1、Chapter 8 Municipal Securities Learning ObjectivesAfter reading this chapter, you will understand the two basic security structures: tax-backed debt and revenue bonds the flow of funds structure for revenue bonds municipal bonds with hybrid structures and special bond security structures such as ref
2、unded bonds and insured municipal bonds the different types of tax-exempt short-term municipal securities what municipal derivative securities areLearning Objectives (continued)After reading this chapter, you will understand the two basic security structures: tax-backed debt and revenue bonds how mu
3、nicipal inverse floaters are created the tax risk that investors face when investing in municipal securities yield spreads within the municipal market the shape of the municipal yield curve the primary and secondary markets for municipal securities the taxable municipal bond marketTypes and Features
4、 of Municipal Securitiesv There are basically two different types of municipal bond security structures:i. tax-backed bondsii. revenue bondsv There are also securities that share characteristics of both tax-backed and revenue bonds.Types and Features of Municipal Securities (continued)v Tax-Backed D
5、ebtTax-backed debt obligations are instruments issued by states, counties, special districts, cities, towns, and school districts that are secured by some form of tax revenue.Tax-backed debt includes general obligation debt, appropriation-backed obligations, and debt obligations supported by public
6、credit enhancement programs.Types and Features of Municipal Securities (continued)v Tax-Backed Debt The broadest type of tax-backed debt is general obligation debt. An unlimited tax general obligation debt is the stronger form of general obligation pledge as it is secured by the issuers unlimited ta
7、xing power. A limited tax general obligation debt is a limited tax pledge because for such debt there is a statutory limit on tax rates that the issuer may levy to service the debt.Types and Features of Municipal Securities (continued)v Tax-Backed Debt Agencies or authorities of several states have
8、issued bonds that carry a potential state liability for making up shortfalls in the issuing entitys obligation. However, the states pledge is not binding. Debt obligations with this nonbinding pledge of tax revenue are called moral obligation bonds.Types and Features of Municipal Securities (continu
9、ed)v Revenue Bonds The second basic type of security structure is found in a revenue bond. Such bonds are issued for either project or enterprise financings in which the bond issuers pledge to the bondholders the revenues generated by the operating projects financed. For a revenue bond, the revenue
10、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.Types and Features of Municipal Securities (continued)v Revenue BondsThere are various restrictive covenants included in the tru
11、st indenture for a revenue bond to protect the bondholders.A rate, or user charge, covenant dictates how charges will be set on the product or service sold by the enterprise.Other covenants specify thati.the facility may not be soldii.the amount of insurance to be maintainediii. requirements for rec
12、ordkeeping and for the auditing of the enterprises financial statements by an independent accounting firmiv. requirements for maintaining the facilities in good orderTypes and Features of Municipal Securities (continued)v Revenue Bonds Examples of revenue bonds include:i.Airport Revenue Bondsii.High
13、er Education Bondsiii. Hospital Revenue Bondsiv. Single-Family Mortgage Revenue Bondsv.Multifamily Revenue Bondsvi. Public Power Revenue Bondsvii. Resource Recovery Revenue Bondsviii.Student Loan Revenue Bondsix. Toll Road and Gas Tax Revenue Bondsx.Water Revenue Bondsxi. Pollution Control Revenue a
14、nd Industrial Development Revenue BondsTypes and Features of Municipal Securities (continued)v Hybrid and Special Bond Securities Some municipal bonds that have the basic characteristics of general obligation bonds and revenue bonds have more issue-specific structures as well. Some examples arei.ins
15、ured bondsii. bank-backed municipal bondsiii. refunded bonds structured/asset-backed securitiesiv. “troubled city” bailout bondsTypes and Features of Municipal Securities (continued)v Hybrid and Special Bond SecuritiesInsured bonds, in addition to being secured by the issuers revenue, are also backe
16、d by insurance policies written by commercial insurance companies.Because municipal bond insurance reduces credit risk for the investor, the marketability of certain municipal bonds can be greatly expanded.There are two major groups of municipal bond insurers.i.The first includes the monoline compan
17、ies that are primarily in the business of insuring municipal bonds.ii.The second group of municipal bond insurers includes the multiline property and casualty companies that usually have a wide base of business, including insurance for fires, collisions, hurricanes, and health problems.Types and Fea
18、tures of Municipal Securities (continued)v Hybrid and Special Bond SecuritiesSince the 1980s, municipal obligations have been increasingly supported by various types of credit facilities provided by commercial banks.There are three basic types of bank support: letter of credit, irrevocable line of c
19、redit, and revolving line of credit.i.A letter-of-credit agreement is the strongest type of support available from a commercial bank.Under this arrangement, the bank is required to advance funds to the trustee if a default has occurred.i.An irrevocable line of credit is not a guarantee of the bond i
20、ssue, although it does provide a level of security.ii.A revolving line of credit is a liquidity-type credit facility that provides a source of liquidity for payment of maturing debt in the event that no other funds of the issuer are currently available.Types and Features of Municipal Securities (con
21、tinued)v Hybrid and Special Bond SecuritiesAlthough originally issued as either revenue or general obligation bonds, municipals are sometimes refunded.A refunding usually occurs when the original bonds are escrowed or collateralized by direct obligations guaranteed by the U.S. government.The escrow
22、fund for a refunded municipal bond can be structured so that the refunded bonds are to be called at the first possible call date or a subsequent call date established in the original bond indenture.Such bonds are known as prerefunded municipal bonds.Although refunded bonds are usually retired at the
23、ir 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.Types and Features of Municipal Securities (continued)v Hybrid and Special Bond Securities There are three reasons why a municipal issuer may r
24、efund an issue by creating an escrow fund.i.Many refunded issues were originally issued as revenue bonds.ii. Some issues are refunded in order to alter the maturity schedule of the obligation.iii. When interest rates have declined after a municipal security has been issued, there is a tax arbitrage
25、opportunity available to the issuer by paying existing bondholders a lower interest rate and using the proceeds to create a portfolio of U.S. government securities paying a higher interest rate.Types and Features of Municipal Securities (continued)v Redemption Features Municipal bonds are issued wit
26、h one of two debt retirement structures, or a combination. Either a bond has a serial maturity structure or it has a term maturity structure. A serial maturity structure requires a portion of the debt obligation to be retired each year. A term maturity structure provides for the debt obligation to b
27、e repaid on a final date. Municipal bonds may be called prior to the stated maturity date, either according to a mandatory sinking fund or at the option of the issuer.Types and Features of Municipal Securities (continued)v Redemption FeaturesThe municipal market has securities with various features.
28、These are zero-coupon bonds, floating-rate bonds, and putable bonds in the municipal bond market.For this market, there are two types of zero-coupon bonds.i.One type is issued at a very deep discount and matures at par.oThe difference between the par value and the purchase price represents a predete
29、rmined compound yield.oThese zero-coupon bonds are similar to those issued in the taxable bond market for Treasuries and corporates.ii.The second type is called a municipal multiplier.oThis is a bond issued at par that has interest payments.oThe interest payments are not distributed to the holder of
30、 the bond until maturity, but the issuer agrees to reinvest the undistributed interest payments at the bonds yield to maturity when it was issued.Municipal Money Market ProductsvTax-exempt money market products include:i. notesii. commercial paperiii.variable-rate demand obligationsiv.a hybrid of th
31、e last two productsMunicipal Money Market Products (continued)vMunicipal notes include tax anticipation notes (TANs), revenue anticipation notes (RANs), grant anticipation notes (GANs), and bond anticipation notes (BANs).These are temporary borrowings by states, local governments, and special jurisd
32、ictions.vUsually, notes are issued for a period of 12 months, although it is not uncommon for notes to be issued for periods as short as three months and for as long as three years.vTANs and RANs (also known as TRANs) are issued in anticipation of the collection of taxes or other expected revenues.T
33、hese are borrowings to even out irregular flows into the treasuries of the issuing entity.vBANs are issued in anticipation of the sale of long-term bonds.Municipal Money Market Products (continued)v Tax-Exempt Commercial PaperAs with commercial paper issued by corporations, tax-exempt commercial pap
34、er is used by municipalities to raise funds on a short-term basis ranging from one to 270 days.The dealer sets interest rates for various maturity dates and the investor then selects the desired date.v Variable-Rate Demand ObligationsVariable-rate demand obligations (VRDOs) are floating-rate obligat
35、ions that have a nominal long-term maturity but have a coupon rate that is reset either daily or every seven days.The investor has an option to put the issue back to the trustee at any time with seven days notice.The put price is par plus accrued interest.Municipal Money Market Products (continued)v
36、 Commercial Paper / VRDO Hybrid The commercial paper/VRDO hybrid is customized to meet the cash flow needs of an investor. As with tax-exempt commercial paper, there is flexibility in structuring the maturity, because the remarketing agent establishes interest rates for a range of maturities. Althou
37、gh the instrument may have a long nominal maturity, there is a put provision, as with a VRDO.Municipal Derivative Securities (continued)v In recent years, a number of municipal products have been created from the basic fixed-rate municipal bond. This has been done by splitting up cash flows of newly
38、 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.v The name derivative securities have been attributed to these bond classes because they deriv
39、e their value from the underlying fixed-rate municipal bond.Municipal Derivative Securities (continued)v Floaters / Inverse Floaters A common type of derivative security is one in which two classes of securities, a floating-rate security and an inverse-floating-rate bond, are created from a fixed-ra
40、te bond. The coupon rate on the floating-rate security is reset based on the results of a Dutch auction. Inverse floaters can be created in one of three ways:i.A municipal dealer can buy in the secondary market a fixed-rate municipal bond and place it in a trust with the trust issuing a floater and
41、an inverse floater.ii. As illustrated in Exhibit 8-1 (see Overhead 8-24), the municipal dealer uses a newly issued municipal bond to create a floater and an inverse floater.iii. Using the municipal swaps market, one creates an inverse floater without the need to create a floater.Exhibit 8-1Creation
42、of a Municipal Inverse FloaterMunicipal floating-rate bondMunicipal inverse-floating-rateFixed-rate municipal bond (newly issued or seasoned)Municipal Derivative Securities (continued)v Strips and Partial Strips Municipal strip obligations are created when a municipal bonds cash flows are used to ba
43、ck zero-coupon instruments. The maturity value of each zero-coupon bond represents a cash flow on the underlying security. Partial strips have also been created from cash bonds, which are zero-coupon instruments to a particular date, such as a call date, and then converted into coupon paying instrum
44、ents. These are called convertibles or step-up bonds. Other products can be created by allocating the interest payments and principal of a fixed-coupon-rate municipal bond to more than two bond classes.Credit Riskv Although municipal bonds at one time were considered second in safety only to U.S. Tr
45、easury securities, today there are new concerns about their credit risks.i. The first concern came out of the New York City billion-dollar financial crisis in 1975.ii. The second reason for concern about municipal securities credit risk is the proliferation in this market of innovative financing tec
46、hniques to secure new bond issues.v What distinguishes these newer bonds from the more traditional general obligation and revenue bonds is that there is no history of court decisions or other case law that firmly establishes the rights of the bondholders and the obligations of the issuers.Credit Ris
47、k (continued)v As with corporate bonds, some institutional investors in the municipal bond market rely on their own in-house municipal credit analysts for determining the credit worthiness of a municipal issue. Other investors rely on the nationally recognized rating companies.v The two leading rati
48、ng companies are Moodys and Standard & Poors, and the assigned rating system is essentially the same as that used for corporate bonds. Although there are numerous security structures for revenue bonds, the underlying principle in rating is whether the project being financed will generate sufficient
49、cash flow to satisfy the obligations due bondholders.Risks Associated with Investing in Municipal Securitiesv The investor in municipal securities is exposed to the same risks affecting corporate bonds plus an additional one that may be labeled tax risk. There are two types of tax risk to which tax-
50、exempt municipal securities buyers are exposed.i. The first is the risk that the federal income tax rate will be reduced.ii. The second type of tax risk is that a municipal bond issued as a tax-exempt issue may eventually be declared to be taxable by the Internal Revenue Service.Copyright 2010 Pears
