Municipal Bonds Overview

Introduction to Municipal Bonds

Municipal bonds, commonly referred to as "munis," are debt securities issued by state and local governments, their agencies, and other political subdivisions to finance public projects and operations. The municipal bond market is one of the largest segments of the U.S. fixed-income market, with over $4 trillion in outstanding debt. For the Series 52 exam, a thorough understanding of municipal bonds is absolutely essential, as these instruments form the core of the examination content.

Municipal bonds serve a critical function in the American economy. They finance the construction and maintenance of roads, bridges, schools, hospitals, water treatment facilities, airports, and countless other public infrastructure projects. Without municipal bonds, state and local governments would be far more reliant on taxes to fund capital improvements, and many projects would simply not get built.

One of the most attractive features of municipal bonds is their tax-exempt status. Interest income from most municipal bonds is exempt from federal income tax, and in many cases, it is also exempt from state and local taxes if the bondholder resides in the issuing state. This tax advantage makes municipal bonds particularly appealing to investors in higher tax brackets, who benefit most from the exclusion of interest income from their taxable income.

The municipal bond market differs significantly from the corporate bond market in several key ways. Municipal bonds are generally considered safer than corporate bonds of similar maturity because of the taxing power of the issuing government or the essential nature of the revenue-producing projects that back them. The historical default rate for investment-grade municipal bonds is extremely low compared to investment-grade corporate bonds.

Municipal bonds are typically issued in denominations of $5,000, which is the standard minimum denomination. They are quoted in terms of yield (yield to maturity or yield to call) rather than in dollar prices, which is the convention for corporate bonds. This yield-based quoting convention, known as a "basis quote," is a key difference that Series 52 candidates must understand. When a municipal bond is quoted at "3.50," it means the bond is priced to yield 3.50% to maturity. Dollar price quotes are used for some municipal bonds, particularly those trading at a premium or discount, and are quoted as a percentage of par value.

Issuers of Municipal Bonds

Municipal bonds can be issued by a wide variety of governmental entities. Understanding who can issue municipal bonds helps you understand the different types of bonds and the security behind them:

• States: State governments issue bonds to finance large-scale infrastructure projects, educational institutions, and other statewide initiatives.
• Cities and Counties: Local governments are among the most frequent issuers, funding schools, roads, water systems, and public safety facilities.
• Special Districts: These are governmental units created for a specific purpose, such as school districts, water districts, sewer districts, and fire districts.
• Authorities and Agencies: Quasi-governmental entities like port authorities, transit authorities, and housing authorities issue revenue bonds backed by specific projects.
• Territories: U.S. territories such as Puerto Rico, Guam, and the U.S. Virgin Islands can issue municipal bonds. Notably, interest on territorial bonds is exempt from federal, state, and local taxes in all 50 states, regardless of where the bondholder resides. This is known as "triple tax-exempt" status.

General Obligation Bonds

General obligation bonds (GO bonds) are one of the two primary categories of municipal bonds. They are backed by the full faith and credit of the issuing governmental entity, which includes the issuer's taxing power. This means the government pledges to use all available resources, including its ability to levy and collect taxes, to pay bondholders. GO bonds are considered among the safest types of municipal bonds because of this broad pledge of support.

The security behind a GO bond depends on the level of government issuing it. At the state level, GO bonds are backed by the state's ability to levy income taxes, sales taxes, license fees, and other revenue sources. States generally have significant flexibility in adjusting tax rates to meet their debt obligations, which provides strong credit support for their bonds.

At the local level (cities, counties, school districts), GO bonds are primarily backed by property taxes, which are assessed on real estate within the jurisdiction. This is often referred to as an "ad valorem" tax, meaning a tax based on the assessed value of the property. Local GO bonds may be further categorized based on the issuer's authority to levy property taxes:

• Unlimited Tax GO Bonds: The issuer has the authority to levy property taxes at whatever rate is necessary to pay debt service on the bonds. There is no cap or ceiling on the tax rate. These bonds carry less credit risk because the issuer has unlimited taxing authority to meet its obligations.
• Limited Tax GO Bonds: The issuer's ability to raise property taxes is capped at a certain rate or percentage. If the existing tax levy is insufficient to cover debt service, the issuer cannot raise taxes beyond the legal limit. These bonds carry more credit risk than unlimited tax GO bonds because the revenue source is constrained.

Voter Approval Requirements

Most GO bonds require voter approval before they can be issued, because they pledge the taxing power of the community. This typically involves a bond referendum in which voters decide whether to authorize the issuance of GO bonds for a specific purpose. The requirement for voter approval serves as a democratic check on government borrowing and ensures that taxpayers have a say in whether their taxes may be raised to repay the bonds.

Some jurisdictions require a simple majority (more than 50%) for approval, while others may require a supermajority (such as two-thirds). The specific requirements vary by state law and local charter. It is important to note that revenue bonds generally do not require voter approval, which is a key difference between the two types of municipal bonds.

Analyzing GO Bond Credit Quality

When evaluating the creditworthiness of a GO bond, analysts consider several factors related to the issuer's economic base and fiscal management:

• Population Trends: A growing population typically indicates a healthy economy and an expanding tax base. Declining population can signal economic distress and a shrinking tax base.
• Assessed Valuation of Property: For bonds backed by property taxes, the total assessed value of property within the jurisdiction is a critical factor. Higher assessed values provide a larger tax base from which to collect revenue.
• Per Capita Debt: This ratio measures the total outstanding debt divided by the population. A high per capita debt level may indicate that the issuer has taken on more debt than its residents can reasonably support.
• Debt-to-Assessed-Value Ratio: This compares the issuer's outstanding debt to the total assessed value of taxable property. A lower ratio suggests the issuer has significant capacity to absorb additional debt.
• Collection Rate: The percentage of property taxes actually collected versus the amount levied. A high collection rate (above 95%) indicates a healthy tax base with property owners able and willing to pay their taxes.
• Diversification of Tax Base: A jurisdiction that relies on a diverse mix of industries and employers is less vulnerable to economic downturns in any single sector.
• Overlapping Debt: This refers to the debt issued by other governmental entities that share the same tax base. For example, a homeowner may pay property taxes to the city, the county, and the school district. The total burden of all overlapping debt is an important consideration.

Revenue Bonds

Revenue bonds are the second major category of municipal bonds. Unlike GO bonds, revenue bonds are not backed by the taxing power of the issuer. Instead, they are secured by the revenues generated by a specific project, facility, or enterprise that the bond proceeds are used to finance. The bondholder's claim is limited to the revenue stream from the designated project, and the issuer's general taxing power is not pledged as security.

Revenue bonds are used to finance a wide variety of income-producing projects. Common examples include toll roads, bridges, airports, water and sewer systems, hospitals, public utilities, stadiums, and convention centers. The fundamental premise is that the project financed by the bonds will generate sufficient revenue through user fees, tolls, or charges to cover operating expenses and debt service payments.

The Revenue Bond Resolution (Trust Indenture)

The terms and conditions of a revenue bond issue are spelled out in a document called the revenue bond resolution or trust indenture. This legal document defines the rights and obligations of the issuer and the bondholders and contains several critical provisions, often referred to as "protective covenants." These covenants are designed to protect bondholders' interests:

• Rate Covenant: The issuer pledges to charge user fees or rates sufficient to cover operating expenses, debt service, and reserve fund requirements. This is one of the most important covenants because it ensures the revenue stream will be adequate.
• Maintenance Covenant: The issuer agrees to maintain the facility in good working condition to ensure it continues to generate revenue.
• Insurance Covenant: The issuer agrees to maintain adequate insurance coverage on the facility.
• Additional Bonds Test: This restricts the issuer's ability to issue additional bonds secured by the same revenue stream. Typically, the issuer must demonstrate that existing revenues meet a minimum coverage ratio (such as 1.25x) before additional bonds can be issued.
• Non-Compete (Non-Impairment) Clause: The issuer agrees not to build or operate a competing facility that could divert revenues from the bonded project.

Flow of Funds

The revenue bond resolution also specifies the flow of funds, which is the order in which revenues are distributed. There are two primary flow-of-funds structures:

Under either pledge, after debt service is paid, remaining funds typically flow into several accounts in the following priority order: Debt Service Reserve Fund, Renewal and Replacement Fund, Surplus Fund (which may be used for any lawful purpose). The debt service reserve fund is particularly important because it serves as a safety net, typically holding an amount equal to one year's maximum annual debt service.

Feasibility Studies

Before a revenue bond is issued, an independent feasibility study is typically conducted to evaluate whether the proposed project will generate sufficient revenue to cover operating costs and debt service. The feasibility study considers factors such as projected demand for the project's services, anticipated user fees or tolls, comparable projects in other locations, demographic and economic trends, and potential competition. The results of the feasibility study are included in the bond's official statement and are a key factor in the credit analysis of the issue.

GO Bonds vs. Revenue Bonds: A Detailed Comparison

Understanding the differences between GO bonds and revenue bonds is one of the most critical topics for the Series 52 exam. The following comparison table summarizes the key differences:

Credit Ratings and Bond Features

Municipal bonds are evaluated and rated by independent credit rating agencies. The three major agencies that rate municipal bonds are Moody's Investors Service, Standard & Poor's (S&P), and Fitch Ratings. These agencies assess the creditworthiness of the issuer and the likelihood that bondholders will receive timely payment of principal and interest.

Rating Scales

Investment-grade ratings indicate lower credit risk and are preferred by institutional investors and fiduciaries. Below investment grade ratings are often called "high yield" or "junk" bonds and carry higher risk and correspondingly higher yields.

Credit Enhancement

Issuers may use various forms of credit enhancement to improve the credit rating of their bonds, which lowers borrowing costs. Common forms of credit enhancement include:

• Bond Insurance: A third-party insurance company guarantees the timely payment of principal and interest. If the issuer defaults, the insurer steps in. Insured bonds typically receive the rating of the insurer, which is usually AAA/Aaa. Major municipal bond insurers include Assured Guaranty and Build America Mutual (BAM).
• Letter of Credit (LOC): A bank provides a guarantee to pay bondholders if the issuer cannot. The bond receives the bank's credit rating. Letters of credit are particularly common with variable rate demand notes (VRDNs).
• State Credit Enhancement Programs: Some states operate programs that provide additional security for bonds issued by local governments within the state.
• Escrow Accounts: Funds are set aside in an escrow account, often invested in U.S. Treasury securities, to guarantee payment. Pre-refunded bonds that are escrowed to maturity with U.S. Treasuries are considered among the safest municipal bonds.

Key Bond Features

Municipal bonds have several important structural features that affect their value and risk:

• Call Provisions: Most municipal bonds are callable, meaning the issuer has the right to redeem the bonds before maturity, usually after a specified call protection period (typically 10 years). Bonds are usually called at par or at a slight premium. Issuers call bonds when interest rates decline so they can refinance at lower rates.
• Sinking Fund: A provision requiring the issuer to retire a portion of the bond issue each year. This reduces the total amount of debt outstanding over time and provides additional security to bondholders by ensuring gradual principal repayment.
• Serial Bonds: A bond issue in which portions of the total issue mature at regular intervals (e.g., annually). Each serial maturity has its own coupon rate. Serial bonds are the most common structure for municipal bonds.
• Term Bonds: All bonds in the issue mature on a single date. Term bonds are more common in revenue bond issues and often include a mandatory sinking fund.
• Balloon Maturity: A combination where most of the principal comes due in the final maturity, with smaller amounts maturing earlier.

The Legal Opinion

Every municipal bond issue must be accompanied by a legal opinion issued by a qualified bond counsel (a specialized law firm). The legal opinion addresses two critical matters: first, that the bonds have been legally issued and constitute valid, binding obligations of the issuer; and second, that the interest on the bonds is exempt from federal income tax (and potentially state and local taxes). A bond sold without a legal opinion is said to be sold "ex-legal," which makes it less marketable and may result in a lower price.