Frank J. Fabozzi, Ph.D., CFA

Adjunct Professor of Finance School of Management Yale University

Debt obligations are issued by state and local governments and by entities that they establish. Local government units include municipalities, counties, towns and townships, school districts, and special service system districts. Included in the category of municipalities are cities, villages, boroughs, and incorporated towns that received a special state charter. Counties are geographical subdivisions of states whose functions are law enforcement, judicial administration, and construction and maintenance of roads. As with counties, towns and townships are geographical subdivisions of states and perform similar functions as counties. A special-purpose service system district, or simply special district, is a political subdivision created to foster economic development or related services to a geographical area. Special districts provide public utility services (water, sewers, and drainage) and fire protection services. Public agencies or instrumentalities include authorities and commissions.

The number of municipal bond issuers is remarkable. One broker/ dealer’s estimate places the total at 60,055. Also, Bloomberg Financial Markets’ (Bloomberg) database contains 55,000 active issuers. Even more noteworthy is the number of different issues. Interactive Data, a company that provides pricing information for institutional investors, claims that it provides daily prices for more than 1.2 million individual issues in its database. Bloomberg’s database contains 1.7 million issues with complete description pages.

In this chapter, we discuss the types of debt obligations issued by states, municipal governments, and public agencies and their instrumentalities. These securities are popularly referred to as municipal securities, although they are also issued by states and public agencies and their instruments.

TAX-EXEMPT AND TAXABLE MUNICIPAL SECURITIES

There are both tax-exempt and taxable municipal securities. “Tax-exempt” means that interest on a municipal security is exempt from federal income taxation. The tax-exemption of municipal securities applies to interest income, not capital gains. The exemption may or may not extend to taxation at the state and local levels.

The state tax treatment depends on (1) whether the issue from which the interest income is received is an “in-state issue” or an “out-of-state issue,” and (2) whether the investor is an individual or a corporation. The treatment of interest income at the state level will be one of the following:

• taxation of interest from municipal issues regardless of whether the issuer is in-state or out-of-state
• exemption of interest from all municipal issues regardless of whether the issuer is in-state or out-of-state
• exemption of interest from municipal issues that are in-state but some form of taxation where the source of interest is an out-of-state issuer.

For individuals, for those states that have a state income tax, only the following states tax interest income from in-state issuers (although there may be some exceptions for certain out-of-state issues): Illinois, Iowa, Kansas, Oklahoma, and Wisconsin. Exhibit 10.1 identifies those states for which out-of-state issues are exempt from taxation. This exhibit also shows the maximum state tax rate on municipals and the effective state tax rate on municipals. (We’ll see what the last three column in Exhibit 10.1 mean later in this chapter.)

Most municipal securities that have been issued are tax-exempt. Municipal securities are commonly referred to as tax-exempt securities although taxable municipal securities have been issued and are traded in the market. Municipalities issue taxable municipal bonds to finance projects that do not qualify for financing with tax-exempt bonds. An example is a sports stadium. The most common types of taxable municipal bonds are industrial revenue bonds and economic development bonds. Since there are federally mandated restrictions on the amount of tax-exempt bonds that can be issued, a municipality will issue taxable bonds when the maximum is reached. There are some issuers who have issued taxable bonds in order to take advantage of demand outside of the United States.

Notes:

(1) Calculations assume a federal tax rate of 38.6% and 100% state tax deduction

(2) Out-of-state bonds are exempt from taxation

(3) Out-of-state bonds may be subject to person property tax

(4) Certain state and local bond issues are exempt from state taxation

(5) Counties may levy an income tax that ranges from 20% to 60% of the state income tax, depending on the county

(6) State tax rate is equal to 25. 5% of the federal tax rate

(7) New York State tax plus New York City tax

Derived from information published in The Bond Buyer Notes.

Source: “How Much Does it Take to ‘Buy Out of State’?” Morgan Stanley Dean Witter. Text provided by John M. Dillon, FVP, Senior Municipal Analyst. Chart provided by Adam Topalian, Principal, Private Wealth Management, Market Strategist. Morgan Stanley Dean Witter is not a tax advisor. Investors should consult their tax advisor before making any tax-related investment decisions.

There are other types of tax-exempt bonds. These include bonds issued by nonprofit organizations. Such organizations are structured so that none of the income from the operations of the organization benefit an individual or private shareholder. The designation of a nonprofit organization must be obtained from the Internal Revenue Service. Since the tax-exempt designation is provided pursuant to Section 501(c)(3) of the Internal Revenue Code, the tax-exempt bonds issued by such organizations are referred to as 501(c)(3) obligations. Museums and foundations fall into this category. Tax-exempt obligations also include bonds issued by the District of Columbia and any possession of the United States—Puerto Rico, the U.S. Virgin Islands, Guam, American Samoa, and the Northern Mariana Islands. The interest income from securities issued by U.S. territories and possessions is exempt from federal, state, and local income taxes in all 50 states.

TAX PROVISIONS AFFECTING MUNICIPALS

Federal tax rates and the treatment of municipal interest at the state and local levels affect municipal security values and strategies employed by investors. There are provisions in the Internal Revenue Code that investors in municipal securities should recognize. These provisions deal with original issue discounts, the alternative minimum tax, and the deductibility of interest expense incurred to acquire municipal securities.

Treatment of Original-Issue Discount

If at the time of issuance the original-issue price is less than its maturity value, the bond is said to be an original-issue discount (OID) bond. 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.

For municipal bonds there is a complex treatment that few investors recognize when purchasing OID municipal bonds. The Revenue Reconciliation Act of 1993 specifies that any capital appreciation from the sale of a municipal bond that was purchased in the secondary market after April 30, 1993 could be either (1) free from any federal income taxes, (2) taxed at the capital gains rate, (3) taxed at the ordinary income rate, or (4) taxed at a combination of the two rates.

The key to the tax treatment is the rule of de minimis for any type of bond. The rule states that a bond is to be discounted up to 0.25% from the par value for each remaining year of a bond’s life before it is affected by ordinary income taxes. The discounted price based on this rule is called the market discount cutoff price. The relationship between the market price at which an investor purchases a bond, the market discount cutoff price, and the tax treatment of the capital appreciation realized from a sale is as follows. If the bond is purchased at a market discount, but the price is higher than the market discount cutoff price, then any capital appreciation realized from a sale will be taxed at the capital gains rate. If the purchase price is lower than the market discount cutoff price, then any capital appreciation realized from a sale may be taxed as ordinary income or a combination of the ordinary income rate and the capital gains rate. (Several factors determine what the exact tax rate will be in this case.)

The market discount cutoff price changes over time because of the rule of de minimis. The price is revised. An investor must be aware of the revised price when purchasing a municipal bond because this price is used to determine the tax treatment.

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.

One of the tax preference items that must be included is certain tax-exempt municipal interest. As a result of AMT, the value of the tax-exempt feature is reduced. However, the interest of not all municipal issues is 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 those issues that are subject to the AMT will trade at a higher yield than those exempt from AMT.

Deductibility of Interest Expense Incurred to Acquire Municipals

Ordinarily, the 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 Internal Revenue Code 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.¹

TYPES OF MUNICIPAL SECURITIES

Municipal securities are issued for various purposes. Short-term notes typically are sold in anticipation of the receipt of funds from taxes or receipt of proceeds from the sale of a bond issue, for example. Proceeds from the sale of short-term notes permit the issuing municipality to cover seasonal and temporary imbalances between outlays for expenditures and inflows from taxes. Municipalities issue long-term bonds as the principal means for financing both (1) long-term capital projects such as schools, bridges, roads, and airports, and (2) long-term budget deficits that arise from current operations.

An official statement describing the issue and the issuer is prepared for new offerings. Municipal securities have legal opinions that are summarized in the official statement. The importance of the legal opinion is twofold. First, bond counsel determines if the issue is indeed legally able to issue the securities. Second, bond counsel verifies that the issuer has properly prepared for the bond sale by having enacted various required ordinances, resolutions, and trust indentures and without violating any other laws and regulations.

There are basically two types of municipal security structures: tax-backed debt and revenue bonds. We describe each type as follows, as well as variants.

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, debt obligations supported by public credit enhancement programs, and short-term debt instruments. We discuss each type as follows.

General Obligation Debt

The broadest type of tax-backed debt is general obligation debt. There are two types of general obligation pledges: unlimited and limited. An unlimited tax general obligation debt (also called an ad valorem property tax debt) is the stronger form of general obligation pledge because it is secured by the issuer’s unlimited taxing power. The tax revenue sources include corporate and individual income taxes, sales taxes, and property taxes. Unlimited tax general obligation debt is said to be secured by the full faith and credit of the issuer. A limited tax general obligation debt (also called a limited ad valorem tax 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.

Certain general obligation bonds are secured not only by the issuer’s general taxing powers to create revenues accumulated in a general fund, but also by certain identified fees, grants, and special charges, which provide additional revenues from outside the general fund. Such bonds are known as double-barreled in security because of the dual nature of the revenue sources. For example, the debt obligations issued by special-purpose service systems may be secured by a pledge of property taxes, a pledge of special fees/operating revenue from the service provided, or a pledge of both property taxes and special fees/operating revenues. In the last case, they are double-barreled.

Appropriation-Backed Obligations

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. The appropriation of funds from the state’s general tax revenue must be approved by the state legislature. However, the state’s pledge is not binding. Debt obligations with this nonbinding pledge of tax revenue are called moral obligation bonds. Because a moral obligation bond requires legislative approval to appropriate the funds, it is classified as an appropriation-backed obligation.

An example of the legal language describing the procedure for a moral obligation bond that is enacted into legislation is as follows:

In order to further assure the maintenance of each such debt reserve fund, there shall be annually apportioned and paid to the agency for deposit in each debt reserve fund such sum, if any, as shall be certified by the chairman of the agency to the governor and director of the budget as necessary to restore such reserve fund to an amount equal to the debt reserve fund requirement. The chairman of the agency shall annually, on or before December 1, make and deliver to the governor and director of the budget his certificate stating the sum or sums, if any, required to restore each such debt reserve fund to the amount aforesaid, and the sum so certified, if any, shall be apportioned and paid to the agency during the then current state fiscal year.

The purpose of the moral obligation pledge is to enhance the creditworthiness of the issuing entity. The first moral obligation bond was issued by the Housing Finance Agency of the state of New York. Historically, most moral obligation debt has been self-supporting; that is, it has not been necessary for the state of the issuing entity to make an appropriation. In those cases in which state legislatures have been called on to make an appropriation, they have. For example, the states of New York and Pennsylvania did this for bonds issued by their Housing Finance Agency; the state of New Jersey did this for bonds issued by the Southern Jersey Port Authority.

Another type of appropriation-backed obligation is lease-backed debt. There are two types of leases. One type is basically a secured long-term loan disguised as lease. The “leased” asset is the security for the loan. In the case of a bankruptcy, the court would probably rule such an obligation as the property of the user of the leased asset and the debt obligation of the user. In contrast, the second type of lease is a true lease in which the user of the leased asset (called the lessee) makes periodic payments to the leased asset’s owner (called the lessor) for the right to use the leased asset. For true leases, there must be an annual appropriation by the municipality to continue making the lease payments.

Dedicated Tax-Backed Obligations

In recent years, states and local governments have issued increasing amounts of bonds where 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 asset-backed securities.

Debt Obligations Supported by Public Credit Enhancement Programs

While a moral obligation is a form of credit enhancement provided by a state, it is not a legally enforceable or legally binding obligation of the state. There are entities that have issued debt that carries some form of public credit enhancement that is legally enforceable. This occurs when there is a guarantee by the state or a federal agency or when there is an obligation to automatically withhold and deploy state aid to pay any defaulted debt service by the issuing entity. Typically, the latter form of public credit enhancement is used for debt obligations of a state’s school systems.

Here are some examples of state credit enhancement programs. Virginia’s bond guarantee program authorizes the governor to withhold state aid payments to a municipality and divert those funds to pay principal and interest to a municipality’s general obligation holders in the event of a default. South Carolina’s constitution requires mandatory withholding of state aid by the state treasurer if a school district is not capable of meeting its general obligation debt. Texas created the Permanent School Fund to guarantee the timely payment of principal and interest of the debt obligations of qualified school districts. The fund’s income is obtained from land and mineral rights owned by the state of Texas.

Short-Term Debt Instruments

Short-term debt instruments include municipal notes, commercial paper, variable-rate demand obligations, and a hybrid of the last two products.

Municipal Notes

Usually, municipal notes are issued for a period of 12 months, although it is not uncommon for such notes to be issued for periods as short as 3 months and for as long as 3 years. Municipal notes include bond anticipation notes (BANs) and cash flow notes. BANs are issued in anticipation of the sale of long-term bonds. The issuing entity must obtain funds in the capital market to pay off the obligation.

Cash flow notes include tax anticipation notes (TANs) and revenue anticipation notes (RANs). 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 treasury of the issuing entity. The pledge for cash flow notes can be either a broad general obligation pledge of the issuer or a pledge from a specific revenue source. The lien position of cash flow noteholders relative to other general obligation debt that has been pledged the same revenue can be either (1) a first lien on all pledged revenue, thereby having priority over general obligation debt that has been pledged the same revenue, (2) a lien that is in parity with general obligation debt that has been pledged the same revenue, or (3) a lien that is subordinate to the lien of general obligation debt that has been pledged the same revenue.

Commercial Paper

In Chapter 6, we discuss commercial paper issued by corporations. Commercial paper is also used by municipalities to raise funds on a short-term basis ranging from 1 day to 270 days. There are two types of commercial paper issued, unenhanced and enhanced. Unenhanced commercial paper is a debt obligation issued based solely on the issuer’s credit quality and liquidity capability. Enhanced commercial paper is a debt obligation that is credit enhanced with bank liquidity facilities (e.g., a letter of credit), insurance, or a bond purchase agreement. The role of the enhancement is to reduce the risk of nonrepayment of the maturing commercial paper by providing a source of liquidity for payment of that debt in the event no other funds of the issuer are currently available.

Provisions in the 1986 tax act restricted the issuance of tax-exempt commercial paper. Specifically, the act limited the new issuance of municipal obligations that are tax exempt, and as a result, every maturity of a tax-exempt municipal issuance is considered a new debt issuance. Consequently, very limited issuance of tax-exempt commercial paper exists. Instead, issuers use one of the next two products to raise short-term funds.

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. The put price is par plus accrued interest. There are unenhanced and enhanced VRDOs.

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 a 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 1 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 is generally 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.

Commercial paper dealers market these products under a proprietary name. For example, the Merrill Lynch product is called Unit Priced Demand Adjustable Tax-Exempt Securities, or UPDATES. Lehman Brothers markets these simply as money market municipals and Goldman Sachs refers to these securities as flexible rate notes.

Revenue Bonds²

The second basic type of security structure is found in a revenue bond. Revenue bonds are issued for enterprise financings that are secured by the revenues generated by the completed projects themselves, or for general public-purpose financings in which the issuers pledge to the bondholders the tax and revenue resources that were previously part of the general fund. This latter type of revenue bond is usually created to allow issuers to raise debt outside general obligation debt limits and without voter approval.

Revenue bonds can be classified by the type of financing. These include utility revenue bonds, transportation revenue bonds, housing revenue bonds, higher education revenue bonds, health care revenue bonds, seaport revenue bonds, sports complex and convention center revenue bonds, and industrial development revenue bonds. We discuss these revenue bonds as follows. Revenue bonds are also issued by Section 501(c)3 entities (museums and foundations).

Utility Revenue Bonds

Utility revenue bonds include water, sewer, and electric 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. Electric utility revenue bonds are secured by revenues produced from electrical operating plants. Some bonds are for a single issuer who constructs and operates power plants and then sells the electricity. Other electric utility 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.

Also included as part of utility revenue bonds are resource recovery revenue bonds. A resource recovery facility converts refuse (solid waste) into commercially saleable energy, recoverable products, and residue to be landfilled. The major revenues securing these bonds usually are (1) fees paid by those who deliver the waste to the facility for disposal, (2) revenues from steam, electricity, or refuse-derived fuel sold to either an electric power company or another energy user, and (3) revenues from the sale of recoverable materials such as aluminum and steel scrap.

Transportation Revenue Bonds

Included in the category of transportation revenue bonds are toll road revenue bonds, highway user tax revenue bonds, airport revenue bonds, and mass transit bonds secured by farebox revenues. For toll road revenue bonds, bond proceeds are used to build specific revenue-producing facilities such as toll roads, bridges, and tunnels. The pledged revenues are the monies collected through tolls. For highway-user tax revenue bonds, the bondholders are paid by earmarked revenues outside of toll collections, such as gasoline taxes, automobile registration payments, and driver’s license fees. The revenues securing airport revenue bonds usually come from either traffic-generated sources’such as landing fees, concession fees, and airline fueling fees—or lease revenues from one or more airlines for the use of a specific facility such as a terminal or hangar.

Housing Revenue Bonds

There are two types of housing revenue bonds: single-family mortgage revenue bonds and multifamily housing revenue bonds. The former revenue bonds are secured by the mortgages and loan repayments on 1-to-4-single-family homes. Security features vary but can include Federal Housing Administration (FHA), Veterans Administration (VA), or private mortgage insurance. Multifamily revenue bonds are usually 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 or interest-cost subsidies. Still others receive only local property tax reductions as subsidies.

Higher Education Revenue Bonds

There are two types of higher education revenue bonds: college and university revenue bonds and student loan revenue bonds. The revenues securing public and private college and university revenue bonds usually include dormitory room rental fees, tuition payments, and sometimes the general assets of the college or university. For student loan revenue bonds, student loan repayments are sometimes 100% guaranteed either directly by the federal government or by a state guaranty agency.

Health Care Revenue Bonds

Health care revenue bonds are issued by private, not-for-profit hospitals (including rehabilitation centers, children’s hospitals, and psychiatric institutions) and other health care providers such as health maintenance organizations (HMOs), continuing care retirement communities and nursing homes, cancer centers, university faculty practice plans, and medical specialty practices. The revenue for health care revenue bonds usually depends on federal and state reimbursement programs (such as Medicaid and Medicare), third-party commercial payers (such as Blue Cross, HMOs, and private insurance), and individual patient payments.

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.

Special Bond Structures

Some municipal securities have special security structures. These include insured bonds, bank-backed municipal bonds, and refunded bonds. We describe these three special security structures as follows.

Insured Bonds

Insured bonds, in addition to being secured by the issuer’s revenue, are also backed by insurance policies written by commercial insurance companies. Insurance on a municipal bond is an agreement by an insurance company to pay the bondholder any bond principal and/or coupon interest that is due on a stated maturity date but that has not been paid by the bond issuer. The payment by the bond insurer is not an advance payment of the principal to pay off the issue and interest. Rather, the payments are made according the original schedule of payments that the issuer would have had to make.

Once issued, municipal bond insurance usually extends for the term of the bond issue, and it cannot be canceled by the insurance company. Because bond insurance is an unconditional promise by the insurer to meet the principal and interest payment obligations of the issuer, should the issuer be unable to do so for the life of the bond issue, it is different from credit enhancement in the form of a letter of credit, described later.

Because municipal bond insurance reduces credit risk for the investor, the marketability of certain municipal bonds can be greatly expanded. Municipal bonds that benefit most from the insurance would include lower-quality bonds, bonds issued by smaller governmental units not widely known in the financial community, bonds that have a sound though complex and confusing security structure, and bonds issued by infrequent local-government borrowers that do not have a general market following among investors.

There are two major groups of municipal bond insurers. The first includes the “monoline” companies that are primarily in the business of insuring municipal bonds. Almost all of the companies that are now insuring municipal bonds can be characterized as monoline in structure. 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. Most new issues in the municipal bond market today are insured by the following monoline insurers: AMBAC Indemnity Corporation (AMBAC); Financial Guaranty Insurance Company (FGIC); Financial Security Assurance, Inc. (FSA); and Municipal Bond Investors Assurance Corporation (MBIA Corp.). State insurance commissions regulate bond insurance companies. In addition, bond insurance companies are rated by credit rating agencies.

The credit quality considerations of bond insurers in evaluating whether or not to insure an issue are more stringent than that used by a rating agency in assigning a rating to an issue. This is because the bond insurer is making a commitment for the life of the issue. In contrast, a rating agency assigns a rating that would be expected to change in the future if there is credit deterioration of the issuer. That is, a rating agency can change a rating but an insurer cannot change its obligation. Consequently, bond insurers typically insure bonds that would have received an investment grade rating (at least triple B) in the absence of any insurance. Depending on competitive conditions and insurer costs, the premium charged for bond insurance typically ranges from 0.1% to 2% of the combined principal and interest payable over the issue’s life.

Bank-Backed Municipal Bonds

Since the 1980s, municipal obligations have been increasingly supported by various types of credit facilities provided by commercial banks. The support is in addition to the issuer’s cash flow revenues. There are three basic types of bank support: letter of credit, irrevocable line of credit, and revolving line of credit.

A letter of credit 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. An irrevocable line of credit is not a guarantee of the bond issue, though it does provide a level of security. 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 no other funds of the issuer are currently available. Because a bank can cancel a revolving line of credit without notice if the issuer fails to meet certain covenants, bond security depends entirely on the creditworthiness of the municipal issuer.

Refunded Bonds

Although originally issued as either revenue or general obligation bonds, municipal bonds are sometimes refunded. A refunding usually occurs when the original bonds are escrowed or collateralized by direct obligations guaranteed by the U.S. government. By this it is meant that a portfolio of securities guaranteed by the U.S. government are placed in a trust. The portfolio of securities is assembled such that the cash flows from the securities match the obligations that the issuer must pay. For example, suppose that a municipality has a 7% $100 million issue with 12 years remaining to maturity. The municipality’s obligation is to make payments of $3.5 million every 6 months for the next 12 years and $100 million 12 years from now. If the issuer wants to refund this issue, a portfolio of U.S. government obligations can be purchased that has a cash flow of $3.5 million every 6 months for the next 12 years and $100 million 12 years from now.

Once this portfolio of securities whose cash flows match those of the municipality’s obligation is in place, the refunded bonds are no longer general obligation or revenue bonds. The bonds are now supported by the cash flows from the portfolio of securities held in an 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 bonds available.

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. While 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.

Municipal Derivative Securities

In recent years, a number of municipal products have been created from the basic fixed-rate municipal bonds. 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.

The name derivative securities has been attributed to these bond classes because they derive their value from the underlying fixed-rate municipal bond. Two examples are municipal strip obligations and inverse floaters.

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 of the underlying security. These are similar to the strips that are created in the Treasury market that are described in Chapter 7.

The primary vehicle to create inverse floaters is the Tender Offer Bond (TOB) programs. TOBs feature a liquidity facility, which makes these floating-rate derivatives putable and therefore eligible for money market funds. These liquidity facilities typically last 364 days and are provided by highly rated banks or broker-dealers. Several proprietary programs have been developed to market and sell plain-vanilla TOBs, which are used by mutual bond funds and insurance companies. Additionally, TOBs are used in more exotic combination trades by a few Wall Street structured products areas. Salomon Smith Barney’s proprietary program is called “ROCs & ROLs.” The short-term certificates are called ROCs or Residual Option Certificates. The inverse floaters are called the “ROLs” or Residual Option Longs. Lehman’s is called RIBS and Trust Receipts, and Morgan Stanley’s proprietary program is called municipal trust certificates.

DEBT RETIREMENT STRUCTURE

Municipal securities are issued with one of two debt retirement structures or a combination of both. Either a bond has a serial maturity structure or 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.

The various provisions explained in Chapter 1 for paying off an issue prior to maturity—call provisions and sinking fund provisions—are also found in municipal securities. In revenue bonds there is a catastrophe call provision that requires the issuer to call the entire issue if the facility is destroyed.

For housing revenue bonds, the repayment of principal is made with each payment by the borrower. More specifically, there is a schedule of principal repayments. We will explain this when we cover mortgage-backed securities in later chapters. Moreover, as will be explained, a borrower has the right to pay off a mortgage prior to the maturity date. Any principal repayment in excess of the scheduled principal repayment is called a prepayment.

CREDIT RISK

Investors rely on the credit ratings that are assigned by the nationally recognized statistical rating organizations, or simply rating companies. While there are three commercial rating companies, the two dominant companies with respect to rating municipal debt obligations are Standard & Poor’s and Moody’s. We discuss these ratings when we cover corporate debt obligations in Chapter 11. The factors that should be considered in assessing the credit risk of an issue are summarized next.

In assessing the credit risk of tax-backed debt, four basic categories are considered. The first category includes information on the issuer’s debt structure to determine the overall debt burden. The second category relates to the issuer’s ability and political discipline to maintain sound budgetary policy. The third category involves determining the specific local taxes and intergovernmental revenues available to the issuer, as well as obtaining historical information both on tax collection rates, which are important when looking at property tax levies, and on the dependence of local budgets on specific revenue sources. The final category of information is an assessment of the issuer’s overall socioeconomic environment. The major factors here include trends of local employment distribution and composition, population growth, real estate property valuation, and personal income.

Revenue bonds are issued for either project or enterprise financings where the bond issuers pledge to the bondholders the revenues generated by the operating projects financed, or for general public-purpose financings in which the issuers pledge to the bondholders the tax and revenue resources that were previously part of the general fund. While there are numerous security structures for revenue bonds, the underlying principle in assessing the credit risk is whether the project being financed will generate sufficient cash flows to satisfy the obligations due bondholders.

The trust indenture and legal opinion should explain what are the revenues for the bonds and how they realistically may be limited by federal, state, and local laws and procedures. The importance of this is that although most revenue bonds are structured and appear to be supported by identifiable revenue streams, those revenues sometimes can be negatively affected directly by other levels of government.

Flow-of-Funds Structure for Revenue Bonds

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. Typically, the flow of funds for a revenue bond is as follows. First, all revenues from the enterprise are put into a revenue fund. From the revenue fund, disbursements for expenses are made to the following funds: operation and maintenance fund, sinking fund, debt service reserve fund, renewal and replacement fund, reserve maintenance fund, and surplus fund.³

TAX RISK

The investor in municipal securities is exposed to tax risk. There are two types of tax risk to which tax-exempt municipal security investors are exposed. The first is the risk that the federal income tax rate will be reduced. The higher the marginal tax rate, the greater the value of the tax-exemption feature. As the marginal tax rate declines, the price of a tax-exempt municipal security will decline.

The second type of tax risk is that a municipal bond issued as a tax-exempt issue may be eventually declared by the Internal Revenue Service to be taxable. This may occur because many municipal revenue bonds have elaborate security structures that could be subject to future adverse congressional action and IRS interpretation. A loss of the tax-exemption feature will cause the municipal bond to decline in value in order to provide a yield comparable to similar taxable bonds.

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 credits”) by regional brokerage firms, local banks, and by 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 whom 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. Some municipal bonds are traded via the Internet.

In the municipal bond markets, an odd lot of bonds is $25,000 or less in par value for retail investors. For institutions, anything less than $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 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 institutional investors, the dealer spread rarely exceeds one-half of one 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. 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.

Actual price and trade information for specific municipal bonds is available on a daily basis at no charge via the Internet at www.investinginbonds.com. This is the homepage of the Bond Market Association. The trade information provided is from the Municipal Securities Rulemaking Board and Standard & Poor’s J.J. Kenny. The original source of the trades reported are dealer-to-dealer transactions and dealer-to-institutional customer and retail (individual investor) transactions.

YIELDS ON MUNICIPAL BONDS

Because of the tax-exempt feature of municipal bonds, the yield on municipal bonds is less than that on Treasuries with the same maturity. Exhibit 10.2 demonstrates this point.

Shown in the exhibit is the yield on AAA general obligation municipal bonds and the yield on same-maturity U.S. Treasuries. The yield ratio is the ratio of the municipal yield to the yield of a same-maturity Treasury security. Notice that the yield ratio increases with maturity. The ratio has changed over time. The higher the tax rate, the more attractive the tax-exempt feature and the lower the yield ratio.

Source: Bloomberg Financial Markets

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. The equivalent taxable yield is computed as follows:

Tax-exempt yield

For example, suppose an investor in the 40% marginal tax bracket is considering the acquisition of a tax-exempt municipal bond that offers a yield of 3.0%. The equivalent taxable yield is 5%, as shown below:

When computing the equivalent taxable yield, the traditionally computed yield to maturity is not the tax-exempt yield if the issue is selling at a discount because only the coupon interest is exempt from federal income taxes. Instead, the yield to maturity after an assumed tax rate on the capital gain is computed and used in the numerator of the formula above. The yield to maturity after an assumed tax on the capital gain is calculated.

Yield Spread Relationships within the Municipal Market

Yield spreads within the municipal bond market are attributable to various factors. Unlike the taxable fixed income market, there is no risk-free interest rate benchmark. Instead, the benchmark interest rate is for a generic triple-A rated general obligation bond or a revenue bond. Thus, the benchmark triple-A rated issue or index is the base rate used in the municipal bond market.

Tax Treatment at the State and Local Levels

State and local governments may tax interest income on municipal issues that are exempt from federal income taxes. Earlier in this chapter we discussed that a state can either tax or exempt the interest depending on whether the source of the interest is from an in-state or out-of-state issuer. The implication is that two municipal securities with the same credit rating and the same maturity may trade at some spread because of the relative demand for bonds of municipalities in different states. For example, in high-income-tax states such as New York and California, the demand for bonds of municipalities will drive down their yield relative to municipalities in a low-income-tax state such as Florida.

Since there is an advantage of buying in-state issues rather than outof-state issues for individual investors in states that tax interest income on out-of-state issues, the question is: What is the yield given up? The last three columns in Exhibit 10.1, labeled “Basis Point Reduction,” can be used by an individual investor to answer that question. It shows for in-state yield levels of 3%, 5%, and 6%, approximately how much must be deducted from the out-of-state issue to obtain the same in-state yield. Take for example, an investor in Oregon who is considering an in-state issue offering a 3% yield. From the exhibit, the basis point reduction can be seen to be 16. This means that if a municipal issuer outside of Oregon is offering a yield of 3.17% (assuming the same credit rating), then this would be the same as investing in a municipal issue in Oregon offering a yield of 3%.