Short-Term Municipal Instruments

Municipal Notes: Short-Term Borrowing

Municipal governments, like all organizations, sometimes face temporary cash-flow mismatches. Property taxes, state aid payments, and other revenue sources may arrive at certain times of the year, while expenses such as payroll, vendor payments, and debt service occur continuously throughout the year. To bridge these gaps, municipalities issue short-term notes, which typically mature in one year or less. Understanding these instruments is essential for the Series 52 exam.

Short-term municipal notes are issued at a discount from par value and mature at face value, much like U.S. Treasury bills. The difference between the purchase price and the face value represents the interest earned by the investor. However, unlike Treasury bills, the interest on municipal notes is typically exempt from federal income tax.

Municipal notes are rated separately from long-term municipal bonds. Moody's uses a special short-term rating scale: MIG 1 (best quality), MIG 2 (high quality), MIG 3 (favorable quality), and SG (speculative grade). S&P uses SP-1+, SP-1, SP-2, and SP-3 for short-term municipal obligations. These rating scales are distinct from the long-term rating scales (Aaa/AAA, etc.) and reflect the unique risk characteristics of short-term instruments.

Tax Anticipation Notes (TANs)

Tax Anticipation Notes are issued in anticipation of future tax collections. Municipalities often need cash before tax revenues are received, so they borrow short-term by issuing TANs. The notes are repaid when the anticipated taxes are collected. For example, if a city expects to receive a large property tax payment in November but needs funds for operations in July, it might issue TANs in July that mature in November or December.

The credit quality of a TAN depends on the reliability of the anticipated tax revenue. If the tax collection rate is historically high and the tax base is stable, the TAN will generally receive a high short-term rating. The primary risk is that tax collections may be lower than expected due to economic downturns, property value declines, or taxpayer delinquencies.

Revenue Anticipation Notes (RANs)

Revenue Anticipation Notes are issued in anticipation of future non-tax revenues, such as federal or state aid payments, grants, or other intergovernmental transfers. Like TANs, RANs are used to bridge cash-flow gaps, but the anticipated revenue source is something other than local taxes. RANs are repaid when the expected revenue is received.

The credit quality of a RAN depends on the certainty of the anticipated revenue. Federal and state aid payments may be subject to budgetary delays or reductions, which could affect the issuer's ability to repay the notes on time. RANs backed by contractually obligated payments tend to carry less risk than those backed by discretionary appropriations.

Tax and Revenue Anticipation Notes (TRANs)

Some issuers combine both concepts into Tax and Revenue Anticipation Notes, which are repaid from a combination of anticipated tax collections and other revenue sources. TRANs provide greater flexibility and security than either TANs or RANs alone because they have multiple revenue sources to draw upon for repayment.

Bond Anticipation Notes (BANs)

Bond Anticipation Notes are issued in anticipation of a future long-term bond issue. The municipality needs funds to begin a project immediately but plans to issue long-term bonds at a later date. The BANs provide interim financing, and they are repaid with the proceeds from the subsequent bond issue. BANs carry a unique risk: if the municipality is unable to issue the long-term bonds (due to market conditions, credit deterioration, or other factors), it may not have the funds to repay the BANs.

BANs are commonly used when a municipality has received voter approval for a bond issue but wants to begin construction before the bonds are actually sold. They can also be used when market conditions are unfavorable for long-term borrowing, and the issuer wants to wait for better rates.

Variable Rate Demand Notes (VRDNs)

Variable Rate Demand Notes, also known as Variable Rate Demand Obligations (VRDOs), are long-term municipal securities that have a variable interest rate that resets at regular intervals (daily, weekly, monthly, or quarterly). Despite their long-term maturity, VRDNs have a "demand" or "put" feature that allows the holder to tender (sell back) the notes to a remarketing agent at par value plus accrued interest, usually with seven days' notice. This put feature effectively transforms a long-term security into a short-term instrument from the investor's perspective.

VRDNs are a major component of the tax-exempt money market. Money market funds that invest in municipal securities are significant buyers of VRDNs because the put feature and variable rate reset give these instruments the liquidity and price stability characteristics that money market funds require.

Key Features of VRDNs

• Interest Rate Reset: The rate is typically reset by a remarketing agent based on market conditions. The most common reset periods are daily and weekly. The rate adjusts to reflect current short-term tax-exempt rates.
• Put (Demand) Feature: The investor can require the issuer or its agent to repurchase the notes at par, usually with one to seven days' notice. This feature protects the investor from price declines that would result from rising interest rates.
• Remarketing Agent: A dealer or bank that resets the interest rate and, when notes are tendered, attempts to resell them to new investors. If the remarketing agent cannot find buyers, the liquidity facility provider steps in.
• Liquidity Facility: A bank provides a standby letter of credit or standby bond purchase agreement that guarantees the purchase of tendered notes that cannot be remarketed. This facility is essential because it ensures the put feature will always be honored.

Municipal Commercial Paper

Municipal commercial paper is a short-term, unsecured promissory note issued by a municipality or its agency, typically maturing in 1 to 270 days. Like corporate commercial paper, it is used to meet short-term working capital needs. Municipal commercial paper offers issuers a flexible, low-cost source of short-term financing because the issuer can choose the maturity and amount of each issuance based on its cash-flow needs.

Municipal commercial paper programs are typically backed by a credit facility, such as a bank letter of credit or line of credit, which ensures that the issuer can repay maturing paper even if it cannot roll over (reissue) the paper in the market. This credit support is critical because commercial paper investors expect to be repaid on time and will not invest without such assurance.

The interest on municipal commercial paper is generally tax-exempt, provided the maturity does not exceed 270 days. This 270-day maturity limit mirrors the exemption from SEC registration that applies to commercial paper under the Securities Act of 1933. However, municipal securities are already exempt from SEC registration as government securities, so the 270-day limit for tax purposes is the more relevant constraint.

Auction Rate Securities (ARS)

Auction Rate Securities are long-term bonds or preferred stock whose interest rate is reset at regular intervals through a Dutch auction process. The auction typically occurs every 7, 28, or 35 days. Investors who wish to hold the security submit "hold" orders, while those wishing to sell submit "sell" orders, and potential new buyers submit orders specifying the minimum rate they would accept. The clearing rate is set at the lowest rate that satisfies all sell orders.

ARS were popular before the 2008 financial crisis, but the auction market froze during the crisis when broker-dealers stopped supporting failed auctions. Investors who expected to be able to sell their ARS at par were suddenly stuck holding long-term illiquid securities. This experience highlighted the important distinction between a security's legal maturity and its expected liquidity. Since the crisis, the ARS market has largely been replaced by VRDNs and other structures.