturity schedules of the securities in the escrow funds match the regular debt-service requirements on the bonds as originally stated in the bond indentures. Such bonds are known as escrowed-to-maturity, or ETM, bonds. It should be noted that under the Tax Reform Law of 1986, such ETM refundings still can be done. In the secondary market there may be ETM refunded municipal bonds outstanding. However, we note that the investor or trader should determine whether all earlier calls have been legally defeased before purchasing an ETM bond.

Dedicated Tax-Backed and Structured Asset-Backed Bonds

More recently, states and local governments have issued increasing amounts of bonds in which the debt service is to be paid from so-called dedicated revenues such as sales taxes, tobacco settlement payments, fees, and penalty payments. Many are structured to mimic the asset-backed bonds that are common in the taxable market. The “assets” providing the security for the municipal bonds are the “dedicated” revenues instead of credit card receivables, home equity loans, and auto loan repayments that are commonly used to secure the taxable asset-backed bonds.

Insured Bonds

Insured bonds, in addition to being secured by the issuer’s revenues, are also backed by insurance policies written by commercial insurance companies. The insurance, usually structured as an insurance contract, is supposed to provide prompt payment to the bondholders if a default should occur. These bonds are discussed in more detail later in this chapter.

Lease-Backed Bonds

Lease-backed bonds usually are structured as revenue-type bonds with annual payments. In some instances the payments may come only from earmarked tax revenues, student tuition payments, or patient fees. In other instances the underlying lessee governmental unit makes annual appropriations from its general fund.

Letter of Credit–Backed Bonds

Some municipal bonds, in addition to being secured by the issuer’s cash-flow revenues, also are backed by commercial bank letters of credit. In some instances the letters of credit are irrevocable and, if necessary, can be used to pay the bondholders. In other instances the issuers are required to maintain investment-quality worthiness before the letters of credit can be drawn on.

Moral Obligation Bonds

A moral obligation bond is a security structure for state-issued bonds that indicates that if revenues are needed for paying bondholders, the state legislature involved is legally authorized, although not required, to make an appropriation out of general state tax revenues.

Territorial Bonds

These are bonds issued by U.S. territorial possessions such as Puerto Rico, the Virgin Islands, and Guam. The bonds are tax-exempt throughout most of the country. Also, the economies of these issuers are influenced by positive special features of the U.S. corporate tax codes that are not available to the states.

Troubled City Bailout Bonds

There are certain bonds that are structured to appear as pure revenue bonds but in essence are not. Revenues come from general-purpose taxes and revenues that otherwise would have gone to a state’s or city’s general fund. Their bond structures were created to bail out underlying general obligation bond issuers from severe budget deficits. Examples were the New York State Municipal Assistance Corporation for the City of New York Bonds (MAC) and the state of Illinois Chicago School Finance Authority Bonds.

Money Market Products

Tax-exempt money market products include notes, commercial paper, variable-rate demand obligations, and a hybrid of the last two products.

Notes

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 of 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 the cash flows caused by the irregular flows of income into the treasuries of the states and local units of government. BANs are issued in anticipation of the sale of long-term bonds.

Tax-exempt money market products generally have some type of credit support. This may come in the form of an irrevocable letter of credit, a line of credit, municipal bond insurance policy, an escrow agreement, a bond purchase agreement, or a guaranteed investment contract. With a bond purchase agreement, a bank obligates itself to purchase the debt if the remarketing agent cannot resell the instrument or make a timely payment. In the case of a guaranteed investment contract, either an insurance company or a bank invests sufficient proceeds so that the cash-flow generated from a portfolio of supporting assets can meet the obligation of the issue.

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. Thus the investor has considerable choice in selecting a maturity to satisfy investment objectives.

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 7 days. The investor has an option to put the issue back to the trustee at any time with 7 days’ notice or the same day in the case of a daily VRDO. The put price is par plus accrued interest.

Commercial Paper Mode

The commercial paper mode 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. Put periods can range from one day to more than 360 days. On the put date, the investor can put back the bonds, receiving principal and interest, or the investor can elect to extend the maturity at the new interest rate and put date posted by the remarketing agent at that time. Thus the investor has two choices when initially purchasing this instrument: the interest rate and the put date. Interest generally is paid on the put date if the date is within 180 days. If the put date is more than 180 days forward, interest is paid semiannually. Some commercial paper dealers market these products under a proprietary name, but most do so simply as money market municipals.

Municipal Derivative Securities

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 resulting bond classes may have far different yield and price volatility characteristics than the underlying fixed-rate municipal bond from which they were created. By expanding the risk/return profile available in the municipal marketplace, institutional investors have more flexibility in structuring municipal bond portfolios either to satisfy a specific asset/liability objective or to make an interest rate or yield-curve bet more efficiently.

The name derivative securities has been attributed to these bond classes because they derive their value from the underlying fixed-rate municipal bond. Much of the development in this market has paralleled that of the taxable and, specifically, the mortgage-backed securities market. The ability of investment bankers to create these securities has been enhanced by the development of the municipal swap market.

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. Two types of inverse floaters dominated the market: auction rate securities and the later-developed tender option bond (TOB) product. TOB programs, in various forms, have existed since the beginning to middle 1980s. Widespread use did not occur until the 1990s.

In 2008, when failed auctions occurred, new issuance of auction rate securities ended. Functionally, TOBs are similar to the auction rate product. Both derivatives are inverse floaters. Auction rate floaters, however, were sold primarily to corporations and individuals, whereas TOB floaters are sold to money market funds. Tax-exempt money market funds have a continuous need for tax-exempt interest. This demand provided a stable buying base for the TOB floaters. To take advantage of this money market demand, TOBs feature a liquidity facility, which makes these floating-rate derivatives putable and therefore money market eligible. These liquidity facilities typically last 364 days and are provided by highly rated banks or broker-dealers.

TOBs are created through trusts. Given this structure, certain provisions must exist for the unwinding of a TOB. For example, if the remarketing agent fails to sell out the floating-rate class or the underlying bond falls below a minimum collateral value, a mandatory tender event is triggered. When a mandatory tender event occurs, the liquidity provider pays the floater holder par plus accrued interest. The trustee simultaneously terminates the trust and liquidates the bonds. The proceeds from this sale are used to first pay par plus accrued interest to the liquidity provider and then any accrued fees. Finally, the inverse floating-rate investor receives the residual value.

Several proprietary programs have been developed to market and sell plain vanilla TOBs, which are used by mutual bond funds, insurance companies and crossover buyers. Additionally, at times TOBs are used in more exotic combination trades by a few Wall Street structured products areas. Citigroup’s proprietary program is referred to as “ROCs & ROLs.” The short-term certificates are called ROCs or Residual Option Certificates. The inverse-floaters are called the ROLs or Residual Option Longs. Barclays’ certificates are called RIBS and Trust Receipts.

THE COMMERCIAL CREDIT RATING OF MUNICIPAL BONDS

Of the municipal bonds that were rated by a commercial rating company in 1929 and plunged into default in 1932, 78% had been rated double-A or better, and 48% had been rated triple-A. Since then, the ability of rating agencies to assess the creditworthiness of municipal obligations has evolved to a level of general industry acceptance and respectability. In most instances, they adequately describe the financial conditions of the issuers and identify the credit-risk factors. However, a small but significant number of relatively recent instances have caused market participants to reexamine their reliance on the opinions of the rating agencies.

As examples, the troubled bonds of the Washington Public Power Supply System (WPPSS) and Orange County, California, should be mentioned. Two major commercial rating companies, Moody’s and Standard & Poor’s, gave their highest ratings to the WPPSS bonds in the early 1980s. Moody’s gave the WPPSS Projects 1, 2, and 3 bonds its very highest credit rating of Aaa and the Projects 4 and 5 bonds its rating of Al. This latter investment-grade rating is defined as having the strongest investment attributes within the upper medium grade of creditworthiness. Standard & Poor’s also had given the WPPSS Projects 1, 2, and 3 bonds its highest rating of AAA and Projects 4 and 5 bonds its rating of A. While these high-quality ratings were in effect, WPPSS sold more than $8 billion in long-term bonds. By 1990, more than $2 billion of these bonds were in default.

Orange County, California, also had very strong credit ratings before its filing for bankruptcy protection on December 6, 1994. This would be the largest municipal bankruptcy filing in U.S. history. The Orange County debacle was unique. The county’s problem was not caused by local economic problems, like Philadelphia’s crisis in the early 1990s, nor was it caused by budget problems, like New York City’s situation in 1975. Orange County’s problem was created by the county Treasurer–Tax Collector’s investment strategy for the Orange County Investment Pool. The investment pool was highly leveraged and contained a large percentage of inverse floaters. As interest rates rose in 1994, the value of the investments decreased, and the institutions that provided the financial leverage decided to terminate those financial agreements. The problem was that if the investment pool were liquidated, the amount of assets would be insufficient to cover all the loans. Since the pool did not have sufficient assets to cover its debt, the county chose to seek the safety of bankruptcy protection.

The county’s voluntary bankruptcy filing was unprecedented. It was a signal to investors that the county did not necessarily intend to repay all its obligations. In most other cases of severe financial hardship, the municipalities tried to meet all their obligations and did not even suggest that they might wish not to fulfill their obligations. What troubled most investors was that Orange County was a vibrant and economically strong area and in all likelihood could fulfill its obligations. This created a different situation for investors and brought the question of an issuer’s ability to pay versus its willingness to pay. This was something that municipal investors rarely, if ever, questioned before Orange County.

Another area investors rarely questioned prior to Orange County was the investment strategies that were being used to manage operating fund investments and other state and local investment funds or pools. It was a common perception that state and local government finance officials invested conservatively and followed policies that emphasized safety of principal and maintenance of liquidity. Immediately following the onset of the Orange County debacle, large investors started to question state and local officials on their investment policies and their use of financial leverage and derivative securities. Because Orange County received high-quality credit ratings prior to its problems, investors started to question the reliability of the commercial credit-rating agencies.

The Washington Public Power Supply System and Orange County, California, are the more notable issuers that had high-quality ratings prior to their problems, but they are not isolated instances. In fact, since 1975, all the major municipal defaults in the industry initially had been given investment-grade ratings by Moody’s and Standard & Poor’s. Of course, it should be noted that in the majority of instances, ratings of the commercial rating companies adequately reflect the condition of the credit. However, unlike 35 years ago, when the commercial rating companies would not rate many kinds of revenue bond issues, today they seem to view themselves as assisting in the capital formation process.

After criticism by some public officials on the federal and state levels, we note that in 2009 the rating agencies recalibrated their ratings upward on many general obligation and essential service revenue bonds. They argued that municipal bond issues should have higher ratings relative to corporate bonds because of historical default rates and recovery levels. This resulted in higher ratings on many municipal bonds.

Today, many large institutional investors, underwriters, and traders use the ratings of the commercial rating agencies as starting points and rely on their own in-house municipal credit analysts for determining the creditworthiness of municipal bonds. However, other investors do not perform their own credit-risk analysis but instead rely entirely on credit-risk ratings by Moody’s, Standard & Poor’s, and Fitch. In this section we discuss the rating categories of these three commercial rating companies.

Moody’s Investors Service

The municipal bond rating system used by Moody’s grades the investment quality of municipal bonds in a nine-symbol system that ranges from the highest investment quality, which is Aaa, to the lowest credit rating, which is C. The respective nine alphabetical ratings and their definitions are found in Exhibit 11–1.

EXHIBIT 11–1
Moody’s Municipal Bond Ratings

images

Municipal bonds in the top four categories (Aaa, Aa, A, and Baa) are considered to be of investment-grade quality. Speculative or noninvestment grade ratings incorporate the five lower rating grade categories (Ba, B, Caa, Ca, and C). Additionally, bonds in the Aa through Caa categories are refined by numeric modifiers 1, 2, and 3, with 1 indicating the top third of the rating category, 2 the middle third, and 3 the bottom third.

The municipal note rating system used by Moody’s is designated by investment-grade categories of Moody’s Investment Grade (MIG), and one speculative grade category; SG as shown in Exhibit 11–2.

EXHIBIT 11–2
Moody’s Municipal Note Ratings*

images

Moody’s also provides credit ratings for tax-exempt commercial paper. These are promissory obligations not having an original maturity in excess of nine months. Moody’s uses three designations, all considered to be of investment grade, and one speculative grade category for indicating the relative repayment capacity of the rated issuers, as shown in Exhibit 11–3.

EXHIBIT 11–3
Moody’s Tax-Exempt Commercial Paper Ratings

images

Standard & Poor’s

The municipal bond rating system used by Standard & Poor’s grades the investment quality of municipal bonds in a 10-symbol system that ranges from the highest investment quality, which is AAA, to the lowest credit rating, which is D.3 Bonds within the top four categories (AAA, AA, A, and BBB) are considered by Standard & Poor’s as being of investment-grade quality. The respective 10 alphabetical ratings and definitions are shown in Exhibit 11–4.

EXHIBIT 11–4
Standard & Poor’s Municipal Bond Ratings

images

Standard & Poor’s also uses a plus (+) or minus (−) sign to show relative standing within the rating categories ranging from AA to CCC.

The municipal note rating system used by Standard & Poor’s grades the investment quality of municipal notes in a four-symbol system that ranges from highest investment quality, SP-1, to the lowest credit rating, SP-3. Notes within the top three categories (i.e., SP-1, SP-2, and SP-3) are considered by Standard & Poor’s as being of investment-grade quality. SP-3 is the speculative category. The respective ratings and summarized definitions are shown in Exhibit 11–5.

EXHIBIT 11–5
Standard & Poor’s Municipal Note Ratings

images

Standard & Poor’s also rates tax-exempt commercial paper. The tax-exempt commercial paper rating categories are shown in Exhibit 11–6.

EXHIBIT 11–6
Standard & Poor’s Tax-Exempt Commercial Paper Ratings

images

Fitch

The third rating company is Fitch. The alphabetical ratings and definitions used by Fitch are given in Exhibit 11–7. Plus (+) and minus (−) signs are used with a rating to indicate the relative position of a credit within the rating category.4 Plus and minus signs are not used for the AAA category.

EXHIBIT 11–7
Fitch Municipal Bond Ratings

images

Additionally, Fitch assigns ratings for obligations that are due up to 36 months. The rating scale has three investment grade symbols, F1 (the highest), F2, and F3. There are two speculative scales, B and C. There is a rating RD for an entity that has defaulted on one or more of its financial commitments, although it is meeting other financial obligations. Lastly, D indicates a broad-based default event for an entity, or the default of a short-term obligation.

MUNICIPAL BOND INSURANCE

Using municipal bond insurance was considered for many years one way to help reduce credit risk within a portfolio. Because of this, it had great appeal to retail investors. Insurance on a municipal bond was an agreement by an insurance company to pay debt service that is not paid by the bond issuer. Municipal bond insurance contracts insure the payment of debt service on a municipal bond to the bondholder. That is, the insurance company promised to pay the issuer’s obligation to the bondholder if the issuer did not do so.

The insurance usually was for the life of the issue. If the trustee or investor had not had his bond paid by the issuer on its due date, he notified the insurer and presented the defaulted bond and coupon. Under the terms of the insurance contract, the insurer generally was obligated to pay sufficient monies to cover the value of the defaulted insured principal and coupon interest when they came due.

Because it was believed that municipal bond insurance reduced the credit risk for the investor, the marketability of certain municipal bonds was greatly expanded. Municipal bonds that benefited most from the insurance would include lower-quality bonds, bonds issued by smaller governmental units not widely known in the financial community, bonds that had a sound although complex and difficult-to-understand security structure, and bonds issued by infrequent local government borrowers who do not have a general market following among investors.

Of course, a major factor for an issuer to obtain bond insurance was that its creditworthiness without the insurance was substantially lower than what it would be with the insurance. That is, the interest cost savings were only of sufficient magnitude to offset the cost of the insurance premium when the underlying creditworthiness of the issuer was lower. There were two major groups of municipal bond insurers. The first includes the “monoline” companies that were primarily in the business of insuring financial securities, including municipal bonds. Almost all the companies that insured municipal bonds could be characterized as monoline in structure. The second group of municipal bond insurers included the “multiline” property and casualty companies that usually had a wide base of business, including insurance for fires, collisions, hurricanes, and health problems.

While for many years until 2008, the majority of insured bonds were with the monoline insurers—most of whom had AAA ratings from all three agencies, and captured 50% of the new issue market—this dramatically changed. With massive defaults in their taxable books of insured bonds, they were rapidly downgraded and faced insolvency. In 2010, with only one monoline insurer left with a single AAA rating, the market share was down to 6%. Toward the end of 2010 Standard & Poor’s downgraded that insurer to AA+ from AAA.

VALUATION METHODS

The traditional method for evaluating municipal bonds is relatively straightforward. First, an investor determines the maturity of the bond, considers the offered price (discount, par, or premium), evaluates any call features or sinking funds, and then considers credit quality. If it is a premium bond and callable, then the investor places more emphasis on the call dates. If the bond is callable and sells at a discount, then the calls are not much of a factor, and the bond is valued using its maturity date. Basically, the investor is determining the relative attractiveness of the bond based on a yield-to-worst calculation. The credit quality is quantified, and the appropriate yield premium for the specific credit quality is added to the base yield-to-worst calculation. Because investors do not perform an option-adjusted spread (OAS) analysis, the yield premium that is applied is a nominal yield premium. The benchmark yields that are used to value the bonds come from a variety of sources, such as yield levels from the primary market, trading levels of similar bonds in the secondary market, and benchmark (triple-A GO, generic sector, state-specific) interest-rate curves.

An investor interested in purchasing a municipal bond must be able to compare the promised yield on a municipal bond with that of a comparable taxable bond. Employing the yield computed with traditional approaches, the following general formula is used to determine the equivalent taxable yield for a tax-exempt bond:

images

For example, suppose that an investor in the 40% marginal tax bracket is considering the acquisition of a tax-exempt bond that offers a tax-exempt yield of 6%. The equivalent taxable yield is 10%, as shown below:

images

When computing the equivalent taxable yield, the traditionally computed yield-to-maturity is not the tax-exempt yield if the issue is selling below par (i.e., selling at a discount) because only the coupon interest is exempt from federal income taxes. Instead, the yield-to-maturity after an assumed capital gains tax is computed and used in the numerator of the formula.

The yield-to-maturity after an assumed capital gains tax is calculated in the same manner as the traditional yield-to-maturity. However, instead of using the redemption value in the calculation, the net proceeds after an assumed tax on any capital gain are used.

There is a major drawback in employing the equivalent taxable yield formula to compare the relative investment merits of a taxable and tax-exempt bond. Recall from the discussion in Chapter 6 that the yield-to-maturity measure assumes that the entire coupon interest can be reinvested at the computed yield. Consequently, taxable bonds with the same yield-to-maturity cannot be compared because the total dollar returns may differ from the computed yield. The same problem arises when attempting to compare taxable and tax-exempt bonds, especially because only a portion of the coupon interest on taxable bonds can be reinvested, although the entire coupon payment is available for reinvestment in the case of municipal bonds. The total return framework that should be employed to compare taxable and tax-exempt bonds is discussed in Chapter 6.

The traditional method of evaluating a municipal bond leaves much to be desired. The basic problem is that the call risk is not analyzed properly. The yield-to-worst calculation ignores the fact that interest rates can change in the future, and the actual timing of the cash flows may not be the same as what was projected. If an investor evaluates a bond to its maturity date, then this investor will be surprised if the bonds are called several years earlier. Conversely, if the investor evaluates a bond to a specific call date and the bond is not called, then this investor will realize a stream of cash flows that is different from what was anticipated. The result of the traditional methodology is that most callable municipal bonds are priced too richly, and the cost of noncallable bonds with extra convexity is cheap. This is especially true for longer-dated bonds. More information about OAS analysis can be found in Chapter 40.

TAX PROVISIONS AFFECTING MUNICIPALS

Federal tax rate levels affect municipal bond values and strategies employed by investors. There are three provisions in the Internal Revenue Code that investors in municipal securities should recognize. These provisions deal with the tax treatment of OIDs, alternative minimum tax, and the deductibility of interest expense incurred to acquire municipal securities. Moreover, there are state and local taxes about which an investor must be aware.

Tax Treatment of Original-Issue Discount Bonds

When purchasing OIDs in the secondary market, investors should analyze the bond carefully owing to the complex tax treatment of OIDs. Few investors think about tax implications when investing in municipal debt. After all, the interest earned on most municipal bonds is exempt from federal taxes. If investors do think about taxes, they probably think about selling bonds at a higher price than the original tax cost. Most investors believe that this would create a capital gain and absent this situation there should be no tax impact. Sounds straightforward, but the municipal world isn’t simplistic. Several years ago the marketplace was introduced to the Revenue Reconciliation Act of 1993, and since then investing in municipals has become more complex. Currently, profit from bonds purchased in the secondary market after April 30, 1993, could be free from any tax implications or taxed at the capital gains rate, ordinary income rate, or a combination of the two rates. To understand this situation, it is essential to understand the rule of de minimus.

In basic terms, the rule of de minimus states that a bond is to be discounted up to 0.25% from the face value for each remaining year of a bond’s life before it is affected by ordinary income taxes. This price is commonly referred to as the “market discount cutoff price.” If the bond is purchased at a market discount but the price is higher than the market discount cutoff price, then any profits will be taxed at the capital gains rate. If the purchase price is lower than the market discount cutoff price, then any profits may be taxed as ordinary income or a combination of the ordinary income rate and the capital gains rate. The exact tax burden depends on several factors.

The rule of de minimus is especially complicated for OID bonds. For these bonds, a revised issue price must be calculated, as well as the market discount cutoff price. The revised issue price does change over time because the OID must be accreted over the life of the bond. The rule of de minimus does not apply to the OID segment, but it does apply to the market discount segment. The market discount segment is equal to the purchase price (secondary market price) minus the revised issue price. If an OID bond is purchased in the secondary market at a price greater than the revised issue price, the bond is considered to have an acquisition premium, and the rule of de minimus does not apply. If the OID bond is purchased at a price below the revised issue price and above the market discount cutoff price, then the OID bond is purchased at a market discount, and any profits will be taxed at the capital gains rate. Finally, if the purchase price of the OID bond is lower than the market discount cutoff price, then any profits may be taxed as ordinary income or a combination of the ordinary income rate and the capital gains rate. The OID topic is complicated. More specific details can be found in the Internal Revenue Service (IRS) Publications.

Alternative Minimum Tax

Alternative minimum taxable income (AMTI) is a taxpayer’s taxable income with certain adjustments for specified tax preferences designed to cause AMTI to approximate economic income. For both individuals and corporations, a taxpayer’s liability is the greater of (1) the tax computed at regular tax rates on taxable income and (2) the tax computed at a lower rate on AMTI. This parallel tax system, the alternative minimum tax (AMT), is designed to prevent taxpayers from avoiding significant tax liability as a result of taking advantage of exclusions from gross income, deductions, and tax credits otherwise allowed under the Internal Revenue Code.

There are different rules for determining AMTI for individuals and corporations. The latter are required to calculate their minimum tax liability using two methods. Moreover, there are special rules for property and casualty companies.

One of the tax preference items that must be included is certain tax-exempt municipal interest. As a result of the AMT, the value of the tax-exempt feature is reduced. However, the interest of some municipal issues is not subject to the AMT. Under the current tax code, tax-exempt interest earned on all private activity bonds issued after August 7, 1986 must be included in AMTI. There are two exceptions. First, interest from bonds that are issued by 501(c)(3) organizations (i.e., not-for-profit organizations) is not subject to AMTI. The second exception is interest from bonds issued for the purpose of refunding if the original bonds were issued before August 7, 1986. The AMT does not apply to interest on governmental or nonprivate activity municipal bonds. An implication is that the issues subjected to the AMT will trade at a higher yield than those exempt from AMT.

Deductibility of Interest Expense Incurred to Acquire Municipals

Some investment strategies involve the borrowing of funds to purchase or carry securities. Ordinarily, interest expense on borrowed funds to purchase or carry investment securities is tax deductible. There is one exception that is relevant to investors in municipal bonds. The IRS specifies that interest paid or accrued on “indebtedness incurred or continued to purchase or carry obligations, the interest on which is wholly exempt from taxes,” is not tax deductible. It does not make any difference if any tax-exempt interest is actually received by the taxpayer in the taxable year. In other words, interest is not deductible on funds borrowed to purchase or carry tax-exempt securities.

Special rules apply to commercial banks. At one time, banks were permitted to deduct all the interest expense incurred to purchase or carry municipal securities. Tax legislation subsequently limited the deduction first to 85% of the interest expense and then to 80%. The 1986 tax law eliminated the deductibility of the interest expense for bonds acquired after August 6, 1986. The exception to this nondeductibility of interest expense rule is for bank-qualified issues. These are tax-exempt obligations sold by small issuers after August 6, 1986, and purchased by the bank for its investment portfolio.

An issue is bank-qualified if (1) it is a tax-exempt issue other than private activity bonds, but including any bonds issued by 501(c)(3) organizations, and (2) it is designated by the issuer as bank-qualified and the issuer or its subordinate entities reasonably do not intend to issue more than $10 million of such bonds. A nationally recognized and experienced bond attorney should include in the opinion letter for the specific bond issue that the bonds are bank-qualified.

State and Local Taxes

The tax treatment of municipal bonds varies by state. There are three types of taxes that can be imposed: (1) an income tax on coupon income, (2) a tax on realized capital gains, and (3) a personal property tax.

Many states levy an individual income tax. Coupon interest from obligations by in-state issuers is exempt from state individual income taxes in most states. A few states levy individual income taxes on coupon interest whether the issuer is in state or out of state.

State taxation of realized capital gains is often ignored by investors when making investment decisions. In many states, a tax is levied on a base that includes income from capital transactions (i.e., capital gains or losses). In many states in which coupon interest is exempt if the issuer is in state, the same exemption will not apply to capital gains involving municipal bonds.

Some states levy a personal property tax on municipal bonds. The tax resembles more of an income tax than a personal property tax. Before 1995, some state and local governments levied this tax on residents who owned municipal bonds where the issuer of the bond was located outside the investor’s home state. While residents owning municipal bonds where the issuer was located within the investor’s home state’s boundaries were exempt from such tax, this tax was declared unconstitutional by the U.S. Supreme Court because it violated the federal commerce clause by favoring in-state businesses over out-of-state business. The determining case was Fulton Corporation v. Janice H. Faulkner, Secretary of Revenue of North Carolina, No. 94-1239 (U.S. S.C. Feb. 21, 1996). After the court ruled on this case, many state and local governments that levied a similar tax repealed the tax or chose not to collect it.

In determining the effective tax rate imposed by a particular state, an investor must consider the impact of the deductibility of state taxes on federal income taxes. Moreover, in some states, federal taxes are deductible in determining state income taxes.

YIELD RELATIONSHIPS WITHIN THE MUNICIPAL BOND MARKET

In this section, we briefly look at some important yield relationships within the municipal bond market.

Differences within an Assigned Credit Rating

Bond buyers primarily use the credit ratings assigned by the commercial rating companies, Standard & Poor’s, Moody’s, and Fitch as a starting point for pricing an issue. The final market-derived bond price is determined by the assigned credit rating and adjustments by investors to reflect their own analysis of credit-worthiness and perception of marketability. For example, insured municipal bonds—when they were a dominant factor in the market—tended to have yields that were substantially higher than noninsured superior-investment-quality municipal bonds, even though most insured bonds were given triple-A ratings by the commercial rating companies. Additionally, many investors have geographic preferences among bonds despite identical credit quality and otherwise comparable investment characteristics.

Differences between Credit Ratings

With all other factors constant, the greater the credit risk perceived by investors, the higher the return expected by investors. The spread between municipal bonds of different credit quality is not constant over time. Reasons for the change in spreads are (1) the outlook for the economy and its anticipated impact on issuers, (2) federal budget financing needs, and (3) municipal market supply-and-demand factors. During periods of relatively low interest rates, investors sometimes increase their holdings of issues of lower credit quality in order to obtain additional yield. This narrows the spread between high-grade and lower-grade credit issues. During periods in which investors anticipate a poor economic climate, there is often a “flight to quality” as investors pursue a more conservative credit-risk exposure. This widens the spread between high-grade and lower-grade credit issues.

Another factor that causes shifts in the spread between issues of different quality is the temporary oversupply of issues within a market sector. For example, a substantial new issue volume of high-grade state general obligation bonds may tend to decrease the spread between high-grade and lower-grade revenue bonds. In a weak market environment, it is easier for high-grade municipal bonds to come to market than for weaker credits. Therefore, it is not uncommon for high grades to flood weak markets at the same time that there is a relative scarcity of medium- and low-grade municipal bond issues.

Differences between In-State and General Market

Bonds of municipal issuers located in certain states (e.g., New York, New Jersey, California, Arizona, Maryland, and Pennsylvania) usually yield considerably less than issues of identical credit quality that come from other states that trade in the “general market.” There are three reasons for the existence of such spreads. First, states often exempt interest from in-state issues from state and local personal income taxes. Interest from out-of-state issues is generally not exempt. Consequently, in states with high income taxes (e.g., New York and California), strong investor demand for in-state issues will reduce their yields relative to bonds of issues located in states in which state and local income taxes are not important considerations (e.g., Illinois and Wisconsin). Of course, it should be noted that bonds of Puerto Rico and other U.S. territorial governments are also exempt from state and local taxation, and enjoy these yield advantages. Second, in some states, public funds deposited in banks must be collateralized by the bank accepting the deposit. This requirement is referred to as “pledging.” Acceptable collateral for pledging typically will include issues of certain in-state issuers. For those qualifying issues, pledging tends to increase demand (particularly for the shorter maturities) and reduce yields relative to nonqualifying comparable issues. The third reason is that investors in some states exhibit extreme reluctance to purchase issues from issuers outside their state or region. In-state parochialism tends to decrease relative yields of issues from states in which investors exhibit this behavior.

Differences between Maturities

One determinant of the yield on a bond is the number of years remaining to maturity. As explained in Chapter 8, the yield-curve depicts the relationship at a given point in time between yields and maturity for bonds that are identical in every way except maturity. When yields increase with maturity, the yield-curve is said to be normal or have a positive slope. Therefore, as investors lengthen their maturity, they require a greater yield. It is also possible for the yield-curve to be inverted, meaning that long-term yields are less than short-term yields. If short, intermediate, and long-term yields are roughly the same, the yield-curve is said to be flat.

In the taxable bond market, it is not unusual to find all three shapes for the yield-curve at different points in the business cycle. However, in the municipal bond market, the yield-curve typically is normal or upward-sloping. Consequently, in the municipal bond market, long-term bonds generally offer higher yields than short- and intermediate-term bonds.

Insured Municipal Bonds

Although insured municipal bonds, when they were rated Aaa/AAA, sold at yields lower than they would without the monoline company insurance, they tended to have yields that were higher than other Aaa/AAA-rated bonds, such as deep-discount refunded bonds. Of course, supply-and-demand forces and in-state taxation factors can distort market trading patterns from time to time. Insured bonds as a generic group before their massive downgrades beginning in 2008 were not viewed in the market as having the same superior degree of safety as either refunded bonds secured with escrowed U.S. Treasuries or those general obligation bonds of states that had robust and growing economies, fiscally conservative budgetary operations, and very low debt burdens.

PRIMARY AND SECONDARY MARKETS

The municipal market can be divided into the primary market and the secondary market. The primary market is one in which all new issues of municipal bonds are sold for the first time. The secondary market is the market in which previously issued municipal securities are traded.

Primary Market

A substantial number of municipal obligations are brought to market each week. 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 or municipal bond departments of commercial banks. Public offerings may be marketed by either competitive bidding or direct negotiations with underwriters. When an issue is marketed via competitive bidding, the issue is awarded to the bidder submitting the best bid.

Most states mandate that general obligation issues be marketed through competitive bidding, but generally this is not required for revenue bonds. Usually state and local governments require a competitive sale to be announced in a recognized financial publication, such as The Bond Buyer, which is the trade publication for the municipal bond industry. The Bond Buyer also provides information on upcoming competitive sales and most negotiated sales, as well as the results of previous weeks.

The sale of bonds by issuers, both competitively and through negotiation, has become more efficient and software based. Two companies offer this service for competitive bond sales. One is I-Deal/Ipreo, which also provides a software platform for negotiated bond sales. The other is the Grant Street Group, which focuses on competitive sales in the municipal market.

Secondary Market

Municipal bonds are traded in the over-the-counter markets supported by municipal bond dealers across the country. Markets are maintained on smaller issuers (referred to as local credits) by regional brokerage firms, local banks, and some of the larger Wall Street firms. Larger issuers (referred to as general market names) are supported by the larger brokerage firms and banks, many of which have investment banking relationships with these issuers. There are brokers who serve as intermediaries in the sale of large blocks of municipal bonds among dealers and large institutional investors. Additionally, beginning in 2000, bonds in the secondary market, as well as some new issue competitive and negotiated bond issues, began to be auctioned and sold over the Internet by large and small broker-dealers to institutional and individual investors.

In the municipal bond markets, an odd lot of bonds is $25,000 or less in par value for retail investors. For institutions, anything below $100,000 in par value is considered an odd lot. Dealer spreads depend on several factors. For the retail investor, the spread can range from as low as one-quarter of one point ($12.50 per $5,000 of par value) on large blocks of actively traded bonds to four points ($200 per $5,000 of par value) for odd-lot sales of an inactive issue. For retail investors, the typical commission should be between 1½ and 2½ points. For institutional investors, the dealer spread rarely exceeds one-half of 1 point ($25 per $5,000 of par value).

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. Certain long-maturity revenue bonds are exceptions. A bond traded and quoted in dollar prices (actually, as a percentage of par value) is called a dollar bond.

It should be noted that many institutional investors, for trading and bond purchasing purposes, price bonds off the MMD scale. This is a daily index of generic AAA’s prices covering the full yield-curve provided by Thomson Municipal Market Data and available to subscribers over the Internet. Also, the Municipal Securities Rulemaking Board (MSRB) in Washington, DC, reports on a daily basis for no charge actual trades and prices of specific bonds. The Internet address is www.investinginbonds.com, which is the home page of the Securities Industry and Financial Markets Association (SIFMA), the trade association for the sell side.

BOND INDEXES

The major provider of total return-based indexes to institutional investors is Barclays Capital. Investors use the Barclays Capital Municipal Bond index (formerly the Lehman Brothers Municipal Bond index) to measure relative total return performance and enhance a fund manager’s ability to outperform the market. Lehman began publishing municipal indexes in January of 1980 and by 2011 Barclays Capital compiles returns and statistics on more than 2,500 benchmarks. They are broad-based performance measures for the tax-exempt bond market. Similar to all bond indexes provided by Barclays Capital, the municipal indexes are rules based and market value weighted. As of 2011, the Barclays Capital Municipal Bond Index contained more than 46,000 bonds with a market value of about $1.2 trillion. To be included in the index, bonds must have a minimum credit rating of Baa/BBB. They must have an outstanding par value of at least $7 million and be part of a transaction of $75 million or greater. The bonds must have been issued after December 31, 1990, and have a remaining maturity of at least one year.

In addition to investment-grade indexes, Barclays Capital offers total return benchmarks for the noninvestment-grade tax-exempt market. To ensure statistically significant, representative benchmarks for the lower capitalized states, Barclays Capital provides state-specific municipal benchmarks with reduced liquidity requirements.

Many investors use Barclays indexes as performance measures for a given market or market segment. The benchmarks are also employed to identify and quantify portfolio bets versus the general market and/or a given peer group.

Indexes also are used to identify relative value opportunities as well as a proxy for the outstanding market. Given the consistent methodologies, the Barclays indexes are used often when comparing tax-exempt and taxable fixed income markets.

In addition to the Barclays indexes, Bank of America Merrill Lynch publishes a number of municipal bond indexes, and The Bond Buyer, the trade daily newspaper, publishes weekly yield indexes.

There are also two services that in the afternoon of each trading day make available generic scales for different maturities and credit ratings. As noted, one is provided by Thomson Municipal Market Data, known in the industry as the MMD scale. The other is by Municipal Market Advisors (MMA).

OFFICIAL STATEMENT

An official statement describing the issue and issuer is prepared for new offerings. Often a preliminary official statement is issued prior to the final official statement. These statements are known as the OS and POS. These statements provide potential investors with a wealth of information. The statements contain basic information about the amount of bonds to be issued, maturity dates, coupons, the use of the bond proceeds, the credit ratings, a general statement about the issuer, and the name of the underwriter and members of the selling group. Much of this information can be found on the cover page or the first few pages of the official statement. It also contains detailed information about the security and sources of payments for the bonds, sources and uses of funds, debt-service requirements, relevant risk factors, issuer’s financial statements, a summary of the bond indenture, relevant agreements, notice of any known existing or pending litigation, the bond insurance policy specimen (if insured), and the form of opinion of bond counsel. The official statement contains most of the information an investor will need to make an informed and educated investment decision.

REGULATION OF THE MUNICIPAL SECURITIES MARKET

As an outgrowth of abusive stock market practices, Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934. The 1934 act created the Securities and Exchange Commission (SEC), granting it regulatory authority over the issuance and trading of corporate securities. Congress specifically exempted municipal securities from both the registration requirements of the 1933 act and the periodic reporting requirements of the 1934 act. However, antifraud provisions did apply to offerings of or dealings in municipal securities.

The exemption afforded municipal securities appears to have been due to (1) the desire for governmental comity, (2) the absence of recurrent abuses in transactions involving municipal securities, (3) the greater level of sophistication of investors in this segment of the securities markets (i.e., institutional investors dominated the market), and (4) the fact that there were few defaults by municipal issuers. Consequently, from the enactment of the two federal securities acts in the early 1930s to the early 1970s, the municipal securities market can be characterized as relatively free from federal regulation.

In the early 1970s, however, circumstances changed. As incomes rose, individuals participated in the municipal securities market to a much greater extent. As a result, public outcries over selling practices occurred with greater frequency. For example, in the early 1970s, the SEC obtained seven injunctions against 72 defendants for fraudulent municipal trading practices. According to the SEC, the abusive practices involved both disregard by the defendants as to whether the particular municipal bonds offered to individuals were in fact appropriate investment vehicles for the individuals to whom they were offered, and misrepresentation—failure to disclose information necessary for individuals to assess the credit risk of the municipal issuer, especially in the case of revenue bonds. Moreover, the financial problems of some municipal issuers, notably New York City, made market participants aware that municipal issuers have the potential to experience severe and bankruptcy-type financial difficulties.

Congress passed the Securities Act Amendment of 1975 to broaden regulation in the municipals market. The legislation brought brokers and dealers in the municipal securities market, including banks that underwrite and trade municipal securities, within the regulatory scheme of the Securities Exchange Act of 1934. In addition, the legislation mandated that the SEC establish a 15-member Municipal Securities Rulemaking Board (MSRB) as an independent, self-regulatory agency whose primary responsibility is to develop rules governing the activities of banks, brokers, and dealers in municipal securities. Rules adopted by the MSRB must be approved by the SEC. The MSRB has no enforcement or inspection authority. This authority is vested with the SEC, the National Association of Securities Dealers, and certain regulatory banking agencies such as the Federal Reserve banks. The Securities Act Amendment of 1975 does not require that municipal issuers comply with the registration requirement of the 1933 act or the periodic-reporting requirement of the 1934 act. There have been, however, several legislative proposals to mandate financial disclosure. Although none has been passed, there is clearly pressure to improve disclosure. Even in the absence of federal legislation dealing with the regulation of financial disclosure, underwriters began insisting on greater disclosure as it became apparent that the SEC was exercising stricter application of the antifraud provisions. Moreover, underwriters recognized the need for improved disclosure to sell municipal securities to an investing public that has become much more concerned about credit risk by municipal issuers. On June 28, 1989, the SEC formally approved the first bond disclosure rule, effective January 1, 1990. The following paragraphs summarize its contents. The rule applies to all new issue municipal securities offerings of $1 million or more. Exemptions have been added for securities offered in denominations of $100,000 or more, if such securities

• Are sold to no more than 35 “sophisticated investors”

• Have a maturity of nine months or less

• Are variable-rate demand instruments

Before bidding on or purchasing an offering, underwriters must obtain and review official statements that are deemed final by the issuer, with the omission of no more than the following information:

• Offering price

• Interest rate

• Selling compensation

• Aggregate principal amount

• Principal amount per maturity

• Delivery dates

• Other terms or provisions required by an issuer of such a security to be specified in a competitive bid, ratings, other terms of the securities depending on such matters, and the identity of the underwriters

The underwriters shall contract with an issuer or its designated agent to receive copies of a final official statement within seven business days after any final agreement to purchase, offer, or sell any offering and in sufficient time to accompany any confirmation that requests payment from any customer.

Except for competitively bid offerings, the underwriters shall send, no later than the next business day, to any potential customer, on request, a single copy of the most recent preliminary official statement, if any.

Underwriters are required to distribute the final official statement to any potential customer, on request, within 90 days, or 25 days if the final official statement is available from a repository.

Most recently, the Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law on July 21, 2010, requires that municipal advisers be subject to SEC registration and MSRB oversight.

Material Event Disclosure under SEC Rule 15c2-12

The first phase of the implementation of amendments to Rule 15c2-12, which took effect on July 3, 1995, required dealers to determine that issuers before issuing new municipal bonds made arrangements to disclose in the future financial information at least annually as well as notices of the occurrence of any of 11 “material event notices” as specified in the rule. By 2011, the amended rule increased the material event notices to 14. Also by 2011, the annual report and notices of material events are filed with the Municipal Securities Rulemaking Board (MSRB), in an electronic format as prescribed by the MSRB. The MSRB designated its Electronic Municipal Market Access system (EMMA), found at http://emma.msrb.org, as the repository for such disclosure filings.

The second phase went into effect on January 1, 1996, and required dealers to have in-house procedures in place to provide reasonable assurance that they will receive prompt notice of any material event notices that are required to be disclosed by the issuers.

The Governmental Accounting Standards Board

The Governmental Accounting Standards Board (GASB) is a nonprofit organization that sets generally accepted accounting standards (GAAP) for state and local governments. Providing detailed guidelines and established in 1984, for many years it has improved financial reporting standards in reports of state and local governments that are used by analysts, auditors, and other users. By improving the transparency of state and local government accounting, it helps prevent issuers from obfuscating budget deficits and long-term liabilities that in the past had resulted in budgetary disasters and bond defaults. The Web address is http://gasb.org.

The National Federation of Municipal Analysts

The National Federation of Municipal Analysts (NMFA) was established in 1983, and by 2011 had a membership of 1,000 municipal professionals, drawing in part from the institutional investors in municipal bonds who advocated increased and timely information for investors. By 2011, its committees have developed detailed disclosure guidelines and risk factors in municipal securities ranging from specific credit sectors to swap structures. They are recommended for municipal bond issuers to use in providing ongoing financial and operating information to investors. The Web address is www.nfma.org.

KEY POINTS

• The majority of tax-exempt securities are issued by state and local governments and by their creations. Most outstanding municipal bonds are tax-exempt securities, meaning that the interest income is exempt from federal income taxes. Consequently, the major motivation for investing in tax-exempt municipal bonds is their tax advantage. The state and local income tax treatment of interest income from municipal bonds varies.

• In terms of municipal bond security structures, there are basically two different types: general obligation bonds (secured by the issuer’s general taxing powers) and revenue bonds (issued for either project or enterprise financings in which the bond issuers pledge to the bondholders the revenues generated by the operating projects financed). There are bonds with security structures that have certain characteristics of general obligation and revenue bonds. These hybrid and special bond securities include refunded bonds, dedicated tax-backed and structured asset-backed bonds, insured bonds, lease-backed bonds, letter of credit–backed bonds, moral obligation bonds, territorial bonds, and troubled city bailout bonds. Municipal money market products include notes, commercial paper, variable-rate demand obligations, and commercial paper mode.

• Municipal bonds are assigned credit ratings by commercial rating agencies (Moody’s, Standard & Poor’s, and Fitch) just like corporate bonds. Some investors do not perform their own credit-risk analysis, but instead rely entirely on credit-risk ratings assigned. Large institutional investors, underwriters, and traders tend to use ratings as a starting point in evaluating a municipal credit and then rely on their own in-house municipal credit analysts for determining the creditworthiness of municipal bonds.

• As in other sectors of the bond market, yield measures such as yield to maturity and yield to call are computed. In comparing a tax-exempt municipal bond yield to that of a comparable taxable yield, the taxable equivalent yield is computed.

• Tax considerations in investing in tax-exempt municipal bonds include original issue discount embedded in an issue, the alternative minimum tax, deductibility of interest expense incurred to acquire a municipal bond, and treatment of interest income at the state and local tax levels.

• Barclays Capital is the major provider of total return–based municipal bond indexes that are used by institutional investors. The Barclays Capital Municipal Bond Index is used to measure relative total return performance. The Barclays indexes are available for a given market or market segment within the municipal bond market. Thomson Municipal Market Data and Municipal Market Advisors are two services that in the afternoon of each trading day make available generic scales for different maturities and different credit ratings in the municipal bond market.

• An official statement (OS) describing the issue and the issuer is prepared for new offerings. Typically a preliminary official statement (POS) is issued prior to the final official statement.

..................Content has been hidden....................

You can't read the all page of ebook, please click here login for view all page.
Reset
3.238.12.0