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Sample Chapter:
CHAPTER FOUR
MUNICIPAL SECURITIES
Introduction
The Municipal Securities Rule Making Board or the MSRB is the organization
responsible for overseeing the municipal securities industry. The MSRB has no
enforcement arm and its only function is to write rules and test questions. As a result the
series 7 exam will contain a large number of questions relating to municipal securities.
Municipal bonds
State and local governments will issue municipal bonds in order to help the local
governments meet their financial needs. Most municipal bonds are considered to be almost as safe as Treasury securities issued by the federal government. However, unlike
the federal government from time to time an issuer of municipal securities does default.
The degree of safety varies from state to state and from municipality to municipality.
Municipal securities may be issued by:
- States
- Territorial possessions of The US such as Puerto Rico
- Legally constituted taxing authorities and their agencies
- Public authorities that supervise ports and mass transit
Types of Municipal Bonds
General Obligation Bond
General obligation bonds also known as “GO’s” are full faith and credit bonds. The
bonds are backed by the full faith and credit of the issuer and by their ability to raise and
levy taxes. In essence tax revenues back the bonds. GO’s will often be issued to fund
projects that benefit the entire community and the financed projects generally do not
produce revenue of any kind. General obligation bonds would be issued for example to
fund a local park, a new school building, or a new police station. General obligation
bonds that have been issued by the state are backed by income and sales taxes while
GO’s that have been issued by local governments or municipalities are backed by
property taxes.
Voter Approval
General obligation bonds are a drain on the tax revenue of the state or municipality that
issues them. The amount of general obligation bonds that may be issued must be within
certain debt limits and require voter approval. The maximum amount of general
obligation debt that may issued is know as the statutory debt limit. State and municipal
governments may not issue general obligation debt in excess of their statutory limit.
Property Taxes
General obligation bonds issued at the local level are mostly supported by property tax
revenue received from property owners. A property owner’s taxes are based on the
assessed value of the property not on its actual market value. Towns will periodically
send an assessor to inspect properties and determine what the properties’ assessed values
are.
Example
A homeowner whose home has a market value of $100,000 will not be taxed on the entire
market value of the home. If the town uses as 75% assessment rate the home’s assessed
value would be $75,000.
Overlapping Debt
Taxpayers are subject to the taxing authority of various municipal authorities. Municipal
debt that is issued by different municipal authorities that draws revenue from the same
base of taxpayers is known as overlapping debt or coterminous debt.
Example:
The county water authority issued bonds that are supported by the property taxes levied
in the county. The water authority’s debt overlaps the towns’ and county’s other general
obligation debt by drawing support from the same tax revenue. State issues are not
included when determining overlapping debt because they are supported by other revenue
sources such as state sales taxes and income taxes.
Revenue Bonds
A revenue bond is a municipal bond that has been issued to finance a revenue-producing
project such as a toll bridge. The proceeds from the issuance of the bond will construct
or repair the facility and the debt payments will be supported by the revenue-generated by
the facility. Municipal revenue bonds are exempt from The Trust Indenture Act of 1939
but all revenue bonds must have an indenture that spells out the following:
- Rate Covenant
- Maintenance Covenant
- Additional Bond Test
- Catastrophe Clause
- Call or Put Features
- Flow of Funds
- Outside Audit
- Insurance Covenant
- Sinking Fund
Industrial Development Bonds / Industrial Revenue Bonds
An industrial revenue bond or an Industrial development bond is a municipal bond issued
for the benefit of a private corporation. The proceeds from the issuance of the bond will
go towards building a facility or towards purchasing equipment for the corporation. The
facility or equipment will then be leased back to the corporation and the lease payments
will support the debt service on the bonds. Interest earned by some high-income earners
on industrial development bonds may be subject to the investor’s alternative minimum
tax. States are limited as to the amount of industrial revenue bonds that may be issued
based on the population of the state.
Lease Rental Bonds
A lease back arrangement is created when a municipality issues a municipal bond to build
a facility for an authority or agency such as a school district. The proceeds of the issue
would be used to build the facility that is then leased to the agency and the lease
payments will support the bond’s debt service.
Special Tax Bonds
A special tax bond is issued to meet a specific goal. The bond’s debt service is paid only
by revenue generated from specific taxes. The debt service on special tax bonds is in
many cases supported by “sin” taxes. Such as taxes on alcohol, tobacco, gasoline, hotel
and motel, and business license taxes. Keep in mind that special tax bonds are revenue
bonds not general obligation bonds.
Special Assessment
A special assessment bond will be issued in order to finance a project that benefits a
specific geographic area or portion of a municipality. Sidewalks and reservoirs are examples of projects that may be financed through issuance of special assessment bonds.
The homeowners in the area that benefit from the project will be subject to a special tax
assessment. The assessment will then be used to support the debt service of the bonds.
Homeowners that do not benefit from the project are not subject to the tax assessment.
Double Barreled Bonds
Double barreled bonds are bonds that have been issued to build or maintain a revenue
producing facility such as a bridge or a roadway. The initial debt service is supported by
the user fees generated by the facility. However if the revenue generated by the facility is
insufficient to support the bond’s interest and principal payments the payments will be
supported by the general tax revenue of the state or municipality. The debt service on
double barreled bonds is backed by two sources of revenue. Because they are also backed
by the tax revenue of the state or municipality revenue bonds are rated and trade like
general obligation bonds.
Moral Obligation Bonds
A moral obligation bond is issued to build or maintain a revenue producing facility such
as a park or tunnel. If the revenue generated by the facility is insufficient to cover the
debt service the state legislature may vote to allocate tax revenue to cover the short fall.
A moral obligation bond does not require that the state cover any shortfall it merely gives
them the option to. Some reasons why a state may elect to cover a shortfall are:
- To keep a high credit rating on all municipal issues
- To ensure that interest rates on their municipal issues do not rise
New Housing Authority / Public Housing Authority
New Housing Authority and Public Housing Authority bonds are issued to build low
income housing. The initial debt service for the bonds is the rental income received from
the project’s tenants. Should the rental income be insufficient to cover the bond’s debt
service the US Government will cover any shortfall. Because the payments are
guaranteed by the federal government, NHA / PHA bonds are considered to be the safest
type of municipal bond. NHA / PHA bonds are not considered to be double barreled
bonds because any shortfall will be covered by the federal government not the state or
municipal government.
Short Term Municipal Financing
States and municipalities like other issuers need to obtain short term financing to manage
their cash flow and will sell both short term notes and tax exempt commercial paper.
Short term notes are sold in anticipation of receiving other revenue and are issued a MIG
rating by Moody’s Investor Service. The MIG ratings range from 1 to 4 with a rating of
MIG 1 being the highest and a rating of MIG 4 being the lowest. The types of short term
notes a state or municipality may issue are:
- Tax Anticipation Notes ( TANs)
- Revenue Anticipation Notes ( RANs)
- Bond Anticipation Notes ( BANs)
- Tax and Revenue Anticipation notes ( TRANs )
A municipality may also issue municipal tax exempt commercial paper that matures in
270 days or less and will usually be backed by a line of credit at a bank.
Issuing Municipal Securities
Prior to issuing any bonds a municipal issuer must authorize the issuance of the bonds
through a bond resolution and obtain a preliminary legal opinion. The bond resolution
authorizes the sale of the bonds and describes the issuer’s obligations to the bondholders.
The preliminary legal opinion helps to determine how the bonds may be offered.
Selecting an Underwriter
Municipal officials can not effectively tend to their duties and try to find investors to
purchase the municipality’s debt. As a result municipal issuers will select and underwriter
or a syndicate of underwriters to sell the bonds for them. There are two ways that the
issuer may select an underwriter. An underwriter may be selected either through a
negotiation with the issuer or through a competitive bidding process. Most revenue bonds
are awarded to the underwriter through negotiation. In a negotiated underwriting the
issuer will select the underwriter and negotiate the best terms directly with them. Most
general obligation bond are awarded though competitive bidding. In competitive bidding
the issuer will invite underwriters to bid on the terms of the issue by publishing an
official notice of sale in the Daily Bond Buyer. The underwriter or syndicate submitting
the bid with the lowest net interest cost or NIC to the issuer will be awarded the issue.
The official notice of sale will include:
- Description of the Issuer
- Description of the Issue
- Dated Date
- Maturity Structure
- Date and Place of Sale Including The Time of Sale
- Denomination of Bonds
- Call or Put Provisions
- Sealed Bid or Other Bidding Provisions
- Amount of Good Faith Deposit Required to Accompany all Bidsü Name of bond Council
- Paying Agent and Trustee
- Expenses Allocated to Issuer or Purchaser
- Terms of Delivery
- Criteria for Awarding The Issue
- Right of Rejection
Interested parties will submit bids based on their ability to market the bonds on behalf of
the issuer. The underwriter is trying to provide the issuer with a competitive rate on their
bonds while still being able to earn a profit by selling the bonds to investors.
The official notice of sale does not include:
- The Yield to Maturity or YTM
- The Bond’s Rating
- The Name of the Underwriter
- The Amount of Accrued Interest
The municipal issuer prepares a bond contract for the benefit of the underwriter and
issuer. The bonds contract includes:
- Bond Resolution
- Trust Indenture ( If any )
- Applicable State and Federal Laws
- Any other documentation regarding the issuer
These documents make up the bond contract and the issuer is required to adhere to all of
the terms and conditions laid out in the various documents.
Creating a Syndicate
Most municipal issues are sold to raise a substantial amount of money. In order to assist
with the marketing of the issue and to spread the risk of underwriting the securities
several investment banks will form a syndicate. The syndicate is a group of underwriters
responsible for selling the issue. Firms participating in a syndicate formed to submit a bid
in a competitive underwriting must sign the syndicate letter or syndicate agreement. The
syndicate letter will disclose all fees and expenses including clearing expenses.
Syndicate participants in a negotiated underwriting must sign the syndicate letter or
syndicate contract. The syndicate agreement will contain:
- Each members participation in the offering ( member’s commitment )
- Method of Allocating Bonds
- Name of Managing Underwriter
- Management Fee and Spread
- Member Expenses and Amount of Good Faith Deposit
- Liability for Unsold Bonds
Type of Syndicate Account Eastern or Western
Syndicate Accounts
Each syndicate member is responsible for selling the bonds that have been allocated to
them based on their participation. A syndicate member may also be responsible for
selling additional bonds if another syndicate member is unable to sell their entire
allocation of bonds. There are two types of syndicate accounts an eastern account also
known as an undivided account and a western account also known as a divided account.
In an eastern account if any bonds remain unsold all of the underwriters must assist in
selling the remaining bonds in accordance with their commitment level regardless of
which syndicate member was unable to sell them.
Example:
Lets assume that there are 3 investment banks participating in a syndicate to underwrite
$10,000,000 worth of municipal bonds. The syndicate account is an eastern account and
the investment banks’ commitment levels are as follows:
Investment Bank Commitment Percentage Dollar Value of Bonds
A 40% $4,000,000
B 30% $3,000,000
C 30% $3,000,000
If investment bank “B” was only able to sell $2,000,000 of their allocation the remaining
$1,000,000 of bonds would have to be sold by all syndicate members based upon their
commitment levels. The remaining bonds would be allocated as follows:
Investment Bank Commitment Percentage Dollar Value of Bonds
A 40% $400,000
B 30% $300,000
C 30% $300,000
Even Though investment bank “B” was responsible for the $1,000,000 of unsold bonds
they would only be required to sell 30% of the remaining bonds or $300,000 worth and
the other syndicate members must sell the remaining bonds in line with their
participation.
In a western account or a divided account any unsold bonds are the responsibility of the
syndicate member who was unable to sell their allocation. If in the above example the
syndicate account had been a western account syndicate member “B “ would have to sell
all $1,000,000 worth of bonds that they failed to sell originally
Submitting The Syndicate Bid
Syndicate members will engage in a series of meetings in order to determine the terms
and conditions of their bid. The syndicate members must determine:
- The Underwriter’s Spread
- The Re Offering Yield
- The Prices and Yields to be Submitted to the Issuer
If all syndicate members can not agree unanimously on one or more conditions they must
agree to accept the decision of the majority of the syndicate members. Only one bid may
be submitted for each syndicate and it will be submitted by the lead or managing
underwriter.
Determining The Re Offering Yield
The Syndicate must determine the re offering yield that will be offered to the investing
public. This is known as writing the scale. Most general obligation municipal bonds are
issued with a serial maturity that matures over a period of years. The longer term
maturities carry higher yields than the bonds that mature earlier. When the syndicate has
determined the prices and yields they will submit the bid to the issuer along with the
required good faith deposit. All competitive underwritings are done on a firm
commitment basis and the syndicate that is awarded the issue is required to purchase all
of the bonds from the issuer even if they can’t sell them to investors.
Awarding The issue
Once all bids have been submitted the issuer and the bond council will meet to determine
which syndicate will be awarded the issue. The bid with the lowest net interest cost or
NIC will usually win the issue. The NIC takes into consideration the actual dollar
amount of interest that will be paid over the life of the issue. Additionally if the issuer
received a premium for the bonds the amount of the premium will be deducted from the
net interest cost. If however the issuer sold the bonds at a discount the amount of the
discount will be added to the overall net interest cost. An alternative calculation used to
award the issue would be based on the true interest cost of the issue or the TIC. The TIC
takes into consideration the time value of the money. Regardless of which method is used
to award the issue the syndicate with the best bid is awarded the issue. The issuer keeps
their good faith deposit and returns the others. The manager of unsuccessful syndicates
must return the good faith deposits to syndicate members with in two business days. The
syndicate that submits the second best bid is known as the cover bid and will be awarded
the issue in the event the wining syndicate can not meet their obligations to the issuer.
The manager of the wining syndicate will open a syndicate account once the issue has
been awarded and the manager is responsible for its operation and must keep accurate
books and records for all account activities
Underwriter’s Compensation
The difference between the price the underwriters pay for the bonds and the price at
which they resell the bonds to the public is known as the spread. The syndicate members
divide up the spread according to their different roles and in accordance with their
participation in the underwriting. The spread consist of:
- Management Fee
- Underwriting Fee
- Additional Takedown
- Selling Concession
The Management Fee
The syndicate manager receives a per bond fee for their role as syndicate manager. They
receive this fee on all bonds regardless of who sells them.
The Underwriting Fee
The Underwriting fee is the part of the spread that is used to cover underwriting
expenses. If any surplus remains after paying all expenses the syndicate members will
split the fee based on their commitment to the underwriting.
The Total Takedown
The Total takedown is what syndicate members can earn on sales of the bonds to their
customers. The total takedown consists if the additional takedown and the selling
concession.
The Selling Concession
The selling concession may be earned on sales of bonds made by dealers who are not
syndicate members. Selling group members may purchase bonds directly from a
syndicate member and earn the selling concession on sales to their customers.
$1,000 Price to Investor Selling Concession $9.00
Additional Takedown $5.00
Underwriting Fee $4.00
Management Fee $2.00
$980 Proceeds to Issuer
Take note: The total takedown in this example is $14 per bond. Syndicate members will
purchase the bonds from the syndicate account at $986 and may earn $14 per bond.
Order Period
The order period is the time set by the syndicate manager during which orders will be
solicited for the bonds. All orders will be filled based upon the order priority agreed to in
the syndicate letter and without regard to when the order was received. The order
allocation priority is very important especially when the issue is in high demand and there
are more orders than bonds available to fill the orders.
Allocation Municipal Bond Orders
The syndicate manager must establish a method for allocating bonds based upon the
priority of orders received by the syndicate. The MSRB requires that this be done in
writing and it is usually detailed in the syndicate agreement along with the details
regarding the sending of confirmations. The method under which the orders will be
allocated may not be left to the syndicate manager’s discretion. However there may be
circumstances under which the syndicate manager may make exceptions so long as these
circumstances are detailed in the syndicate agreement. The syndicate manager must
demonstrate their reasons for deviating from the agreed order if they take an exception to
the agreed allocation process. There are several types of orders that may be received by
the syndicate they are:
- Pre Sale Orders
- Syndicate or Group Net Orders
- Designated Orders
- Member Orders
- Member Related Orders
Pre Sale Orders
Pre Sale orders are entered by institutional investors who agree to purchase the bonds
prior to the bond’s pricing and terms being finalized. Pre sale orders are given the highest
priority when allocating bonds to customers. The total spread less the management fee is
deposited in the syndicate account and is divided up among the syndicate members based
on their participation. If after all pre sale orders are filled any bonds remain they will be
allocated to the syndicate orders.
Series 7 Exam Information
Time Limit: 6 Hours (the exam is broken into two parts, each has a time limit of 3 hours)
Number of Questions: 260 total. 125 for each part, and 10 pre-test questions that do not count towards the exam grade (and are not indicated in the exam).
Passing Score: 70%
Format: Multiple Choice
Enrollment Fee: $250 US. This includes a $110 examination enrollment fee, and a $ 90 NYSE development fee. Please visit the NASD Registration/Exam Fee Schedule for more information.
Prerequisites: You must be sponsored by a firm who is a member of the NASD or is a Self Regulatory Organization (SRO).
Corequisites: N/A
Exam Date(s): Any weekday
Exam Locations: Find your U.S. or international exam center here
Official Exam Website: http://www.nasdr.com
NASD Securities and Futures Prep Series 7 General Securities Representative NASD
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Series 7:
General Securities Registered Representative
(Pub. 2007, 480+ pages)
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Series 7 Exam Information
Time Limit: 6 Hours (the exam is broken into two parts, each has a time limit of 3 hours)
Number of Questions: 260 total. 125 for each part, and 10 pre-test questions that do not count towards the exam grade (and are not indicated in the exam).
Passing Score: 70%
Format: Multiple Choice
Enrollment Fee: $250 US. This includes a $110 examination enrollment fee, and a $ 90 NYSE development fee.
Please visit the NASD Registration/Exam Fee Schedule for more information.
Prerequisites: You must be sponsored by a firm who is a member of the NASD or is a Self Regulatory Organization (SRO).
Corequisites: N/A
Exam Date(s): Any weekday
Exam Locations: Find your U.S. or international exam center here
Official Exam Website: http://www.nasdr.com
Securities and Futures Prep Series 7: General Securities Representative NASD
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