Chapter 8
IN THIS CHAPTER
Understanding municipal bond basics
Comparing general obligation bonds to revenue bonds
Reviewing other types of municipal bonds
Following the rules
Recognizing sources of municipal bond information
Municipal bonds are securities that state governments, local governments, or U.S. territories issue. The municipality uses the money it borrows from investors to fund and support projects, such as roads, sewer systems, hospitals, and so on. In most cases, the interest received from these bonds is federally tax free to investors.
Even though you’re most likely going to spend a majority of your time selling equity securities (stocks), for some unknown reason, the Series 7 tests heavily on municipal securities. As a matter of fact, municipal bonds are one of the most heavily tested areas on the entire exam. If you’ve flipped ahead, you may have noticed that this chapter isn’t one of the biggest in the book. Why is that? Well, I cover a lot of the bond basics, such as par value, maturity, types of maturities (term, serial, and balloon), the seesaw, and so on, in Chapter 7. Also, you can find some of the underwriting information in Chapter 5.
This chapter and the real exam focus mainly on the differences between GO (general obligation) bonds and revenue bonds. I also gives you plenty of example questions for practice.
Most Series 7 municipal test questions are on general obligation (GO) bonds. The following sections help you prepare.
The following question tests your knowledge of GO bonds.
Which of the following projects are MORE likely to be financed by general obligation bonds than revenue bonds (discussed later in this chapter)?
(A) I and II only
(B) III and IV only
(C) I and III only
(D) I, III, and IV only
The correct answer is Choice (B). Remember that GO bonds are issued to fund nonrevenue producing projects. A new municipal hospital and a public sports arena will produce income that can back revenue bonds. However, a new junior high school and a new library need the support of taxes to pay off the bonds and, therefore, are more likely to be financed by GO bonds.
The Series 7 exam tests your ability to analyze different types of municipal securities and help a customer make a decision that best suits her needs. You should be able to analyze a GO bond like you’d analyze other investments; however, because they’re backed by taxes rather than sales of goods and services (like most corporations are), GO bonds have different components to look at when analyzing the marketability and safety of the issue.
Many different items can affect the marketability of municipal bonds, including the characteristics of the issuer, factors affecting the issuer’s ability to pay, and municipal debt ratios. You certainly want to steer investors away from municipal bonds that aren’t very marketable, unless those investors are willing to take extra risk. Here’s a list of some of the other items that can affect the bonds’ marketability:
One factor that influences the safety of a GO bond is the municipality’s ability to deal with debt. After you consider the issuer’s name, you can look at previous issues that the municipality had and find out whether it was able to pay off the debt in a timely manner.
In addition to the municipality’s name (and credit history), you want to look at its current debt. Net overall debt includes the debt that the municipality owes directly plus the portion of the overlapping debt that the municipality is responsible for:
To determine the debt per capita (per person), take the debt (overall, direct, or overlapping) and divide it by the number of people in the municipality. Obviously, for an investor, the lower this number is, the better.
Taxes — one of life’s little certainties — are another factor that influence the safety of GO bonds. Property taxes (which local municipalities — not states — collect) and sales taxes are the driving force behind paying back investors. Aided and abetted by traffic fines and licensing fees, taxes put money in the municipal coffers and eventually in investors’ hands. The following factors come into play:
Property values: Ad valorem (property) taxes are the largest source of backing for GO bonds. Even though people living in a municipality want their property values to be low (at least for tax purposes), people investing in municipal bonds want the property values to be high. The higher the assessed value, the more taxes collected and the easier it is for the municipality to pay off its debt.
When you’re dealing with Series 7 questions that ask you to calculate the ad valorem taxes for an individual, always go with the assessed value, not the market value. Ad valorem taxes are based on mills, or thousandths of a dollar (1 mill = $0.001). To help you remember that a mill equals 0.001, remember that mills has two ls, so you need to have two zeros after the decimal point.
Try your hand at a question involving property taxes, an issue that affects the safety of GO bonds.
An individual has a house with a market value of $350,000 and an assessed value of $300,000. What is the ad valorem tax if the tax rate is 24 mills?
(A) $720
(B) $840
(C) $7,200
(D) $8,400
The answer you want is Choice (C). First make sure that you start with the assessed value; multiply it by the tax rate and then by 0.001 to get the answer:
To keep yourself from making a careless mistake, multiply the three numbers separately; the tax rate may be single or double digits. Multiplying by 0.001 means moving a decimal point three places to the left, so 24 mills is $0.024, not $0.0024. In this case, if you multiplied $300,000 by 0.0024 (or 2.4 mills), you got a wrong answer, Choice (A).
Certain issues of GO bonds are considered bank qualified. When municipal bonds are purchased on margin (see Chapter 9), interest expenses associated with purchasing securities are not tax deductible even in the case of municipal bonds. However, if the municipal bonds are bank qualified, banks can purchase the municipal bonds on margin and deduct 80 percent of the margin interest expense on their taxes while still receiving tax-free interest from the municipal bonds. Unfortunately, this big advantage isn't available to investors like you and me.
Unlike the tax-backed GO bonds (see the preceding sections), revenue bonds are issued to fund municipal facilities that’ll generate enough income to support the bonds. These bonds raise money for certain utilities, toll roads, airports, hospitals, student loans, and so on.
A municipality can also issue industrial development revenue bonds (IDRs) to finance the construction of a facility for a corporation that moves into that municipality. Remember that even though a municipality issues IDRs, they’re actually backed by lease payments made by a corporation. Because the corporation is backing the bonds, the credit rating of the bonds is derived from the credit rating of the corporation.
As with any investment, you need to check out the specifics of the security. For instance, when gauging the safety of a revenue bond, you want to see whether it has a credit enhancement (insurance), which provides a certain degree of safety. You also want to look at call features (whether the issuer has the right to force investors to redeem their bonds early). You can assume that if a bond is callable, it has a higher yield than a noncallable bond because the investor is taking more risk (the investor doesn’t know how long she can hold onto the bond).
For Series 7 exam purposes (and if you ever sell one or more revenue bonds), you also need to be familiar with the revenue-bond-specific items in this section. For instance, municipal revenue bonds involve covenants, wonderful little promises that protect investors by holding the issuer legally accountable. Table 8-1 shows some of the promises that municipalities make on the municipal bond indenture.
TABLE 8-1 Revenue Bond Covenants
Type of Covenant |
Promises That the Municipality Will … |
Rate covenant |
Charge sufficient fees to people using the facility to be able to pay expenses and the debt service (principal and interest on the bonds) |
Maintenance covenant |
Adequately take care of the facility and any equipment so the facility continues to earn revenue |
Insurance covenant |
Adequately insure the facility |
Other factors that provide investors with a certain degree of comfort are that municipalities must provide financial reports and are subject to outside audits for all their revenue bond issues.
Obviously, municipalities don’t want to default on their loans. That’s why issuers use the additional bonds test, which says that if the municipality is going to issue more bonds backed by the same project, it must prove that the revenues will be sufficient to cover all the bonds. The indenture on the initial bonds may be open-ended or closed-ended. If it’s open-ended, additional bonds will have equal claims to the assets. If it’s closed-ended, any other bonds issued are subordinate to (in other words, rank lower than) the original issue.
As with GO bonds, revenue bonds are often backed by credit enhancements (insurance), which will pay the investors in the event that the issuer defaults. Since revenue bonds are backed by a revenue-producing facility, most revenue bond issuers also carry catastrophe insurance. A catastrophe clause states that if a facility is destroyed due to a catastrophic event such as a flood, hurricane, tornado, or the like, the municipality will use the insurance that it purchased to call the bonds and pay back bondholders.
The flow of funds relates only to revenue bonds. The flow of funds tells you what a municipality does with the money collected from the revenue-producing facility that’s backing the bonds. Typically, the flow of funds is as follows:
The debt service coverage ratio is an indication of the ability of a municipal issuer to meet the debt service payments on its bonds. The higher the debt service coverage ratio, the more likely the issuer is to be able to meet interest and principal payments on time.
The following question tests your debt service coverage ratio knowledge. Use the following formula to answer it.
A municipality generates $10,000,000 in revenues from a facility. It must pay off $6,000,000 in operating and maintenance expenses, $1,500,000 in principal, and $500,000 in interest. Under a net revenue pledge, what is the debt service coverage ratio?
(A) 1 to 1
(B) 1.5 to 1
(C) 2 to 1
(D) 4 to 1
The right answer is Choice (C). Because the question states that the municipality is using a net revenue pledge, you have to calculate the net revenue. First, using the earlier equation, figure the net revenue by subtracting the operation and maintenance expenses ($6,000,000) from the gross revenue ($10,000,000), which gives you $4,000,000. Next, take the $4,000,000 and divide it by the combined principal and interest. The principal is $1,500,000 and the interest is $500,000, which gives you a total of $2,000,000. After dividing the $4,000,000 by $2,000,000, you come up with a ratio of 2 to 1, which means that the municipality brought in two times the amount of money needed to pay the debt service (principal and interest). A debt service coverage ratio of 2 to 1 is considered adequate for a municipality to pay off its debt. A debt service coverage ratio of less than 2 to 1 may indicate that the municipality may have problems meeting its debt obligations.
Here’s how your equation should look:
As you can imagine, like corporations and partnerships, municipalities need help selling their issues. To that end, they can choose their underwriter(s) directly (the way almost all corporations and DPPs do it) or through a competitive (bidding) process.
Note: Whether the new municipal securities are being sold via a competitive or negotiated offering, the SEC requires that the underwriter(s) make sure that the issuer (state of local government) enters into an agreement to provide required information to the Municipal Securities Rulemaking Board (MSRB). The information required includes annual financial information such as operating data and audited financial statements. In addition, the issuer must provide event notices such as principal and interest payment delinquencies; bond calls or tender offers; ratings changes; unscheduled draws on debt service reserves; bankruptcy; appointment of a successor trustee; defeasances, and so on. Issuers must submit annual disclosures on or before the specified date specified in the continuing disclosure agreement or provide a notice of a failure to do so via the Electronic Municipal Access (EMMA) website.
Issuers are exempt from providing continuing disclosure if the entire issue is less than $1 million, or the bonds sold to no more than 35 unaccredited (sophisticated) investors and sold in units of no less than $100,000, or the bonds are sold in denominations of $100,000 or more and mature in 9 months or less from initial issuance. The bonds were issued prior to July 1995.
Competitive offering: Because general obligation (GO) bonds are backed by the taxing power of the municipality, the municipal issuers are responsible for getting the best deal for the people living in their municipality. In order to insure the best deal, they will post an advertisement known as a Notice of Sale in the Daily Bond Buyer (the main source of information about new municipal bonds) saying that they are accepting bids on a new issue of bonds. At this point, interested underwriters will submit a good faith deposit (to prove their sincerity) and their bids to the issuer. As you may suspect, the winner of the bid will be the underwriter that presents the lowest cost to the taxpayers backing the bond. The lowest cost could be the result of issuing the bond with a lower coupon rate and/or agreeing to pay more to purchase the bonds. Don’t be too concerned about the underwriters who don’t win; they’ll get their good faith deposit back.
The Notice of Sale contains all bidding information about new municipal issues. Besides just saying that it is taking bids, the issuer also gives bidding details. It will tell potential underwriters where to submit bids, the amount of the good faith deposit, whether it is expecting bids on an NIC (net interest cost) or a TIC (true interest cost) basis, the amount of bonds to be issued, the maturity of bonds to be issued, and so on. It is the responsibility of the underwriters to determine the coupon rate (they’ll determine this based on the credit history of the issuer, the amount of outstanding debt, the size of the issue, the tax base, and so on) and selling price of the issue. Remember, the underwriter(s) need to be able to sell the issue and still make a profit. So, the selling price and the coupon rate have to be attractive to investors. You should remember that the difference between the cost the issuer pays for the security and the amount it receives from investors is called the spread. For argument’s sake, say that the underwriter(s) agrees(s) to purchase the bonds for $990 each from the issuer and then reoffer them to the public for $1,000 each; then the spread is $10 per bond. The underwriter(s)’ profit lies within that spread.
Note: Another method of advance refunding is called crossover refunding. Crossover refunding is when the revenue stream which was originally pledged to pay the debt service on the refunded bonds continues to be used to pay the principal and interest on those bonds until they mature or are called. Once that happens, those pledged revenues crossover and are used to pay principal and interest on the refunding issue and escrowed securities are used to pay the refunded bonds. When both the refunded and refunding bonds are both outstanding, the debt service on the refunding bonds is paid from the interest earnings on the money invested by the municipality from the sale of the refunding issue.
Pre-refunded bonds may be escrowed to maturity, meaning that the proceeds of sale from the new issue of bonds is held in an escrow account. Typically the money held in the escrow account is invested in securities with a high credit rating such as Treasury securities. The interest and principal received in the escrow account will be used to make principal and interest payments to the bondholders.
No matter the type of offering, like corporate bonds, municipal bonds may be issued with call (prepayment) provisions. As such, there are a wide variety of ways municipal bonds can be called.
TABLE 8-2 Callable Bond Benefits and Risks
|
Benefit |
Risk |
Investor |
Higher coupon rate |
May not be able to keep the bond as long as wanted and if the bond is called, may have to invest at a lower coupon rate |
Issuer |
May call the bonds at a time that's beneficial and can issue new bonds with a lower coupon rate |
Making higher coupon payments than non-callable bonds |
Along with standard revenue and GO bonds (see the earlier sections on these topics), you’re required to know the specifics of the following bonds:
Public housing authority bonds (PHAs): These bonds are also called new housing authority (NHA) bonds and are issued by local housing authorities to build and improve low-income housing. These bonds are backed by U.S. government subsidies, and if the issuer can’t pay off the debt, the U.S. government makes up any shortfalls.
Because PHAs are backed by the issuer and the U.S. government, they’re considered among the safest municipal bonds.
Moral obligation bonds: These bonds are issued by a municipality but backed by a pledge from the state government to pay off the debt if the municipality can’t. Given this additional backing of the state, they’re considered safe. Moral obligation bonds need legislative approval to be issued.
Because they’re called moral obligation bonds, the state has a moral responsibility — but not a legal obligation — to help pay off the debt if the municipality can’t.
The following question tests your ability to answer questions about the safety of municipal bonds:
Rank the following municipal bonds in order from safest to riskiest.
(A) I, II, III, IV
(B) III, II, I, IV
(C) II, III, IV, I
(D) II, IV, III, I
The correct answer is Choice (B). If you remember that public housing authority bonds are considered the safest of the municipal bonds because they’re backed by U.S. government subsidies, this question’s easy, because only one answer choice starts with III. Anyway, public housing authority bonds would be the safest; moral obligation bonds, which are also considered very safe because the state government has a moral obligation to help pay off the debt if needed, follow. Next come revenue bonds, which are backed by a revenue-producing facility. Remember that industrial development revenue bonds (IDRs) are considered the riskiest municipal bonds because although they’re technically municipal bonds, they’re backed only by lease payments made by a corporation.
The diversity of maturities hopefully will look familiar to you because it was covered in the Securities Industry Essentials exam. Not only can bond certificates be in different forms, but they can also be scheduled with different types of maturities. Maturity schedules depend on the issuer’s needs. Most municipalities issue either term bond or serial bonds. The following list presents an explanation of the types of bond issues and maturity schedules:
Term bonds: Term bonds are all issued at the same time and have the same maturity date. For example, if a company issues 20 million dollars of term bonds, they may all mature in 20 years. Because of the large payment that’s due at maturity, most corporations issuing this type of bond have a sinking fund. Most corporations issue term bonds because they lock in a coupon rate for a long period of time.
A corporation creates a sinking fund when it sets aside money over time in order to retire its debt. Investors like to see that a sinking fund is in place because it lowers the likelihood of default (the risk that the issuer can’t pay interest or par value back at maturity).
Serial bonds: In this type of bond issue, a portion of the outstanding bonds mature at regular intervals (for example, 10 percent of the entire issue matures yearly). Serial bonds are usually issued by corporations and municipalities to fund projects that provide regular income streams. Most municipal (local government) bonds are issued with serial maturity.
A serial bond that has more bonds maturing on the final maturity date is called a balloon issue.
Municipalities can certainly offer a wide variety of ways to issue securities. Below you'll find the ways that'll be tested on the Series 7. For the most part, the names pretty much explain what they are but you should read on to get a deeper understanding:
Although the interest on most municipal bonds is federally tax free and sometime triple tax free (the interest is exempt from federal, state, and local taxes), there are some that you need to be aware of that are taxable. These bonds are still issued and backed by a municipality but are still taxable. These bonds were created under the Economic Recovery and Reinvestment Act of 2009 and are called Build America Bonds (BABs). The idea behind the BABs is to help municipalities raise money for infrastructure projects such as tunnels, bridges, roads, and so on. These bonds have either a higher coupon rate than most other municipal bonds because the municipality receives tax credits from the federal government or are more attractive because the investors receive tax credits from the federal government. As such, these municipal bonds become more attractive to all investors, even ones with lower income tax rates. Even though the Build America Bond program expired in 2010, there are still plenty of these bonds out there so, you will be tested on them. The two types of Build America Bonds are:
When municipalities need short-term (interim) financing, municipal notes come into play. These notes bring money into the municipality until other revenues are received. Municipal notes typically have maturities of one year or less (usually three to five months). Know the different types of municipal notes for the Series 7 exam:
Municipal notes are not rated the same as municipal or corporate bonds (AAA, AA, A, and so on). Municipal notes have ratings as follows (from best to worst):
The following question tests your knowledge of municipal notes.
Suffolk County, New York, would like to even out its cash flow. Which of the following municipal notes would Suffolk County MOST likely issue?
(A) RANs
(B) BANs
(C) GANs
(D) TANs
The answer you want is Choice (D). You have to use a little common sense to answer this one. Because the question doesn’t state that the municipality is expecting a grant or issuing long-term bonds, you should cross out Choices (B) and (C). Likewise, you can’t assume that the municipality will be collecting revenues from some project, so Choice (A) is out. However, municipalities collect property taxes at regular intervals, so (D) is the best choice.
Municipal fund securities are similar to investment companies (see Chapter 9) but are exempt from that definition under section 2(b) of the Investment Company Act of 1940. Municipal fund securities are established by municipal governments, municipal agencies, or educational institutions but do not represent loans to the government. Included in municipal fund securities are Section 529 plans, ABLE accounts, and Local Government Investment Pools.
529 plans are specialized educational savings accounts available to investors. These plans are also known as qualified tuition plans because they are designed to allow money to be saved for qualified expenses for higher education (colleges, postsecondary trade and vocational schools, postgraduate programs, and so on). As such, there is an owner (the one who sets up and contributes to the plan, typically a parent but doesn't have to be) and a beneficiary (the one who benefits from the plan, typically a child or relative of the person who set up the plan). Contribution allowance varies from state-to-state and is made from after-tax dollars. However, withdrawals of the amount invested plus interest received are tax free, meaning that the earnings grow on a tax-deferred basis, and there's no tax due if used for qualified educational expenses. Investors must receive an official statement or offering circular prior to opening the account. You should note the following:
Note: Up until recently, 529 plans were only allowed to be set up for higher education. However, due to the new tax laws, 529 plans may be set up for private kindergarten through 12th grade education. If a 529 plan is set up for K-12 education, the maximum contribution is $10,000 per year per beneficiary.
ABLE (Achieving a Better Life Experience) accounts are designed for individuals with provable disabilities and their families. Because of the extra needs and expenses (educational, housing, transportation, health, assistive technology, legal fees, and so on) required for taking care of individuals with disabilities, ABLE accounts allow people to invest after-tax dollars. Any earnings or distributions are tax-free as long as they are used to pay for qualified disability expenses for the beneficiary. ABLE accounts may be opened by the eligible individual, a parent or guardian, or a person granted power of attorney on behalf of the individual with the disability. However, once the account is opened, anyone can contribute. As with college savings plans above, the investments may be conservative, moderate, or aggressive. Many states have annual contribution caps and maximum account balances. ABLE accounts may be opened for the disabled person even if he or she is receiving other benefits such as social security disability, Medicaid, private insurance, and so on. In order to be eligible, the onset of the disability must've been discovered before the individual reached age 26.
Note: Rule G-45 requires dealers underwriting ABLE programs or 529 savings plans (but not LGIPs) to submit information such as plan descriptive information, assets, asset allocation information for each plan available, contributions, performance data, and so on semiannually and performance data annually through the Electronic Municipal Market Access (EMMA) system. MSRB's EMMA system is designed to provide market transparency to help protect market participants.
Local government investment pools (LGIPs) are established by states to provide other government entities (cities, counties, school districts, and so on) with a short-term investment vehicle for investing their funds. Since these are set up by state governments for state entities, LGIPs are exempt from SEC registration. As such, there is no prospectus requirement but they do have disclosure documents to cover investment policies, operating procedures, and so on. Although they aren't money market funds, they are similar in the fact that many LGIPs operate similar to one. Like money market funds, the NAV is typically set at $1.00, and normally the money is invested safely, although it doesn't have to be. LGIPs may be sold directly to municipalities or through municipal advisors hired by the municipal issuers.
As with other securities, there are rules relating to the advertising of municipal fund securities such as 529 plans. Advertisements relating to municipal fund securities must do the following:
Municipal bonds typically have lower yields than most other bonds. You may think that because U.S. government securities (T-bills, T-notes, T-bonds, and so on) are the safest of all securities, they should have the lowest yields. Not so, because municipal bonds have a tax advantage that U.S. government bonds don’t have: The interest received on municipal bonds is federally tax-free.
The taxable equivalent yield (TEY) tells you what the interest rate of a municipal bond would be if it weren’t federally tax-free. You need the following formula to compare municipal bonds and corporate bonds equally:
The following question tests your ability to answer a TEY question.
Mrs. Stevenson is an investor who is in the 30 percent tax bracket. Which of the following securities would provide Mrs. Stevenson with the BEST after-tax yield?
(A) 5 percent GO bond
(B) 6 percent T-bond
(C) 7 percent equipment trust bond
(D) 7 percent mortgage bond
The right answer is Choice (A). If you were to look at this question straight up without considering any tax advantages, the answer would be either (C) or (D). However, you have to remember that the investor has to pay federal taxes on the interest received from the T-bond, equipment trust bond, and mortgage bond but doesn’t have to pay federal taxes on the interest received from the GO municipal bond. So you need to set up the TEY equation to be able to compare all the bonds equally:
Looking into the Series 7 examiners’ heads, you have to ask yourself, “Why would they be asking me this question?” Well, because they want to make sure that you know that the interest received on municipal bonds is federally tax-free. Therefore, if you somehow forget the formula, you’re still likely to be right if you pick a municipal bond as the answer when you get a question like the preceding one.
Note: Although this situation is less likely, the Series 7 may ask you to determine the municipal equivalent yield (MEY), which is the yield on a taxable bond after paying taxes. Once you have that yield, you can compare it to a municipal bond to help determine the best investment for one of your customers. The formula for the municipal equivalent yield is as follows:
Bonds that U.S. territories (and federal districts) issue are triple tax-free (the interest is not taxed on the federal, state, or local level). These places include
Additionally, in most cases (there are a few exceptions), if you buy a municipal bond issued within your own state, the interest will be triple tax-free.
You'll find that I cover a lot of this stuff in the previous chapter. Some of the calculations that you'll be responsible for include dollar price, accrued interest (including long or short first coupons also known as odd first coupons), relationship of bond prices to changes in maturity, coupon, current yield, and so on. The following sections describe some of the other pricing and mathematical calculations you'll need to know for the Series 7.
Remember the seesaw: There is an inverse relationship between interest rates and bond prices. As interest rates increase, outstanding bond prices decrease. When interest rates decrease, outstanding bond prices increase. So when municipal bonds are trading at a premium (above par value), it is usually because interest rates have dropped or the municipality's credit rating increased. Anyway, to the municipal issuer, this means that it can now issue new bonds with a lower coupon rate and save some money. Because it is likely in this scenario that the municipal issuer will call its callable bonds when interest rates decrease, callable bonds trading at a premium must be quoted yield to call (YTC) instead of yield to maturity (YTM). (You can find the calculations for YTC and YTC in Chapter 7.)
A basis point (bp) is a unit of measurement used when quoting and comparing yields on all bonds or notes. Basis points are 1/100th of a point. For example, if the yield on a bond increased from 3.25 to 3.27 percent, it is referred to as a two basis point increase.
Occasionally, an issuer may default on its bonds. This means that the issuer is no longer making interest payments. If a bond is trading in default, there is no way to calculate yields. For bearer (coupon) bonds, all unpaid coupons must be attached in order to be considered good delivery.
Municipal bonds may be quoted on a yield/basis price or on a dollar price. To figure out the yield/basis (YTM) price, please refer to Chapter 7. For municipal bonds quoted as a dollar price, remember that it is a percentage of dollar price. So a $1,000 par value municipal bond quoted at 98 means that the bond is actually trading at a price of $980 (98% of $1,000 par). However, although some municipal bonds may be available with par values of $1,000, most trade in minimum denominations of $5,000 and many have minimum denominations as high as $25,000 or $100,000 to attract institutional investors.
What is the actual dollar price of a $5,000 par value municipal bond trading at 99?
(A) $99
(B) $990
(C) $4,950
(D) $5,000
The answer you want is Choice (C). This question is relatively easy if you remember that the “99” in the question is a percentage of par value, so the $5,000 face value bond is not actually trading at $99. You can use the following equation to get your answer:
Going back to Chapter 7, remember that if the interest (coupon) rate is based on a percentage of par value, so an investor with a 4% municipal bond with a par value of $25,000 will receive annual interest of $1,000 (4% × $25,000 par). Since most bonds pay semiannual interest, this investor would receive $500 every 6 months.
Yes, unfortunately, the Series 7 tests you on rules relating to municipal bonds. Rules are a part of life and a part of the Series 7 exam. A lot of the rules relating to municipal securities were already covered on the Securities Industry Essentials exam. This section covers just a few rules that are specific to municipal securities, but if you’re itching for more regulations, don’t worry — you can see plenty more rules in my favorite (and I use that term loosely) chapter: Chapter 16.
All confirmations of trades (MSRB Rule G-15) must be sent or given to customers at or before the completion of the transaction (settlement date). Municipal securities settle the regular way (three business days after the trade date). The following items are included on the confirmation:
A brokerage firm has to keep all advertising for a minimum of three years, and these ads must be easily accessible (not in a bus storage locker) for at least two years.
The Municipal Securities Rulemaking Board (MSRB) requires a principal (manager) to approve all advertising material of the firm prior to its first use. The principal must ensure that the advertising is accurate and true.
Although no particular guideline states what percentage broker-dealers can charge (as with the 5% markup policy — see Chapter 16), all commissions, markups, and markdowns must be fair and reasonable, and policies can’t discriminate among customers. The items that firms should consider follow:
You can’t take race, ethnicity, religion, gender, sexual orientation, disability, age, funny accents, or how much you like (or dislike) the client into account.
Even though a lot of the “G” rules were covered in the Securities Industry Essential exam, FINRA obviously decided that you should know even more.
Rules G-8 and G-9 (books and records requirements): All brokers, dealers, and municipal securities dealers must keep records regarding municipal securities business. Among the many items they have to keep are the following:
You aren’t expected to remember the entire list. Just get a general feeling for what’s required. It looks like the MSRB wants the broker-dealer or municipal securities dealer to maintain records of just about everything.
Rule G-32 (disclosures in connection with primary offerings): When a client purchases a new issue of municipal securities, the client must receive an Official Statement at or prior to the delivery.
If the municipal underwriting was done on a negotiated basis (where the issuer chose the underwriter directly), the municipal firm must disclose the initial offering price, the spread and/or any fee received as a result of the transaction. If the underwriting was done on a competitive (bidding) basis, the spread does not need to be disclosed.
As with other investments, you need to be able to locate information if you’re going to sell municipal securities to investors. You may find that information about municipal bonds is not as readily available as it is for most other securities. Some municipal bonds are relatively thin issues (not many are sold or traded) or may be of interest only to investors in a particular geographic location. This section reviews some of the information that you have to know to ace the Series 7 exam.
A bond resolution (indenture) provides investors with contract terms including the coupon rate, years until maturity, collateral backing the bond (if any), and so on. Although not required by law, almost every municipal bond comes with a bond indenture, which is printed on the face of most municipal bond certificates. It makes the bonds more marketable because the indenture serves as a contract between the municipality and a trustee who’s appointed to protect the investors’ rights. Included in the indenture are the flow of funds (see “Revenue Bonds: Raising Money for Utilities and Such,” earlier in this chapter) and any assets that may be backing the issue.
Printed on the face of municipal bond certificates, the legal opinion is prepared and signed by a municipal bond counsel (attorney). The purpose of the legal opinion is to verify that the issue is legally binding on the issuer and conforms to tax laws. Additionally, the legal opinion may state that interest received from the bonds is tax exempt.
Here are the two types of legal opinions:
Municipal bonds don’t have a prospectus; instead, municipalities provide an official statement. As with prospectuses, official statements come in preliminary and final versions. The preliminary version of the statement doesn’t include an offering price or coupon rate. The official statement is the document that the issuer prepares; it states what the funds will be used for, provides information about the municipality, and details how the funds will be repaid. The official statement also includes
The Bond Buyer, which is published Monday through Friday every week, is a newspaper that provides information about municipal issues, including new municipal bonds. (You can also find it online at www.bondbuyer.com
.) Included in The Bond Buyer are the following statistics and information:
Official notice of sale: Municipalities looking to accept underwriting bids for new issues of municipal bonds publish the official notice of sale in The Bond Buyer; the official notice of sale includes
Because GO bonds are backed by taxes paid by people living in the municipality, issuers are more likely to take bids by underwriters for GO bonds than for revenue bonds. The winning bid has the lowest net interest cost to the issuer (the lowest interest rate and/or the highest purchase price).
The Bond Buyer also offers some pretty nifty municipal bond indexes. Here they are:
The 20-Bond GO Index: Also called the Bond Buyer’s Index, this index measures the average yield of 20 municipal GO bonds with 20 years to maturity; all these bonds have a rating of A or better.
To help you remember that The Bond Buyer’s Index has 20 bonds with 20 years to maturity, remember that two Bs equals two 20s.
Along with The Bond Buyer (see the preceding section), investors and registered reps can also find additional information about municipal bonds in public newspapers, dealer offering sheets, EMMA, and RTRS.
EMMA (Electronic Municipal Market Access; https://emma.msrb.org
) is a free comprehensive online source of information about municipal bonds (educational materials, official statements, trade information, 529 plan disclosure documents, market information, credit ratings, and so on) and is designed specifically for retail nonprofessional investors. Once an official statement has been submitted to EMMA, a broker-dealer may disclose to investors or potential investors of the security how to view and print out the official statement obtained from EMMA. In the event that the customer wishes the broker-dealer to send a copy of the official statement, the broker-dealer is obligated to do so.
RTRS (Real Time Reporting System) is a system operated by the MSRB where brokers and dealers can report trades of most municipal securities. As you can see from the name of the system, “real time” means that trades must be reported promptly (within 15 minutes). RTRS is open on business days between the hours of 7:30 a.m. and 6:30 p.m. EST. Trades taking place outside of those hours must be reported within 15 minutes of the opening of RTRS the next business day. Transactions reported to RTRS will be used to disclose market activity, prices, and to assess transaction fees.
The following municipal securities transactions do not have to be disclosed to RTRS: