General characteristics of GOs

When you’re preparing to take the Series 7 exam, you need to recognize and remember a few items that are specific to GO bonds:

• They fund nonrevenue producing facilities. GO bonds are not self-supporting because municipalities issue them to build or support projects that don’t bring in enough (or any) money to help pay off the bonds. GOs fund schools, libraries, police departments, fire stations, and so on.
• They’re backed by the full faith and credit (taxing power) of the municipality. The taxes of the people living in the municipality back general obligation bonds.
• They require voter approval. Because the generous taxes of the people living in the municipality back the bonds, those same people have the right to vote on the project.

The following question tests your knowledge of GO bonds.

Analyzing 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.

Bringing in taxes, fees, and fines

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.

• Population: Obviously, the more people who live in a municipality and pay taxes to back the bond issue, the better. Also, the population trend is important. Investors prefer to see more people moving into a municipality than moving out.
• Tax base: The tax base is comprised of the number of people living in the municipality, the assessed property values, and how much the average person makes. Larger tax bases are ideal.
• Sales per capita: Because sales taxes also support GO bonds, the amount of sales per capita (the amount of goods the average person buys) is also important.
• Traffic fines and licensing fees: You know that $100 speeding ticket that you got last month? The money that you paid in fines helped pay off some of the municipality’s debt. I hope that makes you feel better.

Municipal GO bonds are backed by the huge taxing power of a municipality, so GO bonds usually have higher ratings and lower yields than revenue bonds. Because investors aren’t taking as much risk, they don’t get as much reward, or yield.

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).

General characteristics of revenue bonds

Before taking the Series 7 exam, you need to recognize and remember a couple items that are specific to revenue bonds:

• They don’t need voter approval. Because revenue bonds fund a revenue-producing facility and therefore aren’t backed by taxes, they don’t require voter approval. The revenues that the facility generates should be sufficient to pay off the debt.
• They require a feasibility study. Prior to issuing revenue bonds, the municipality hires consultants to prepare a feasibility study. The study basically answers the question, Does this make sense? The study includes estimates of revenues that the facility could generate, along with any economic, operating, or engineering aspects of the project that would be of interest to the municipality.

Analyzing revenue bonds

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.

If you see the word covenant on the Series 7 exam, immediately think of revenue bonds.

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:

1. Operation and maintenance: This item is normally the first that the municipality pays from revenues it receives. If the municipality doesn’t adequately maintain the facility and pay its employees, it’ll cease to run.
2. Debt service: Usually the next item paid after operation and maintenance is the debt service (principal and interest on the bonds).
3. Debt service reserve: After paying the first two items, the municipality puts aside money into the debt service reserve to pay one year’s debt service.
4. Reserve maintenance fund: This fund helps supplement the general maintenance fund.
5. Renewal and replacement fund: This fund is for exactly what you’d expect — renewal projects (updating and modernizing) and replacement of equipment.
6. Surplus fund: Municipalities can use this fund for several purposes, such as redeeming bonds, paying for improvements, and so on.

Revenues are normally dispersed as I describe in the preceding list. This system is called a net revenue pledge because the net revenues (gross revenues minus operation and maintenance) are used to pay the debt service. However, if the municipality pays the debt service before paying the operation and maintenance, it’s called a gross revenue pledge.

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.

Here’s how your equation should look:

If the question doesn’t specifically ask for gross revenues or net revenues, you can assume net because that’s the more common way that a municipality pays off its debt.

Escrow requirements

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.

Call features

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.

• Par or premium: Typically bonds are called or redeemed at par or an accreted value (see Chapter 7 for more on accretion and amortization) in the case of original issue discount (OID) bonds or zero-coupon bonds, plus accrued interest up to the redemption date. However, in some cases, they may be called or redeemed above par or accreted value plus accrued interest up to the redemption date, which is called a premium call.
• Optional: This provision gives the holders the right or option to redeem their bonds on or after a specified date determined by the issuer. Typically, that date is set at least ten years from the issue date.
• Mandatory: Mandatory redemptions occur at either on a scheduled basis (in specified amounts or in amounts then on deposit in the sinking fund) or based on when a certain amount of money is available in the sinking fund (sinking fund call).
• Partial or in-whole call: Depending on the terms of the bond contract, the issuer may make an in-whole call, where all the callable bonds of that issue must be redeemed or a partial call where only a portion of the issue must be redeemed.
• Sinking fund: Issuers of callable bonds often set up sinking funds, which are where the issuer puts money aside to pay off the bonds at some future date. Once there is enough money in the sinking fund to redeem the bonds, there will be a mandatory sinking-fund call.
• Extraordinary calls: These are a mandatory or optional redemptions due to an extraordinary event such as the loss of a revenue-producing facility backing the bonds. The loss could be due to a hurricane, flooding, fire damage, loss to eminent domain, and so on.
• Make whole calls: This type of call provision allows the issuer to pay off the debt securities early but at a higher expense. In the case of make whole calls, the issuer must make a lump-sum payment based on the net present value of future interest payments that would be due on the bonds that will not be paid due to the bonds being called. Because of the high cost to the municipality, bonds with make whole call provisions are rarely issued.

Callable bonds are riskier for investors because they aren't sure how long they're going to be able to hold their bonds. And, barring a catastrophe, issuers usually call their bonds when interest rates drop so that they can issue new bonds with a lower coupon rate. So the benefit to issuers is that they won't be stuck making high coupon payments when interest rates fall. The benefit to investors is that they receive a higher coupon rate on callable bonds. Table 8-2 summarizes the benefits and risks.

Although much more rare, municipal securities may also be issued with put or tender options. These are much rarer because it puts more control in the hands of investors and takes some of the control away from the issuers. Put options gives the investors the right to require the issuer (or agent of the issuer, tender agent) to purchase their bonds usually at par value at certain times prior to the maturity date. Typically, puttable bonds are variable-rate securities (see “Specific types of municipal securities” later in this chapter), with the put option exercisable on dates on which the floating/variable rate changes. Put options give investors more control but usually at the cost of a lower interest rate than a non-puttable security.

Rank the following municipal bonds in order from safest to riskiest.

1. Revenue bonds
2. Moral obligation bonds
3. Public housing authority bonds
4. Industrial development revenue bonds

(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.

Municipal bond diversity of maturities

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).

• Series bonds: These bonds are issued in successive years but have only one maturity date. Issuers of series bonds pay interest only on the bonds that they’ve issued so far. Construction companies that are building developments in several phases issue this type of bond. Because this type of bond is issued mainly by construction companies, they are usually not issued by municipalities.

• 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.

Specific types of municipal securities

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:

• Original Issue Discount (OID) bonds: Actually, the name is pretty self-explanatory. An OID is a bond that was originally issued at a discount and matures at par value. The difference between the original purchase price and par value must be adjusted over the life of the bond (see Chapter 7) and is treated as federally tax-free interest. If selling the bond before maturity, you have to take the adjusted book value and compare it to the selling price to determine if there's a gain or loss. OIDs may also receive semiannual interest payments. OIDs that don't receive interest payments are considered zero-coupon bonds.
• Zero-coupon bonds: Zero-coupon bonds are a type of original issue discount bond that receives no interest payments. These bonds are issued at a deep discount and mature at par value. These bonds must be accreted (see Chapter 7) over the life of the bond until reaching face value at maturity. The annual accretion is considered federally tax-free interest.
• Capital-appreciation bonds (CABs): The issuers of these municipal bonds reinvest the principal amount received from issuing the bonds at a stated compounded rate until maturity. At maturity, investors receive the maturity value, which represents the initial principal amount and the total investment return. CABs are different from zero-coupon bonds because the investment return is in the form of compounded interest instead of the accreted original value. CABs are sold at a deeply discounted price with maturity values in multiples of $5,000.
• Variable-rate securities: These securities have interest rates that fluctuate (vary) in response to market movements. Variable-rate securities are also known as floating-rate securities. The floating or variable rate is set at specified intervals. As with auction-rate securities, because the interest rate is reset occasionally, the market price of the security tends to remain more stable. Variable-rate securities typically have initial maturities of 10 years or more.
• Auction-rate securities: These are municipal bonds where the interest rate is reset periodically based on a Dutch auction. A Dutch auction is a process by which new securities are sold at the best bid price, which translates to the lowest yield to the issuer (highest selling price and/or lowest coupon rate). Because the coupon rate is reset periodically, the prices of auction-rate securities are more likely to remain stable when interest rates change.

Taxable municipal bonds

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:

• Tax Credit BABs: Investors of this type of Build America Bonds receive tax credits equal to 35 percent of the coupon rate.
• Direct Payment BABs: When a municipality issues Direct Payment BABs, it receives reimbursements from the U.S. Treasury equal to 35 percent of the coupon rate. As such, direct payment BABs would tend to have a higher coupon rate than tax credit BABs.

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.

Section 529 plans

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:

• Contribution levels may vary from one state to another but is typically up to $15,000 per year per beneficiary.
• Rollovers are allowed once every 12 months. An investor may roll over the funds from one state's 529 plan to another state's plan or to a Coverdell ESA.
• The investor may change investment options offered by the plan up to twice a year.
• There aren't any income limits placed on the investors of a 529 plan.
• Many investors contribute monthly although not required.
• Any account balances that are unused (like suppose the beneficiary decides not to go to college or goes to a cheaper local college) can be transferred to another related beneficiary.
• The assets in the account always remain under control of the owner (donor) even after the beneficiary becomes of legal age (which is 18 in most states).
• In some cases, plans can be set up as prepaid tuition plans (which allows investors to prepay college at a locked-in rate) or a college savings plan, which allows owners to invest as he or she sees fit (aggressively, moderately, or conservatively).
• As with other securities, there are disclosure requirements. When you're promoting 529 plans, you should discuss the risks and costs associated with different types of plans, recommend that they check out the tax benefits in their home state, and provide a disclaimer stating that the customer should read the disclosure document associated with the investment.
• If money is withdrawn for a non-qualified reason, the IRS may assess a 10% tax penalty.

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 accounts

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

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.

Municipal fund securities advertisements

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:

• Remind investors to review the investment objectives, expenses, and risks involved with the particular municipal fund security prior to investing.
• Disclose that an official statement relating to the municipal fund security will provide additional information. And the official statement should be read and understood prior to investing.
• Name the firm as an underwriter if it publishes the advertisement and will also supply the official statement.

The beneficiary of a 529 plan may live in another state. So, advertisements relating to 529 savings plans must tell investors to take into consideration the rules and tax benefits of the beneficiaries’ home state also prior to investing.

Comparing municipal and corporate bonds equally

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:

Because the investor’s tax bracket comes into play with municipal bonds, municipal bonds are better suited for investors in higher tax brackets.

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:

Scot-free! Taking a look at triple tax-free municipal bonds

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

• Puerto Rico
• Guam
• U.S. Virgin Islands
• American Samoa
• Washington, D.C.

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.

Unless you see the U.S. territories or Washington, D.C., in a municipal bond question, don’t assume that the bonds are triple tax-free. Even if the question states that the investor buys a municipal bond issued within her own state, don’t assume that it’s triple tax-free unless the question specifically states that it is.

The tax advantage of municipal bonds applies only to interest received. If investors sell municipal bonds for more than their cost basis, the investors have to pay taxes on the capital gains.

Pricing of municipal securities and other mathematical calculations

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.

Municipal bond quotations

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:

Confirmations

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:

• The broker-dealer’s name, address, and phone number
• The capacity of the trade (whether the firm acted as a broker or dealer)
• The dollar amount of the commission (if the firm’s acting as a broker)
• The customer’s name
• Any bond particulars, such as the issuer’s name, interest rate, maturity, call features (if any), and so on
• The trade date, time of execution, and the settlement date
• Committee on Uniform Securities Identification Procedures (CUSIP) identification number (if there is one)
• Bond yield and dollar price
• Any accrued interest
• The registration form (registered as to principal only, book entry, or fully registered)
• Whether the bonds have been called or pre-refunded
• Any unusual facts about the security

Advertising and record keeping

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.

Advertising includes any material designed for use in the public media. Advertising includes offering circulars, market and form letters, summaries of official statements, and so on. However, preliminary and final official statements are not considered advertising because they’re prepared by the issuer; therefore, they don’t require approval from a principal.

Commissions

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:

• The market value of the securities at the time of the trade.
• The total dollar amount of the transaction. Although you’re going to charge more money for a larger transaction, the percentage charged is usually lower.
• The difficulty of the trade. If you had to jump through hoops to make sure the trade was completed, you’re entitled to charge more.
• The fact that you and the firm that you work for are entitled to make a profit (which is, of course, the reason you got involved in the business to begin with).

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.

“G” even more rules

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.

The following list isn’t as huge as it could be because many of the rules are already covered throughout this book. However, you’re not expected to know the minute details of each rule, just the main idea. Fortunately, many of them just make sense. Also, don’t worry about the rule numbers; pay more attention to the rule.

• 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:

  • Records of original entry (blotters): Itemized daily records of all purchases and sales of municipal securities
  • Account records: Account records for each customer account
  • Securities records: Separate records showing all municipal securities positions
  • Subsidiary records: Records of municipal securities in transfer, municipal securities borrowed or loaned, municipal securities transactions not completed by the settlement date, and so on
  • Put options and repurchase agreements
  • Records for agency transactions
  • Records concerning primary offerings
  • Copies of confirmations (for more on confirmations, see Chapter 16)
  • Customer account information
  • Customer complaints
  • Records concerning political contributions

  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-9 (preservation of records): MSRB’s record-keeping requirements are very similar to but not exactly the same as FINRA’s requirements. Most records have to be kept either four or six years. To keep you from pulling your hair out (this coming from a bald man), look at the record-keeping requirements in Chapter 16, where I note how the MSRB rules and FINRA rules are different.
• Rule G-11 (primary offering practices): During the underwriting of new municipal securities, the underwriting syndicate must set up a system for allocation of orders (which orders get filled first). In addition, it must indicate conditions that might change the priority for the allocation of orders.
• Rule G-12 (uniform practice): Rule G-12 was established to create a uniform practice between municipal securities broker-dealers in how to handle transactions. Included are settlement dates, good delivery requirements, how to handle mutilated certificates, and so on. Most of this information is covered in more detail in Chapter 16.
• Rule G-13 (quotations): According to MSRB rules, all quotations for municipal securities published or distributed by any broker-dealer, municipal securities dealer, or person associated with a broker-dealer or municipal securities dealer must be bona fide (genuine).
• Rule G-17 (conduct of municipal securities and municipal advisory activities): Municipal securities broker-dealers, municipal securities dealers, municipal advisors, agents, and so on shall deal fairly with all persons and not engage in dishonest, deceptive, or unfair practices.
• Rule G-19 (suitability of recommendations and transactions): As with other securities, brokers, dealers, and municipal securities, prior to recommending municipal securities to a customer, must have a reasonable basis to believe that the recommendation is appropriate for the customer. Brokers or dealers must make sure that the recommendation fits the customer's investment profile. Included in that profile should be the customer's age, other investments, risk tolerance, tax situation, financial situation, investment experience, time horizon, liquidity needs, and so on.
• Rule G-21 (advertising): Advertisements by municipal securities dealers, brokers, and dealers can’t contain false or misleading statements. Advertisements include published material used in electronic or other public media, promotional literature (written or electronic) made available to customers or the public, circulars, market letters, seminar text, press releases, and so on. However, preliminary official statements, official statements, offering circulars, and so on are not considered advertisements.
• Rule G-27 (supervision): All firms selling municipal securities must have a designated principal to oversee the firm's representatives. In addition, all firms selling municipal securities must create and update as need a written supervisory procedures manual. Principals are responsible for approving in writing, the opening of all new customer accounts, each municipal securities transaction, the handling of customer complaints and actions taken, correspondence relating to municipal securities trades.
• Rule G-28 (transactions with employees and partners of other municipal securities professionals): When an employee of a municipal securities firm opens an account at another municipal securities firm, the municipal securities firm opening the account must notify the employing firm in writing. Besides notifying the employing firm, duplicate confirmations must be sent to the employing firm along with complying with any other requests from the employing firm.
• Rule G-30 (pricing and commissions): If buying or selling municipal securities for a customer on a principal basis (for or from the dealer’s inventory), the aggregate price including the markdown or markup must be fair and reasonable. If buying or selling municipal securities on an agency basis for a customer, the broker-dealer is responsible for making a reasonable effort to obtain the best price for the customer and the commission charged must be fair and reasonable in relation to prevailing market conditions.

• 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.

• Rule G-34 (CUSIP numbers, new issue and market information requirements): For new issues of municipal bonds (whether negotiated or competitive offerings), the managing underwriters must apply to the Committee on Uniform Security Identification Procedures (CUSIP) to receive identification numbers for the bonds for each maturity, if more than one. For negotiated offerings where the underwriter(s) is/are chosen directly, the managing underwriter must apply prior to the pricing of the new municipal issue. For competitive offerings, the managing underwriter must apply after winning the bid. In the event that the municipal issuer hired an advisor, the municipal advisor must apply no later than the business day after the Notice of Sale is published.
• Rule G-38 (solicitation of municipal securities business): Brokers, dealers, or municipal securities dealers may not provide or agree to provide payment for solicitation of municipal securities business to any person who is not affiliated with the broker, dealer or municipal securities dealer.

The bond resolution (indenture)

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.

Legal opinion

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.

If a bond is stamped ex-legal, it does not contain a legal opinion.

Here are the two types of legal opinions:

• Qualified legal opinion: The bond counsel has some reservations about the issue.
• Unqualified legal opinion: The bond counsel is issuing a legal opinion without reservations.

Normally, you’d think of qualified as a good thing and unqualified as a bad thing. For legal opinions, think the opposite!

Official statement

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 offering terms
• The underwriting spread (see Chapter 5)
• A description of the bonds
• A description of the issuer
• The offering price
• The coupon rate
• The feasibility statement
• The legal opinion

The Bond Buyer

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:

• The visible supply: The total dollar amount of municipal bonds expected to reach the market within the next 30 days
• The placement ratio: The percentage of new issues this week as compared to new issues offered for sale the previous week

• 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

  • When and where bids can be submitted
  • The total amount of the sale
  • Amount of the good-faith deposit
  • The type of bond being offered (GO or revenue)
  • Methods for calculating cost (net interest cost or true interest cost)
  • The taxes backing the issue

  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.

• The 11 GO Bond Index: This index should be a nice, easy one for you to remember because it’s the average yield of 11 bonds (of course) from the 20-bond index with a rating of AA or better.
• The 25 Revenue Bond Index: Also called the RevDex, this index is the average yield of 25 revenue bonds with 30 years to maturity rated A or better.
• The Municipal Bond Index: Also called the 40-Bond Index, this index is the average dollar price of 40 highly traded GO and revenue bonds with an average maturity of 20 years and a rating of A or better.

Additional info

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.