Municipal Bonds

General Obligation (GO) Bonds

General obligation bonds are municipal securities backed by the full faith, credit, and taxing power of the issuing municipality. They are the most common type of municipal bond and are considered among the safest because the issuer pledges its ability to levy taxes to repay bondholders. GO bonds finance general public purposes such as schools, parks, government buildings, and road improvements.

Backing and Security

GO bonds are supported by the issuer's unlimited (or sometimes limited) taxing authority. The primary tax sources include:

• Ad valorem (property) taxes: The most important revenue source for GO bonds. Ad valorem means "according to value" -- the tax is based on the assessed value of real property. The issuer can raise property tax rates as needed to meet debt service obligations.
• Income taxes: Some municipalities levy local income taxes that can support GO bonds (primarily states and larger cities).
• Sales taxes: General sales tax revenue may also back GO bonds.
• License fees and other general revenues: Various fees collected by the municipality contribute to the general fund.

Authorization and Approval

GO bonds typically require voter approval through a bond referendum or ballot initiative because they pledge the government's taxing power. The steps in the GO bond issuance process include:

1. The governing body (city council, county board, etc.) proposes the bond issue.
2. Voters approve the issuance in a general or special election (usually requires a simple majority or supermajority depending on the jurisdiction).
3. The bonds are issued through a competitive bid process (GO bonds are almost always sold through competitive bidding, not negotiated sales).

Statutory Debt Limits

Most municipalities have statutory debt limits that cap the total amount of GO debt the municipality can issue, typically expressed as a percentage of assessed property values. Bonds issued within this limit are considered funded debt. Some bonds are exempt from the debt limit (e.g., school bonds, utility bonds), known as self-supporting or non-tax-supported debt even though they may technically be GO bonds.

Types of GO Bonds

• Unlimited tax GO bonds: The issuer can raise taxes without limit to meet debt service. These are the strongest type of GO bond.
• Limited tax GO bonds: The issuer's taxing authority is capped at a specific rate or amount. These are less secure because the tax ceiling may not generate sufficient revenue in difficult economic times.
• Double-barreled bonds: Backed by BOTH a specific revenue source (like tolls) AND the issuer's general taxing power. If the revenue source is insufficient, the government's taxing power provides backup. These are analyzed as GO bonds.

Revenue Bonds

Revenue bonds are backed solely by the revenues generated by a specific project, facility, or enterprise financed by the bond issue. Unlike GO bonds, revenue bonds are NOT backed by the taxing power of the municipality. If the project fails to generate sufficient revenue, bondholders may not be fully repaid.

Types of Revenue Bonds

• Airport revenue bonds: Backed by landing fees, terminal rents, and concession revenues.
• Hospital revenue bonds: Backed by patient fees and insurance reimbursements.
• Toll road / bridge / tunnel bonds: Backed by toll revenues.
• Water and sewer revenue bonds: Backed by user fees and charges.
• Power revenue bonds (electric utility): Backed by ratepayer charges.
• Housing revenue bonds: Backed by mortgage payments from housing projects.
• Industrial development revenue bonds (IDRBs): Issued by a municipality on behalf of a private corporation. The corporation leases the facility and makes payments that cover debt service. The credit quality depends on the corporation, not the municipality.

Feasibility Study

Before issuing revenue bonds, an independent feasibility study is conducted to evaluate whether the project can generate sufficient revenue to cover debt service and operating expenses. The study analyzes projected usage, pricing, competition, demographics, and economic conditions. Bond analysts and rating agencies rely heavily on feasibility studies when assessing revenue bond credit quality.

Trust Indenture Covenants

Revenue bond trust indentures (also called bond resolutions) contain specific protective covenants that safeguard bondholders' interests:

• Rate covenant: The issuer promises to set user fees and charges at levels sufficient to cover debt service and maintain required reserves. This is the most important covenant for revenue bondholders.
• Maintenance covenant: The issuer agrees to properly maintain the facility to preserve its revenue-generating capacity.
• Insurance covenant: The issuer must maintain adequate insurance against casualty and other risks.
• Additional bonds test: Restricts the issuer from issuing additional bonds (diluting existing bondholders' claims) unless revenue coverage ratios meet specified thresholds.
• Non-discrimination covenant (for airport bonds): The facility must be open to all users without discrimination.

Flow of Funds

Revenue bond indentures specify the priority order in which revenues are allocated. There are two common structures:

Net revenue pledge: Operating and maintenance expenses are paid first from gross revenues. The remaining net revenue is then used to pay debt service, fund reserve accounts, and cover other obligations. This is the most common structure.

Gross revenue pledge: Debt service is paid first from gross revenues, before operating and maintenance expenses. This provides stronger bondholder protection but is less common.

GO Bonds vs. Revenue Bonds

Municipal Bond Analysis

Analysts evaluate GO bonds and revenue bonds using different criteria. For GO bonds, the focus is on the issuer's tax base and debt burden. For revenue bonds, the analysis centers on the project's revenue-generating capacity.

GO Bond Analysis Factors

• Debt per capita: Total debt outstanding divided by the population. Higher values indicate a heavier debt burden per resident.
• Debt-to-assessed value ratio: Total debt divided by the total assessed value of property. Indicates the leverage relative to the tax base.
• Collection rate: The percentage of taxes actually collected versus taxes levied. High collection rates (above 90%) indicate a healthy tax base.
• Population and employment trends: Growing populations and diversified employment bases support stronger creditworthiness.
• Per capita income: Higher income levels suggest residents can support tax increases if needed.

Overlapping Debt

Overlapping debt (also called coterminous debt) arises when multiple governmental entities (city, county, school district, special district) share the same geographic area and tax base. Each entity's debt represents a claim on the same taxpayers. Analysts calculate the total overall net debt by adding the issuer's direct debt to its proportional share of overlapping debt from all overlapping entities.

Tax Treatment of Municipal Bonds

The tax-exempt status of municipal bond interest is the most significant feature that distinguishes municipal bonds from other fixed-income securities. Understanding the tax rules is critical for the Series 7 exam.

Federal Tax Exemption

Interest income on most municipal bonds is exempt from federal income tax. This exemption is based on the doctrine of reciprocal immunity (the federal and state governments do not tax each other's obligations) and is codified in the Internal Revenue Code. This tax advantage means municipalities can borrow at lower interest rates than comparable taxable bonds.

Triple Tax-Free Bonds

Municipal bonds may be triple tax-free (exempt from federal, state, AND local income taxes) when the bondholder resides in the same state as the issuer. For example, a New York City resident holding New York City municipal bonds pays no federal, New York State, or New York City income tax on the interest. This makes in-state munis especially attractive for residents of high-tax states.

Alternative Minimum Tax (AMT)

While most municipal bond interest is tax-exempt, certain private activity bonds are subject to the Alternative Minimum Tax (AMT). Private activity bonds benefit private entities (such as industrial development revenue bonds). For taxpayers subject to the AMT, the interest on these bonds is added back as a preference item, potentially creating tax liability. Municipal bonds subject to AMT typically offer slightly higher yields to compensate.

Capital Gains Are Taxable

Although interest income is tax-exempt, capital gains on municipal bonds are fully taxable. If an investor buys a muni bond at $950 and sells it for $1,000, the $50 gain is subject to capital gains tax. Only the interest is exempt.

Taxable Equivalent Yield (TEY)

To compare a tax-exempt municipal bond yield with a taxable bond yield, investors calculate the taxable equivalent yield:

Formula: TEY = Tax-Exempt Yield / (1 - Marginal Tax Rate)

Build America Bonds and Special Types

Build America Bonds (BABs)

Build America Bonds were created under the American Recovery and Reinvestment Act of 2009 (ARRA). Unlike traditional municipal bonds, BABs are taxable municipal bonds that pay interest subject to federal income tax. In exchange, the issuing municipality receives a federal subsidy equal to 35% of the interest cost. This mechanism allowed municipalities to access a broader investor base (including tax-exempt investors like pension funds, who derive no benefit from traditional tax-exempt munis).

There are two types of BABs:

• Tax Credit BABs: The bondholder receives a federal tax credit equal to 35% of the interest, reducing their net tax liability.
• Direct Payment BABs: The federal government pays the 35% subsidy directly to the issuing municipality, which uses it to offset interest costs. The bondholder receives full taxable interest.

While the BABs program has expired for new issuances, existing BABs remain outstanding and are testable material for the Series 7.

MSRB Rules

The Municipal Securities Rulemaking Board (MSRB) is the self-regulatory organization (SRO) that establishes rules governing the municipal securities market. Unlike FINRA (which regulates broker-dealers) and the SEC (which has ultimate authority), the MSRB cannot directly enforce its rules. Enforcement is delegated to FINRA (for broker-dealers) and banking regulators (for municipal dealer banks).

Key MSRB Rules for the Series 7

Rule G-17: Fair Dealing

All municipal securities dealers must deal fairly with all persons and must not engage in any deceptive, dishonest, or unfair practice. This is the foundational ethical rule for the municipal market and is similar to FINRA's general fair dealing requirements. Dealers must disclose all material information related to transactions with customers.

Rule G-30: Prices and Commissions

Municipal securities dealers must ensure that prices charged to customers are fair and reasonable, taking into account all relevant factors including market conditions, the size of the transaction, the expense of executing the trade, and the dealer's services. There is no fixed maximum markup or markdown for municipal securities; instead, the "fair and reasonable" standard applies. However, the MSRB provides guidance that markups generally should not exceed 2-3% for institutional trades and may be somewhat higher for smaller retail transactions.

Rule G-37: Political Contributions

Commonly known as the "pay-to-play" rule, G-37 restricts municipal finance professionals (MFPs) from engaging in municipal securities business with an issuer for two years after making a political contribution exceeding $250 to an official of that issuer who can influence the awarding of municipal bond business. Key details:

• The $250 de minimis exception applies only to contributions by MFPs who are entitled to vote for the official (i.e., they live in the jurisdiction).
• Non-residents who contribute any amount trigger the two-year ban.
• The rule targets the practice of making political contributions to win municipal bond underwriting and advisory business.
• Municipal finance professionals include any associated person of a dealer who solicits municipal bond business or supervises those who do.

Rule G-19: Suitability

Municipal dealers must make suitable recommendations based on the customer's financial situation, tax status, investment objectives, and other relevant information. Before recommending municipal securities, the dealer must have a reasonable basis for believing the investment is appropriate for the customer.

Rule G-32: Disclosures

Dealers must deliver an official statement (the municipal equivalent of a prospectus) to customers no later than settlement of the transaction for new issues. For secondary market trades, dealers must inform customers that an official statement is available through the MSRB's Electronic Municipal Market Access (EMMA) system.