Municipal Securities Representative Exam

General obligation (GO) bonds are backed by the full faith, credit, and taxing power of the issuing municipality. They are supported by property taxes (ad valorem taxes) and sometimes income or sales taxes. GO bonds typically require voter approval and are subject to statutory debt limits. They are generally considered lower risk than revenue bonds because of the broad taxing authority behind them.

Revenue bonds are backed solely by the revenue generated from a specific project or facility, such as a toll road, water system, or hospital. They do not require voter approval and are not subject to debt limits. Revenue bonds carry higher risk than GO bonds because repayment depends on the project's ability to generate sufficient revenue. Key protective provisions include the rate covenant (pledging to set rates high enough to cover debt service) and the additional bonds test (limiting new debt issuance).

The flow of funds in a revenue bond indenture specifies the priority order in which project revenues are distributed. Under the more common net revenue pledge, operating and maintenance (O&M) expenses are paid first, then debt service, followed by reserve funds, and finally any surplus. Under a gross revenue pledge, debt service is paid first from all revenues before any operating expenses.

Key funds in the flow include the debt service reserve fund (typically equal to one year's maximum annual debt service, providing a cushion if revenues fall short), the renewal and replacement fund (for maintaining the facility), and the surplus fund (excess revenues that may be used for future projects or to retire outstanding bonds).

In a competitive underwriting, the issuer publishes a Notice of Sale and multiple underwriting syndicates submit sealed bids. The syndicate offering the lowest net interest cost (NIC) or true interest cost (TIC) wins the issue. GO bonds are typically sold through competitive bidding because their credit quality is well-established and easy to compare.

In a negotiated underwriting, the issuer selects an underwriter in advance and negotiates the terms, timing, and pricing of the offering. Revenue bonds are more commonly sold through negotiation because their unique project characteristics benefit from a more collaborative structuring process. The senior managing underwriter helps structure the bond issue, time the sale, and price the bonds based on market conditions.

Municipal underwriting syndicates allocate bonds using a priority system established in the syndicate agreement. The typical priority order is: presale orders (received before the bid is awarded, highest priority), group net orders (benefit the entire syndicate, second priority), designated orders (customer specifies which syndicate members share the credit), and member orders (placed by syndicate members for their own accounts, lowest priority).

The spread is the difference between the price paid to the issuer and the public offering price. It consists of the management fee (to the lead manager), the takedown (to the selling dealer), and additional expenses. The concession is the portion of the takedown offered to non-syndicate selling group members.

The tax-equivalent yield (TEY) allows investors to compare the yield of a tax-exempt municipal bond with a taxable bond on an equal basis. The formula is: TEY = Municipal Yield / (1 - Marginal Tax Rate). For example, a 3% municipal bond for an investor in the 37% federal tax bracket has a TEY of 3% / (1 - 0.37) = 4.76%.

This calculation is essential for determining suitability. Municipal bonds are most beneficial for investors in higher tax brackets because the tax savings are proportionally greater. An investor in a low tax bracket may achieve better after-tax returns from taxable bonds. Municipal bonds are generally not suitable for tax-deferred accounts (IRAs, 401(k)s) because these accounts already shelter income from taxation, making the tax exemption redundant.

Municipal bond interest is generally exempt from federal income tax. If the bondholder resides in the state of issuance, the interest may also be exempt from state and local income taxes ("triple tax-exempt"). However, certain private activity bonds may be subject to the Alternative Minimum Tax (AMT).

Capital gains on municipal bonds are fully taxable. The de minimis rule applies when a bond is purchased at a market discount greater than 0.25% per year to maturity -- the discount at sale or maturity is taxed as ordinary income rather than capital gains. Original issue discount (OID) on municipal bonds is treated as tax-exempt interest accreted over the life of the bond, increasing the holder's cost basis annually.

MSRB Rule G-37 (the "pay-to-play" rule) prohibits municipal securities dealers from engaging in municipal securities business with an issuer for two years after any contribution to an official of that issuer who can influence the awarding of municipal securities business. This prevents firms from using political contributions to win underwriting or advisory mandates.

A de minimis exemption allows contributions of up to $250 per election to officials for whom the contributor is entitled to vote. Municipal finance professionals (MFPs) and their supervisors are considered "covered associates" subject to the rule. Firms must report all contributions quarterly to the MSRB. The two-year ban applies even if the contribution is returned, making awareness of this rule critical for all municipal securities professionals.

MSRB Rule G-17 is the foundational fair dealing rule requiring that dealers deal fairly with all persons in the conduct of their municipal securities business. It prohibits deceptive, dishonest, or unfair practices. This rule serves as the basis for many MSRB enforcement actions.

Under G-17's interpretive guidance for underwriters, the senior managing underwriter has specific disclosure obligations to the issuer, including disclosing the arm's-length nature of the underwriter-issuer relationship (the underwriter is not a fiduciary), all material financial characteristics and risks of the financing, and any conflicts of interest. These disclosures must be made in writing and in a timely manner to ensure the issuer can make informed decisions.