Municipal Bonds BA 561 – Supply Chain Management April 30, 2012 Chip Ullstad

Overview What is a municipal bond? Who sells municipal bonds & why? Who buys municipal bonds & why? Bond ratings, risks and regulation Summary & Questions

What is a municipal bond? Fixed debt instruments Tax secured bonds Revenue secured bonds Tax secured, two types, general obligation bonds secured by a community’s full faith and credit (a phrase used primarily in conjunction with General Obligation bonds to pledge use of all taxing powers and resources, if necessary, to pay the bond holders. Moral obligation, state offers non-binding promise to pay. Revenue bonds, secured by dedicated revenue stream such as water, sewer or other user fees Terms range from 10-30 years, average 15. Daily trading volume about $16 B/day. Terms and volume

Who sells municipal bonds? State and local governments School districts Service districts Public utilities The first municipal bond in the US was sold by New York City in 1812 to fund construction of the Erie Canal Self-funding infrastructure

Why sell a municipal bond? Fund capital improvements Tax leveraged financing Align revenue and debt streams Stagger principal repayment Short term financing

How are municipal bonds sold? Voter approval Legal opinion Audit report Competitively bid Structure (serial bonds)

What is a serial bond?

Bond funded facilities

Reliance on municipal bonds Over the past 65 years municipal bond debt has increased from $20B following world war II to 3.7 T in 2010, almost 200 fold. 1945 1980 2010

Who buys municipal bonds? MUNICIPAL BOND INVESTORS, 09/2011 About 50% of municipal bonds are held by individual investors or households, mutual funds hold about 25% and institutional investors hold the remaining 50%.

Why buy a municipal bond? Tax exempt earnings l Federal (almost all) l State (depends) l Local (depends) Almost all municipal bonds provide a federal tax shelter. There are some municipal bonds that the federal government doesn’t deem eligible for tax exempt earnings, because of limited public benefit. These are termed taxable bonds and are used to fund Investor-led housing, local sports facilities, and borrowing to replenish a municipality’s underfunded pension plan Advantages vary with AGI

Tax Equivalent Rates (Federal) Tax shelter advantage of municipal bonds varies from 1.5% to 2% based on federal income tax bracket. This spread is greater when state and local income taxes are considered.

States with income tax Income tax benefits from municipal bonds can be further leveraged in states and cities with income tax. 43 of 50 states and Washington DC have state income taxes that provide tax shelters to municipal bonds sold within their state.

Example Frances, AGI = $250,000

Example Charlie, AGI = $20,000

Bond Rating Agencies Bond rating agencies Ratings protect bond buyers l Moody’s (major) l Standard & Poors (major) l Fitch (minor) Ratings protect bond buyers

Bond ratings and risks Bond rating criteria Regulation l Economy l Financial health l Demographics Bonds are regulated by the Municipal Secrities Rule Making Board, an advisory commission to the SEC, Regulation

Risk comparison Highly rated municipal bonds (AAA & AA) have not defaulted. Investment grade municipal bonds (BBB and greater) about 20X safer than similarly rated corporate bonds.

Summary Muni’s fund capital improvements Two general types of bonds & security Individual & institutional investors Can shelter earned & investment income Municipal bonds are fixed debt instruments that fund capital improvements for state, local and quasi-governmental organizations. Two types of bonds – tax secured general obligation bonds and revenue secured bonds Like all investments, carry risk

Questions

References Bond rating criteria, http://www.munibondadvisor.com/rating.htm Municipal bond regulation, http://www.sec.gov/info/municipal.shtml Municipal bond debt history, http://www.sec.gov/spotlight/municipalsecurities.shtml Definition of municipal bonds, http://www.investinginbonds.com/learnmore.asp?catid=8&subcatid=53&id=231 Data for municipal bond holder graph, http://2.bp.blogspot.com/-Yo8EgQgF3K4/UCuqUb1NpHI/AAAAAAAABbM/oMiAnED24JE/s400/6a01348793456c970c0163064 Serial bond table (munis vs. corporate, http://www.investinganswers.com/images/definition%20--%20serial%20bond.gif Map, state income tax rates, http://taxfoundation.org/sites/taxfoundation.org/files/docs/income_rates_large.png Municipal bond rating criteria, http://www.munibondadvisor.com/rating.htm