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Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-1 Chapter 8 Municipal Securities
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-2 Learning Objectives After reading this chapter, you will understand the two basic security structures: tax-backed debt and revenue bonds the flow of funds structure for revenue bonds municipal bonds with hybrid structures and special bond security structures such as refunded bonds and insured municipal bonds the different types of tax-exempt short-term municipal securities what municipal derivative securities are
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-3 Learning Objectives (continued) After reading this chapter, you will understand the two basic security structures: tax-backed debt and revenue bonds how municipal inverse floaters are created the tax risk that investors face when investing in municipal securities yield spreads within the municipal market the shape of the municipal yield curve the primary and secondary markets for municipal securities the taxable municipal bond market
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-4 Types and Features of Municipal Securities There are basically two different types of municipal bond security structures: i.tax-backed bonds ii.revenue bonds There are also securities that share characteristics of both tax-backed and revenue bonds.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-5 Types and Features of Municipal Securities (continued) Tax-Backed Debt Tax-backed debt obligations are instruments issued by states, counties, special districts, cities, towns, and school districts that are secured by some form of tax revenue. Tax-backed debt includes general obligation debt, appropriation-backed obligations, and debt obligations supported by public credit enhancement programs.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-6 Types and Features of Municipal Securities (continued) Tax-Backed Debt The broadest type of tax-backed debt is general obligation debt. An unlimited tax general obligation debt is the stronger form of general obligation pledge as it is secured by the issuer’s unlimited taxing power. A limited tax general obligation debt is a limited tax pledge because for such debt there is a statutory limit on tax rates that the issuer may levy to service the debt.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-7 Types and Features of Municipal Securities (continued) Tax-Backed Debt Agencies or authorities of several states have issued bonds that carry a potential state liability for making up shortfalls in the issuing entity’s obligation. However, the state’s pledge is not binding. Debt obligations with this nonbinding pledge of tax revenue are called moral obligation bonds.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-8 Types and Features of Municipal Securities (continued) Revenue Bonds The second basic type of security structure is found in a revenue bond. Such bonds are issued for either project or enterprise financings in which the bond issuers pledge to the bondholders the revenues generated by the operating projects financed. For a revenue bond, the revenue of the enterprise is pledged to service the debt of the issue. The details of how revenue received by the enterprise will be disbursed are set forth in the trust indenture.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-9 Types and Features of Municipal Securities (continued) Revenue Bonds There are various restrictive covenants included in the trust indenture for a revenue bond to protect the bondholders. A rate, or user charge, covenant dictates how charges will be set on the product or service sold by the enterprise. Other covenants specify that i.the facility may not be sold ii.the amount of insurance to be maintained iii.requirements for recordkeeping and for the auditing of the enterprise’s financial statements by an independent accounting firm iv.requirements for maintaining the facilities in good order
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-10 Types and Features of Municipal Securities (continued) Revenue Bonds Examples of revenue bonds include: i.Airport Revenue Bonds ii.Higher Education Bonds iii.Hospital Revenue Bonds iv.Single-Family Mortgage Revenue Bonds v.Multifamily Revenue Bonds vi.Public Power Revenue Bonds vii.Resource Recovery Revenue Bonds viii.Student Loan Revenue Bonds ix.Toll Road and Gas Tax Revenue Bonds x.Water Revenue Bonds xi.Pollution Control Revenue and Industrial Development Revenue Bonds
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-11 Types and Features of Municipal Securities (continued) Hybrid and Special Bond Securities Some municipal bonds that have the basic characteristics of general obligation bonds and revenue bonds have more issue-specific structures as well. Some examples are i.insured bonds ii.bank-backed municipal bonds iii.refunded bonds structured/asset-backed securities iv.“troubled city” bailout bonds
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-12 Types and Features of Municipal Securities (continued) Hybrid and Special Bond Securities Insured bonds, in addition to being secured by the issuer’s revenue, are also backed by insurance policies written by commercial insurance companies. Because municipal bond insurance reduces credit risk for the investor, the marketability of certain municipal bonds can be greatly expanded. There are two major groups of municipal bond insurers. i.The first includes the monoline companies that are primarily in the business of insuring municipal bonds. ii.The second group of municipal bond insurers includes the multiline property and casualty companies that usually have a wide base of business, including insurance for fires, collisions, hurricanes, and health problems.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-13 Types and Features of Municipal Securities (continued) Hybrid and Special Bond Securities Since the 1980s, municipal obligations have been increasingly supported by various types of credit facilities provided by commercial banks. There are three basic types of bank support: letter of credit, irrevocable line of credit, and revolving line of credit. i.A letter-of-credit agreement is the strongest type of support available from a commercial bank. Under this arrangement, the bank is required to advance funds to the trustee if a default has occurred. i.An irrevocable line of credit is not a guarantee of the bond issue, although it does provide a level of security. ii.A revolving line of credit is a liquidity-type credit facility that provides a source of liquidity for payment of maturing debt in the event that no other funds of the issuer are currently available.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-14 Types and Features of Municipal Securities (continued) Hybrid and Special Bond Securities Although originally issued as either revenue or general obligation bonds, municipals are sometimes refunded. A refunding usually occurs when the original bonds are escrowed or collateralized by direct obligations guaranteed by the U.S. government. The escrow fund for a refunded municipal bond can be structured so that the refunded bonds are to be called at the first possible call date or a subsequent call date established in the original bond indenture. Such bonds are known as prerefunded municipal bonds. Although refunded bonds are usually retired at their first or subsequent call date, some are structured to match the debt obligation to the retirement date. Such bonds are known as escrowed-to-maturity bonds.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-15 Types and Features of Municipal Securities (continued) Hybrid and Special Bond Securities There are three reasons why a municipal issuer may refund an issue by creating an escrow fund. i.Many refunded issues were originally issued as revenue bonds. ii.Some issues are refunded in order to alter the maturity schedule of the obligation. iii.When interest rates have declined after a municipal security has been issued, there is a tax arbitrage opportunity available to the issuer by paying existing bondholders a lower interest rate and using the proceeds to create a portfolio of U.S. government securities paying a higher interest rate.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-16 Types and Features of Municipal Securities (continued) Redemption Features Municipal bonds are issued with one of two debt retirement structures, or a combination. Either a bond has a serial maturity structure or it has a term maturity structure. A serial maturity structure requires a portion of the debt obligation to be retired each year. A term maturity structure provides for the debt obligation to be repaid on a final date. Municipal bonds may be called prior to the stated maturity date, either according to a mandatory sinking fund or at the option of the issuer.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-17 Types and Features of Municipal Securities (continued) Redemption Features The municipal market has securities with various features. These are zero-coupon bonds, floating-rate bonds, and putable bonds in the municipal bond market. For this market, there are two types of zero-coupon bonds. i.One type is issued at a very deep discount and matures at par. o The difference between the par value and the purchase price represents a predetermined compound yield. o These zero-coupon bonds are similar to those issued in the taxable bond market for Treasuries and corporates. ii.The second type is called a municipal multiplier. o This is a bond issued at par that has interest payments. o The interest payments are not distributed to the holder of the bond until maturity, but the issuer agrees to reinvest the undistributed interest payments at the bond’s yield to maturity when it was issued.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-18 Municipal Money Market Products Tax-exempt money market products include: i.notes ii.commercial paper iii.variable-rate demand obligations iv.a hybrid of the last two products
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-19 Municipal Money Market Products (continued) Municipal notes include tax anticipation notes (TANs), revenue anticipation notes (RANs), grant anticipation notes (GANs), and bond anticipation notes (BANs). These are temporary borrowings by states, local governments, and special jurisdictions. Usually, notes are issued for a period of 12 months, although it is not uncommon for notes to be issued for periods as short as three months and for as long as three years. TANs and RANs (also known as TRANs) are issued in anticipation of the collection of taxes or other expected revenues. These are borrowings to even out irregular flows into the treasuries of the issuing entity. BANs are issued in anticipation of the sale of long-term bonds.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-20 Municipal Money Market Products (continued) Tax-Exempt Commercial Paper As with commercial paper issued by corporations, tax-exempt commercial paper is used by municipalities to raise funds on a short-term basis ranging from one to 270 days. The dealer sets interest rates for various maturity dates and the investor then selects the desired date. Variable-Rate Demand Obligations Variable-rate demand obligations (VRDOs) are floating-rate obligations that have a nominal long-term maturity but have a coupon rate that is reset either daily or every seven days. The investor has an option to put the issue back to the trustee at any time with seven days’ notice. The put price is par plus accrued interest.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-21 Municipal Money Market Products (continued) Commercial Paper / VRDO Hybrid The commercial paper/VRDO hybrid is customized to meet the cash flow needs of an investor. As with tax-exempt commercial paper, there is flexibility in structuring the maturity, because the remarketing agent establishes interest rates for a range of maturities. Although the instrument may have a long nominal maturity, there is a put provision, as with a VRDO.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-22 Municipal Derivative Securities (continued) In recent years, a number of municipal products have been created from the basic fixed-rate municipal bond. This has been done by splitting up cash flows of newly issued bonds as well as bonds existing in the secondary markets. These products have been created by dividing the coupon interest payments and principal payments into two or more bond classes, or tranches. The name derivative securities have been attributed to these bond classes because they derive their value from the underlying fixed-rate municipal bond.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-23 Municipal Derivative Securities (continued) Floaters / Inverse Floaters A common type of derivative security is one in which two classes of securities, a floating-rate security and an inverse-floating-rate bond, are created from a fixed-rate bond. The coupon rate on the floating-rate security is reset based on the results of a Dutch auction. Inverse floaters can be created in one of three ways: i.A municipal dealer can buy in the secondary market a fixed-rate municipal bond and place it in a trust with the trust issuing a floater and an inverse floater. ii.As illustrated in Exhibit 8-1 (see Overhead 8-24), the municipal dealer uses a newly issued municipal bond to create a floater and an inverse floater. iii.Using the municipal swaps market, one creates an inverse floater without the need to create a floater.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-24 Exhibit 8-1 Creation of a Municipal Inverse Floater Municipal floating-rate bondMunicipal inverse-floating-rate Fixed-rate municipal bond (newly issued or seasoned)
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-25 Municipal Derivative Securities (continued) Strips and Partial Strips Municipal strip obligations are created when a municipal bond’s cash flows are used to back zero-coupon instruments. The maturity value of each zero-coupon bond represents a cash flow on the underlying security. Partial strips have also been created from cash bonds, which are zero-coupon instruments to a particular date, such as a call date, and then converted into coupon paying instruments. These are called convertibles or step-up bonds. Other products can be created by allocating the interest payments and principal of a fixed-coupon-rate municipal bond to more than two bond classes.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-26 Credit Risk Although municipal bonds at one time were considered second in safety only to U.S. Treasury securities, today there are new concerns about their credit risks. i.The first concern came out of the New York City billion-dollar financial crisis in ii.The second reason for concern about municipal securities credit risk is the proliferation in this market of innovative financing techniques to secure new bond issues. What distinguishes these newer bonds from the more traditional general obligation and revenue bonds is that there is no history of court decisions or other case law that firmly establishes the rights of the bondholders and the obligations of the issuers.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-27 Credit Risk (continued) As with corporate bonds, some institutional investors in the municipal bond market rely on their own in-house municipal credit analysts for determining the credit worthiness of a municipal issue. Other investors rely on the nationally recognized rating companies. The two leading rating companies are Moody’s and Standard & Poor’s, and the assigned rating system is essentially the same as that used for corporate bonds. Although there are numerous security structures for revenue bonds, the underlying principle in rating is whether the project being financed will generate sufficient cash flow to satisfy the obligations due bondholders.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-28 Risks Associated with Investing in Municipal Securities The investor in municipal securities is exposed to the same risks affecting corporate bonds plus an additional one that may be labeled tax risk. There are two types of tax risk to which tax-exempt municipal securities buyers are exposed. i.The first is the risk that the federal income tax rate will be reduced. ii.The second type of tax risk is that a municipal bond issued as a tax-exempt issue may eventually be declared to be taxable by the Internal Revenue Service.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-29 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Yields on Municipal Bonds A common yield measure used to compare the yield on a tax-exempt municipal bond with a comparable taxable bond is the equivalent taxable yield, which is computed as: Example: Suppose that an investor in the 40% marginal tax bracket is considering the acquisition of a tax-exempt municipal bond that offers a yield of 6.5%. What is the equivalent taxable yield? 6.5%/(1-40%)
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-30 Yields on Municipal Bonds (continued) Because of the tax-exempt feature of municipal bonds, the yield on municipal bonds is less than that on Treasuries with the same maturity. The yield on municipal bonds is compared to the yield on Treasury bonds with the same maturity by computing the following ratio: Yield spreads within the municipal bond market are attributable to differences between credit ratings (quality spreads), sectors within markets (intramarket spreads), and differences between maturities (maturity spreads).
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-31 Municipal Bond Market Primary Market Municipal obligations are brought to market weekly. A state or local government can market its new issue by offering bonds publicly to the investing community or by placing them privately with a small group of investors. When a public offering is selected, the issue usually is underwritten by investment bankers and/or municipal bond departments of commercial banks. Most states mandate that general obligation issues be marketed through competitive bidding, but generally this is not required for revenue bonds. An official statement describing the issue and the issuer is prepared for new offerings. Municipal bonds have legal opinions that are summarized in the official statement.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-32 Municipal Bond Market (continued) Secondary Market Municipal bonds are traded in the over-the-counter market supported by municipal bond dealers across the country. Markets are maintained on smaller issuers (referred to as local general credits) by regional brokerage firms, local banks, and by some of the larger Wall Street firms. Larger issuers (referred to as general names) are supported by the larger brokerage firms and banks, many of whom have investment banking relationships with these issuers.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-33 Municipal Bond Market (continued) Secondary Market The convention for both corporate and Treasury bonds is to quote prices as a percentage of par value with 100 equal to par. Municipal bonds, however, generally are traded and quoted in terms of yield (yield to maturity or yield to call). The price of the bond in this case is called a basis price. The exception is certain long-maturity revenue bonds. A bond traded and quoted in dollar prices (actually, as a percentage of par value) is called a dollar bond.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-34 The Taxable Municipal Bond Market Taxable municipal bonds have their interest taxed at the federal level. Because there is no tax advantage, an issuer must offer a higher yield than for another tax-exempt municipal bond. There are three reasons why a municipality would want to issue a taxable municipal bond and thereby have to pay a higher yield than if it issued a tax-exempt municipal bond: i.Some activities do not benefit the public at large and municipalities have to finance these restricted activities in the taxable bond market. ii.The U.S. income tax code imposes restrictions on arbitrage opportunities that a municipality can realize from its financing activities. iii.Municipalities do not view their potential investor base as solely U.S. investors. When bonds are issued outside of the United States, the investor does not benefit from the tax-exempt feature.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-35 The Taxable Municipal Bond Market (continued) The most common types of activities for taxable municipal bonds used for financing are: i.local sports facilities ii.investor-led housing projects iii.advanced refunding of issues that are not permitted to be refunded because the tax law prohibits such activity iv.underfunded pension plan obligations of the municipality.
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