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					                                         CHAPTER 8

                              MUNICIPAL SECURITIES

                                   CHAPTER SUMMARY
Municipal securities are issued by state and local governments and by governmental entities such
as “authorities” or special districts. There are both tax-exempt and taxable municipal bonds.
Most municipal bonds outstanding are tax-exempt, which means that interest on municipal bonds
is exempt from federal income taxation, and it may or may not be taxable at the state and local
levels. Proceeds from the sale of short-term notes permit the issuing municipality to cover
seasonal and temporary imbalances between outlays for expenditures and inflows from taxes.
Municipalities issue long-term bonds as the principal means for financing both long-term capital
projects such as schools, bridges, roads, and airports and long-term budget deficits that arise
from current operations.

TYPES AND FEATURES OF MUNICIPAL SECURITIES

There are basically two different types of municipal bond security structures: tax-backed bonds
and revenue bonds. There are also securities that share characteristics of both tax-backed and
revenue bonds.

Tax-Backed Debt

Tax-backed debt obligations are instruments issued by states, counties, special districts, cities,
towns, and school districts that are secured by some form of tax revenue. Tax-backed debt
includes general obligation debt, appropriation-backed obligations, and debt obligations
supported by public credit enhancement programs.

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 because it is secured by the
issuer’s unlimited taxing 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.

Agencies or authorities of several states have issued bonds that carry a potential state liability for
making up shortfalls in the issuing entity’s obligation. However, the state’s pledge is not binding.
Debt obligations with this nonbinding pledge of tax revenue are called moral obligation bonds.

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 of the
enterprise is pledged to service the debt of the issue. The details of how revenue received by the


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enterprise will be disbursed are set forth in the trust indenture.

There are various restrictive covenants included in the trust 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. An additional bonds’ covenant indicates whether
additional bonds with the same lien may be issued. Other covenants specify that the facility may
not be sold, the amount of insurance to be maintained, requirements for recordkeeping and for
the auditing of the enterprise’s financial statements by an independent accounting firm, and
requirements for maintaining the facilities in good order.

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 are insured bonds,
bank-backed municipal bonds, refunded bonds, structured/asset-backed securities, and “troubled
city” bailout bonds.

Insured bonds, in addition to being secured by the issuer’s revenue, are also backed 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. The first includes the monoline
companies that are primarily in the business of insuring municipal bonds. Almost all of the
companies that are now insuring municipal bonds can be characterized as monoline in structure.
The second group of municipal bond insurers includes the multiline property and casualty
companies that usually have a wide base of business, including insurance for fires, collisions,
hurricanes, and health problems.

Since 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 credit, and revolving line of credit. 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. An irrevocable line of
credit is not a guarantee of the bond issue, although it does provide a level of security. A
revolving line of credit is a liquidity-type credit facility that provides a source of liquidity for
payment of maturing debt in the event that no other funds of the issuer are currently available.

Although 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 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
their first or subsequent call date, some are structured to match the debt obligation to the
retirement date. Such bonds are known as escrowed-to-maturity bonds.



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There are three reasons why a municipal issuer may refund an issue by creating an escrow fund.
First, many refunded issues were originally issued as revenue bonds. Second, some issues are
refunded in order to alter the maturity schedule of the obligation. Third, when interest rates
decline after a municipal security is issued, there is a tax arbitrage 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.

Redemption Features

Municipal bonds are issued with 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 be repaid on a final date.

Special Investment Features

The municipal market has securities with various features. 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. One type is issued at a very deep discount and matures at par.
The difference between the par value and the purchase price represents a predetermined
compound yield. These zero-coupon bonds are similar to those issued in the taxable bond market
for Treasuries and corporates. The second type is called a municipal multiplier. This is a bond
issued at par that has interest payments. The interest payments are not distributed to the holder of
the bond until maturity, but the issuer agrees to reinvest the undistributed interest payments at the
bond’s yield to maturity when it was issued.

MUNICIPAL MONEY MARKET PRODUCTS

Tax-exempt money market products include notes, commercial paper, variable-rate demand
obligations, and a hybrid of the last two products.

Municipal Notes

Municipal 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 jurisdictions. Usually, 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. TANs and RANs (also known as TRANs) are issued
in anticipation of the collection of taxes or other expected revenues. These are borrowings to
even out irregular flows into the treasuries of the issuing entity. BANs are issued in anticipation
of the sale of long-term bonds.

Tax-Exempt Commercial Paper

As with commercial paper issued by corporations, tax-exempt commercial paper is used by



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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.

Variable-Rate Demand Obligations

Variable-rate demand obligations (VRDOs) are floating-rate obligations that have a nominal
long-term maturity but have a coupon rate that is reset either daily or every 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.

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. Although the instrument
may have a long nominal maturity, there is a put provision, as with a VRDO.

MUNICIPAL DERIVATIVE SECURITIES

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 issued bonds as well as
bonds existing in the secondary markets. These products have been created by dividing the
coupon interest payments and principal payments into two or more bond classes, or tranches.
The name derivative securities has been attributed to these bond classes because they derive their
value from the underlying fixed-rate municipal bond.

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-rate 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. First, a municipal dealer can buy in the
secondary market a fixed-rate municipal bond and place it in a trust. The trust then issues a
floater and an inverse floater. The second method is similar to the first except that the municipal
dealer uses a newly issued municipal bond to create a floater and an inverse floater. The third
method is to create an inverse floater without the need to create a floater. This is done using the
municipal swaps market.

Strips and Partial Strips

Municipal strip obligations are created when a municipal bond’s cash flows are used to back
zero-coupon instruments. The maturity value of each zero-coupon bond represents a cash flow
on the underlying security.

Partial strips have also been created from cash bonds, which are zero-coupon instruments to a



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particular date, such as a call date, and then converted into coupon paying instruments. 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 RISK

Although municipal bonds at one time were considered second in safety only to U.S. Treasury
securities, today there are new concerns about the credit risks of municipal securities. The first
concern came out of the New York City billion-dollar financial crisis in 1975. The second reason
for concern about municipal securities credit risk is the proliferation in this market of innovative
financing techniques to secure new bond issues. 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.

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. The two leading rating
companies are Moody’s and Standard & Poor’s, 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 cash flow to satisfy the obligations due bondholders.

RISKS ASSOCIATED WITH INVESTING IN MUNICIPAL SECURITIES

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-
exempt municipal securities buyers are exposed. The first is the risk that the federal income tax
rate will be reduced. 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.

YIELDS ON MUNICIPAL BONDS

A common yield measure used to compare the yield on a tax-exempt municipal bond with a
comparable taxable bond is the equivalent taxable yield. The equivalent taxable yield is
computed as follows:

                                                         tax-exempt yield
                        equivalent taxable yield =                             .
                                                     ( 1  marginal tax rate )

Yield Spreads

Because of the tax-exempt feature of municipal bonds, the yield on municipal bonds is less than
that on Treasuries with the same maturity. The yield on municipal bonds is compared to the yield
on Treasury bonds with the same maturity by computing the following ratio:



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                                              yield on municipal bond
                       yield ratio =                                        .
                                       yield on same maturity Treasury bond

Yield spreads within the municipal bond market are attributable to differences between credit
ratings (i.e., quality spreads), sectors within markets (intramarket spreads), and differences
between maturities (maturity spreads).

MUNICIPAL BOND MARKET

Primary Market

A substantial number of municipal obligations are brought to market each week. A state or local
government can market its new issue by offering bonds publicly to the investing community or
by placing them privately with a small group of investors. When a public offering is selected, the
issue usually is underwritten by investment bankers and/or municipal bond departments of
commercial banks. Most states mandate that general obligation issues be marketed through
competitive bidding, but generally this is not required for revenue bonds. An official statement
describing the issue and the issuer is prepared for new offerings. Municipal bonds have legal
opinions that are summarized in the official statement.

Secondary Market

Municipal bonds are traded in the over-the-counter market supported by municipal bond dealers
across the country. Markets are maintained on smaller issuers (referred to as local general
credits) by regional brokerage firms, local banks, and by some of the larger Wall Street firms.
Larger issuers (referred to as general names) are supported by the larger brokerage firms and
banks, many of whom have investment banking relationships with these issuers.

The convention for both corporate and Treasury bonds is to quote prices as a percentage of par
value with 100 equal to par. Municipal bonds, however, generally are traded and quoted in terms
of yield (yield to maturity or yield to call). The price of the bond in this case is called a basis
price. The exception is certain long-maturity revenue bonds. A bond traded and quoted in dollar
prices (actually, as a percentage of par value) is called a dollar bond.

THE TAXABLE MUNICIPAL BOND MARKET

Taxable municipal bonds are bonds whose interest is taxed at the federal income tax level.
Because there is no tax advantage, an issuer must offer a higher yield than for another tax-
exempt municipal bond. Why would a municipality want to issue a taxable municipal bond and
thereby have to pay a higher yield than if it issued a tax-exempt municipal bond? There are three
reasons for this. First, some activities do not benefit the public at large and municipalities have to
finance these restricted activities in the taxable bond market. Second, the U.S. income tax code
imposes restrictions on arbitrage opportunities that a municipality can realize from its financing
activities. Third, municipalities do not view their potential investor base as solely U.S. investors.
When bonds are issued outside of the United States, the investor does not benefit from the tax-
exempt feature.


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The most common types of activities for taxable municipal bonds used for financing are (i) local
sports facilities, (ii) investor-led housing projects, (iii) advanced refunding of issues that are not
permitted to be refunded because the tax law prohibits such activity, and (iv) underfunded
pension plan obligations of the municipality.




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              ANSWERS TO QUESTIONS FOR CHAPTER 8
                   (Questions are in bold print followed by answers.)

1. Answer the following questions.

(a) Explain why you agree or disagree with the following statement: “All municipal bonds
are exempt from federal income taxes.”

One would disagree with the statement: “All municipal bonds are exempt from federal income
taxes.” The argument and clarification are given below.

Municipal securities are issued by state and local governments and by governmental entities such
as “authorities” or special districts. There are both tax-exempt and taxable municipal bonds.
“Tax-exempt” means that interest on municipal bonds is exempt from federal income taxation,
and it may or may not be taxable at the state and local levels. Most municipal bonds outstanding
are tax-exempt.

Taxable municipal bonds are bonds whose interests are taxed at the federal income tax level.
Because there is no tax advantage, an issuer must offer a higher yield than for another tax-
exempt municipal bond. The yield must be higher than the yield on U.S. government bonds
because an investor faces credit risk by investing in a taxable municipal bond. The investors in
taxable municipal bonds are investors who view them as alternatives to corporate bonds.

(b) Explain why you agree or disagree with the following statement: “All municipal bonds
are exempt from state and local taxes.”

One would disagree with the statement that all municipal bonds are exempt from state and local
taxes. “Tax-exempt” means that interest on municipal bonds is exempt from federal income
taxation, and it may or may not be taxable at the state and local levels. Thus, not all municipal
bonds are exempt from state and local taxes.

2. If Congress changes the tax law so as to increase marginal tax rates, what will happen to
the price of municipal bonds?

An increase in the maximum marginal tax rate for individuals will increase the attractiveness of
municipal securities. This was seen with the Tax Act of 1990 which raised the maximum
marginal tax rate to 33%. Ceteris paribus, an increase in tax rates will have a positive effect on
the price of municipal securities as demand will increase. An increase in price is needed to
restore the desired returns.

On the other hand, a decrease in the maximum marginal tax rate for individuals will decrease the
attractiveness of municipal securities. This was seen with the Tax Reform Act of 1986 where the
maximum marginal tax rate for individuals was reduced from 50% to 28%. Ceteris paribus, a
decrease in tax rates will have a negative effect on the price of municipal bonds as demand will
decrease. The effect of a lower tax rate was once again seen in 1995 with congressional


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proposals regarding the introduction of a flat tax when tax-exempt municipal bonds began
trading at lower prices. The higher the marginal tax rate, the greater the value of the tax
exemption features. As the marginal tax rate declines, the price of a tax-exempt municipal
security also declines.

3. What is the difference between a general obligation bond and a revenue bond?

The two basic security structures are tax-backed debt and revenue bonds. The former are secured
by the issuer’s general taxing power. Revenue bonds are used to finance specific projects and are
dependent on revenues from those projects to satisfy the obligations. Thus, the difference
between general obligation bonds and revenue bonds involves how the bonds are secured. More
details are supplied below.

There are basically two different types of municipal bond security structures: tax-backed bonds
and revenue bonds. Tax-backed debt obligations are instruments issued by states, counties,
special districts, cities, towns, and school districts that are secured by some form of tax revenue.
Tax-backed debt includes general obligation debt, appropriation-backed obligations, and debt
obligations supported by public credit enhancement programs.

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

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 of the
enterprise is pledged to service the debt of the issue. There are various restrictive covenants
included in the trust 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.

4. Which type of municipal bond would an investor analyze using an approach similar to
that for analyzing a corporate bond?

Investors use a similar approach to analyze both municipal bonds and corporate bonds. 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. The two leading rating companies
are Moody’s and Standard & Poor’s, and the assigned rating system is essentially the same as
that used for corporate bonds. More details on the actual procedure are given below.

In evaluating general obligation bonds, the commercial rating companies assess information in
four basic categories. The first category includes information on the issuer’s debt structure to
determine the overall debt burden. The second category relates to the issuer’s ability and political



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discipline to maintain sound budgetary policy. The focus of attention here usually is on the
issuer’s general operating funds and whether it has maintained at least balanced budgets over
three to five years. The third category involves determining the specific local taxes and
intergovernmental revenues available to the issuer as well as obtaining historical information
both on tax collection rates, which are important when looking at property tax levies, and on the
dependence of local budgets on specific revenue sources. The fourth and last category of
information necessary to the credit analysis is an assessment of the issuer’s overall
socioeconomic environment. The determinations that have to be made here include trends of
local employment distribution and composition, population growth, real estate property
valuation, and personal income, among other economic factors.

5. In a revenue bond, which fund has priority when funds are disbursed from the reserve
fund, the operation and maintenance fund, or the debt service reserve fund?

For a revenue bond, the revenue of the enterprise is pledged to service the debt of the issue. The
details of how revenue received by the enterprise will be disbursed are set forth in the trust
indenture. Typically, the flow of funds for a revenue bond is as follows. First, all revenues from
the enterprise are put into a revenue fund. It is from the revenue fund that disbursements for
expenses are made to the following funds with priority given to those listed first: operation and
maintenance fund, sinking fund, debt service reserve fund, renewal and replacement fund,
reserve maintenance fund, and surplus fund. Thus, the operation and maintenance fund has
priority over the debt service reserve fund. More details are supplied below.

Operations of the enterprise have priority over the servicing of the issue’s debt, and cash needed
to operate the enterprise is deposited from the revenue fund into the operation and maintenance
fund. The pledge of revenue to the bondholders is a net revenue pledge, net meaning after
operation expenses, so cash required to service the debt is deposited next in the sinking fund.
Disbursements are then made to bondholders as specified in the trust indenture. Any remaining
cash is then distributed to the reserve funds. The purpose of the debt service reserve fund is to
accumulate cash to cover any shortfall of future revenue to service the issue’s debt. The specific
amount that must be deposited is stated in the trust indenture. The function of the renewal and
replacement fund is to accumulate cash for regularly scheduled major repairs and equipment
replacement. The function of the reserve maintenance fund is to accumulate cash for
extraordinary maintenance or replacement costs that might arise. Finally, if any cash remains
after disbursement for operations, debt servicing, and reserves, it is deposited in the surplus fund.
The issuer can use the cash in this fund in any way it deems appropriate.

6. In a revenue bond, what is a catastrophe call provision?

In revenue bonds there is a catastrophe call provision that requires the issuer to call the entire
issue if the facility is destroyed. More information on the retirement structure of municipal bonds
including call provisions are given below.

Municipal bonds are issued with 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



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provides for the debt obligation to be repaid on a final date. Usually, term bonds have maturities
ranging from 20 to 40 years and retirement schedules (sinking fund provisions) that begin 5 to 10
years before the final term maturity. 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. In revenue
bonds there is a catastrophe call provision that requires the issuer to call the entire issue if the
facility is destroyed.

7. What is the tax risk associated with investing in a municipal bond?

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-
exempt municipal securities buyers are exposed.

The first is the risk that the federal income tax rate will be reduced. The higher the marginal tax
rate, the greater the value of the tax exemption feature. As the marginal tax rate declines, the
price of a tax-exempt municipal security will decline.

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

8. “An insured municipal bond is safer than an uninsured municipal bond.” Indicate
whether you agree or disagree with this statement.

Everything else being equal, an insured municipal bond is safer. However, generally speaking,
municipal bonds that are insured are riskier than those not insured especially if they are of
inferior quality. Thus, the insurance does not guarantee they are safer than an uninsured
municipal bond. More details are supplied below.

Insured bonds, in addition to being secured by the issuer’s revenue, are also backed by insurance
policies written by commercial insurance companies. Insurance on a municipal bond is an
agreement by an insurance company to pay the bondholder any bond principal and/or coupon
interest that is due on a stated maturity date but that has not been paid by the bond issuer. When
issued, this municipal bond insurance usually extends for the term of the bond issue, and it
cannot be canceled by the insurance company.

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




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9. In your view, would the typical AAA- or AA-rated municipal bond be insured?

A major factor for an issuer to obtain bond insurance is that its credit worthiness without the
insurance is substantially lower than what it would be with the insurance. This is more likely to
be the case for a bond of lower quality. Thus, an AA-rated bond is more likely to profit from
insurance than an AAA-rated. However, even for an AA-rated bond, it is still considered a
quality grade and most investors would not be too concerned about default. Consequently, it is
unlikely that the yield for an AA-rated municipal bond could be lowered enough by being
insured to make up for the cost of insurance. In general, although insured municipal bonds sell at
yields lower than they would without the insurance, they tend to have yields higher than other
AAA-rated bonds.

10. Explain the different types of refunded bonds.

Although originally issued as either revenue or general obligation bonds, municipals are
sometimes refunded. Two types of refunded bonds are prerefunded and escrowed-to-maturity
bonds. These types are described below.

A refunding usually occurs when the original bonds are escrowed or collateralized by direct
obligations guaranteed by the U.S. government. By this it is meant that a portfolio of securities
guaranteed by the U.S. government is placed in trust. The portfolio of securities is assembled
such that the cash flow from all the securities matches the obligations that the issuer must pay.
When this portfolio of securities whose cash flow matches that of the municipality’s obligation is
in place, the refunded bonds are no longer secured as either general obligation or revenue bonds.
The bonds are now supported by the portfolio of securities held in an escrow fund.

The escrow fund for a refunded municipal bond can be structured so that the refunded bonds are
to be called at the first possible call date or a subsequent call date established in the original bond
indenture. Such bonds are known as prerefunded municipal bonds. Although refunded bonds are
usually retired at their first or subsequent call date, some are structured to match the debt
obligation to the retirement date. Such bonds are known as escrowed-to-maturity bonds.

11. Give two reasons why an issuing municipality would want to refund an outstanding
bond issue.

There are three reasons why a municipal issuer may refund an issue by creating an escrow fund.
First, many refunded issues were originally issued as revenue bonds. Included in revenue issues
are restrictive-bond covenants. The municipality may wish to eliminate these restrictions. The
creation of an escrow fund to pay the bondholders legally eliminates any restrictive-bond
covenants. This is the motivation for the escrowed-to-maturity bonds. Second, some issues are
refunded in order to alter the maturity schedule of the obligation. Third, when interest rates have
declined after a municipal security has been issued, there is a tax arbitrage 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. This is the motivation for
the prerefunded bonds.




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12. Answer the following questions.

(a) What are the three basic types of bank support for a bank-backed municipal security?

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

(b) Which is the strongest type of support available from a commercial bank?

A letter-of-credit agreement is the strongest type of support given by a commercial bank. Under
this arrangement, the bank is required to advance funds to the trustee if there is a default. An
irrevocable line of credit is not a guarantee of the bond issue, although it does provide security.
A revolving line of credit is a liquidity-type credit facility that provides a source of liquidity for
payment of maturing debt in the event that no other funds of the issuer are available. Because a
bank can cancel a revolving line of credit without notice if the issuer fails to meet certain
covenants, bond security depends entirely on the credit worthiness of the municipal issuer.

13. What are TAN, RAN, GAN, and BAN?

Municipal 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 jurisdictions. Usually, 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. TANs and RANs (also known as TRANs) are issued
in anticipation of the collection of taxes or other expected revenues. These are borrowings to
even out irregular flows into the treasuries of the issuing entity. BANs are issued in anticipation
of the sale of long-term bonds.

14. Why has there been a decline in the issuance of tax-exempt commercial paper?

As with commercial paper issued by corporations, tax-exempt commercial paper 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. Provisions
in the 1986 tax act have restricted the issuance of tax-exempt commercial paper. Specifically, the
act limits the new issuance of municipal obligations that is tax exempt, and as a result, every
maturity of a tax-exempt municipal issuance is considered a new debt issuance. Consequently,
very limited issuance of tax-exempt commercial paper exists. Instead, issuers use either variable-
rate demand obligations (VRDOs) or a commercial paper/VRDO hybrid.

15. Answer the following questions.

(a) Explain how an inverse-floating-rate municipal bond can be created.

A common type of derivative security is one in which two classes of securities, a floating-rate



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security and an inverse-floating-rate bond, are created from a fixed-rate bond. The sum of the
interest paid on the floater and inverse floater (plus fees associated with the auction) must always
equal the sum of the fixed-rate bond from which they were created.

Inverse floaters can be created in one of three ways. First, a municipal dealer can buy in the
secondary market a fixed-rate municipal bond and place it in a trust. The trust then issues a
floater and an inverse floater. The second method is similar to the first except that the municipal
dealer uses a newly issued municipal bond to create a floater and an inverse floater. The third
method is to create an inverse floater without the need to create a floater. This is done using the
municipal swaps.

(b) Who determines the leverage of an inverse floater?

The dealer determines the leverage of an inverse floater by choosing the ratio of floaters to
inverse floaters. For example, an investment banking firm may purchase $100 million of the
underlying bond in the secondary market and issue $50 million of floaters and $50 million of
inverse floaters. The dealer may opt for a 60/40 or any other split. The split of floaters/inverse
floaters determines the leverage of the inverse floaters and thus affects its price volatility when
interest rates change.

(c) What is the duration of an inverse floater?

The duration of an inverse floater is a multiple of the underlying fixed-rate issue from which it
was created. The multiple is determined by the leverage. To date, the most popular split of
floaters and inverse floaters has been 50/50. In such instances, the inverse floater will have
double the duration of the fixed-rate bond from which it is created. Determination of the leverage
will be set based on the desires of investors at the time of the transaction.

16. For years, observers and analysts of the debt market believed that municipal securities
were free of any risk of default. Why do most people now believe that municipal debt can
carry a substantial amount of credit or default risk?

Although municipal bonds at one time were considered second in safety only to U.S. Treasury
securities, today there are new concerns about the credit risks of municipal securities.

The first concern came out of the New York City billion-dollar financial crisis in 1975. This
financial crisis sent a loud and clear warning to market participants in general —regardless of
supposedly ironclad protection for the bondholder, when issuers such as large cities have severe
financial difficulties, the financial stakes of public employee unions, vendors, and community
groups may be dominant forces in balancing budgets. This reality was reinforced by the federal
bankruptcy law that took effect in October 1979, which made it easier for the issuer of a
municipal security to go into bankruptcy.

The second reason for concern about municipal securities credit risk is the proliferation in this
market of innovative financing techniques to secure new bond issues. It is not possible to
determine in advance the probable legal outcome if the newer financing mechanisms were to be



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challenged in court. This is illustrated most dramatically by the bonds of the Washington Public
Power Supply System (WPPSS), where bondholder rights to certain revenues were not upheld by
the highest court in the state of Washington. The two major commercial rating companies gave
their highest ratings to these bonds in the early 1980s. While these high-quality ratings were in
effect, WPPSS sold more than $8 billion in long-term bonds. By 1986 more than $2 billion of
these bonds were in default.

17. Answer the following questions.

(a) What is the equivalent taxable yield for an investor facing a 40% marginal tax rate, and
who can purchase a tax-exempt municipal bond with a yield of 7.2?

A common yield measure used to compare the yield on a tax-exempt municipal bond with a
comparable taxable bond is the equivalent taxable yield. The equivalent taxable yield is
computed as follows:

                                                        tax-exempt yield
                        equivalent taxable yield =                           .
                                                     (1  marginal tax rate)

In our problem, we assume that an investor in the 40% marginal tax bracket is considering the
acquisition of a tax-exempt municipal bond that offers a yield of 7.2%. Inserting our values into
our equation gives:

                                                   0.072
                    equivalent taxable yield =               = 0.1200 = 12.00%.
                                                 (1  0.40 )

(b) What are the limitations of using the equivalent taxable yield as a measure of relative
value of a tax-exempt bond versus a taxable bond?

When computing the equivalent taxable yield, the traditionally computed yield to maturity is not
the tax-exempt yield if the issue is selling at a discount because only the coupon interest is
exempt from federal income taxes. Instead, the yield to maturity after an assumed tax rate on the
capital gain is computed and used in the numerator of the formula that computes the equivalent
taxable yield. Also, as described below, one must realize that the effects of other taxes can also
pose problems when comparing tax-exempt bonds versus taxable bonds.

Because of the tax-exempt feature of municipal bonds, the yield on municipal bonds is less than
that on Treasuries with the same maturity. Bonds of municipal issuers located in certain states
yield considerably less than issues of identical credit quality that come from other states that
trade in the general market. One reason for this is that states often exempt interest from in-state
issues from state and local personal income taxes, whereas interest from out-of-state issues is
generally not exempt. Consequently, in states with high income taxes, such as New York and
California, strong investor demand for in-state issues will reduce their yields relative to bonds of
issuers located in states where state and local income taxes are not important considerations (e.g.,
Florida).



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18. Answer the following questions.

(a) What is typically the benchmark yield curve in the municipal bond market?

In the municipal bond market, several benchmark curves exist. In general, a benchmark yield
curve is constructed for AAA-quality-rated state general obligation bonds.

(b) What can you say about the typical relationship between the yield on short-term and
long-term municipal bonds?

In the Treasury and corporate bond markets, it is not unusual to find at different times either
upward, downward or flat shapes for the yield curve. In general, the municipal yield curve is
positively sloped indicating that short-term bonds have lower yields than long-term bonds. The
most likely explanation is a maturity premium although other reasons could be present including
expectations about inflation and supply versus demand considerations.

19. How does the steepness of the Treasury yield curve compare with that of the municipal
yield curve?

Assume slopes for both Treasury bonds and municipal bonds are upward sloping. If so, then a
steeper municipal yield curve implies that yields for longer term municipal bonds increase more
rapidly than for Treasury bonds. This could be caused if certain factors are more prominent in
the municipal bond market. For example, if longer term municipal bonds are in shorter supply
compared to Treasury bonds, then this factor could lead to greater yields for longer term
maturities for municipal bonds. Consequently, a steeper upward sloping yield curve for
municipal bonds would result. Similarly, if longer term municipal bonds are seen as increasing
more rapidly in terms of credit risk with longer maturities, then the upward slope for yield curves
for municipal bonds would be steeper. Finally, investing in municipal securities exposes
investors to the same qualitative risks as investing in corporate bonds, with the additional risk
that a change in the tax law may affect the price of municipal securities adversely. Since the
impact can be greater for longer term maturities, this could cause yield curve for municipal
bonds to be steeper.

20. Explain why the market for taxable municipal bonds competes for investors with the
corporate bond market.

Like the corporate bond market, taxable municipal bonds are bonds whose interests are taxed at
the federal income tax level. Thus, investors are going to look at the risk and return trade-off to
determine which bond they prefer. Because there is no tax advantage, investors will expect a
higher return for a lower rated bond regardless of whether it is a municipal or corporate bond.
For either a municipal or corporate bond, their yields must be higher than for another tax-exempt
municipal bond. Also, their yields must be higher than the yield on U.S. government bonds
because an investor faces credit risk by investing in either bond.




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