CHAPTER 8
MUNICIPAL SECURITIES
ANSWERS TO QUESTIONS FOR CHAPTER 8
(Questions are in bold print followed by answers.)
2. If Congress changes the tax law so as to increase marginal tax rates, what will happen to
the price of municipal bonds?
An increase in the maximum marginal tax rate for individuals will increase the attractiveness of
municipal securities. This was seen with the Tax Act of 1990 which raised the maximum
marginal tax rate to 33%. Ceteris paribus, an increase in tax rates will have a positive effect on
the price of municipal securities as demand will increase. An increase in price is needed to
restore the desired returns.
On the other hand, a decrease in the maximum marginal tax rate for individuals will decrease the
attractiveness of municipal securities. This was seen with the Tax Reform Act of 1986 where the
maximum marginal tax rate for individuals was reduced from 50% to 28%. Ceteris paribus, a
decrease in tax rates will have a negative effect on the price of municipal bonds as demand will
decrease. The effect of a lower tax rate was once again seen in 1995 with congressional
proposals regarding the introduction of a flat tax when tax-exempt municipal bonds began
trading at lower prices. The higher the marginal tax rate, the greater the value of the tax
exemption features. As the marginal tax rate declines, the price of a tax-exempt municipal
security also declines.
4. Which type of municipal bond would an investor analyze using an approach similar to
that for analyzing a corporate bond?
Investors use a similar approach to analyze both municipal bonds and corporate bonds. As with
corporate bonds, some institutional investors in the municipal bond market rely on their own inhouse municipal credit analysts for determining the credit worthiness of a municipal issue; other
investors rely on the nationally recognized rating companies. The two leading rating companies
are Moody’s and Standard & Poor’s, and the assigned rating system is essentially the same as
that used for corporate bonds. More details on the actual procedure are given below.
In evaluating general obligation bonds, the commercial rating companies assess information in
four basic categories. The first category includes information on the issuer’s debt structure to
determine the overall debt burden. The second category relates to the issuer’s ability and political
discipline to maintain sound budgetary policy. The focus of attention here usually is on the
issuer’s general operating funds and whether it has maintained at least balanced budgets over
three to five years. The third category involves determining the specific local taxes and
intergovernmental revenues available to the issuer as well as obtaining historical information
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both on tax collection rates, which are important when looking at property tax levies, and on the
dependence of local budgets on specific revenue sources. The fourth and last category of
information necessary to the credit analysis is an assessment of the issuer’s overall
socioeconomic environment. The determinations that have to be made here include trends of
local employment distribution and composition, population growth, real estate property
valuation, and personal income, among other economic factors.
6. In a revenue bond, what is a catastrophe call provision?
In revenue bonds there is a catastrophe call provision that requires the issuer to call the entire
issue if the facility is destroyed. More information on the retirement structure of municipal bonds
including call provisions are given below.
Municipal bonds are issued with one of two debt retirement structures, or a combination. Either a
bond has a serial maturity structure or it has a term maturity structure. A serial maturity structure
requires a portion of the debt obligation to be retired each year. A term maturity structure
provides for the debt obligation to be repaid on a final date. Usually, term bonds have maturities
ranging from 20 to 40 years and retirement schedules (sinking fund provisions) that begin 5 to 10
years before the final term maturity. Municipal bonds may be called prior to the stated maturity
date, either according to a mandatory sinking fund or at the option of the issuer. In revenue
bonds there is a catastrophe call provision that requires the issuer to call the entire issue if the
facility is destroyed.
8. “An insured municipal bond is safer than an uninsured municipal bond.” Indicate
whether you agree or disagree with this statement.
Everything else being equal, an insured municipal bond is safer. However, generally speaking,
municipal bonds that are insured are riskier than those not insured especially if they are of
inferior quality. Thus, the insurance does not guarantee they are safer than an uninsured
municipal bond. More details are supplied below.
Insured bonds, in addition to being secured by the issuer’s revenue, are also backed by insurance
policies written by commercial insurance companies. Insurance on a municipal bond is an
agreement by an insurance company to pay the bondholder any bond principal and/or coupon
interest that is due on a stated maturity date but that has not been paid by the bond issuer. When
issued, this municipal bond insurance usually extends for the term of the bond issue, and it
cannot be canceled by the insurance company.
Because municipal bond insurance reduces credit risk for the investor, the marketability of
certain municipal bonds can be greatly expanded. Municipal bonds that benefit most from the
insurance would include lower quality bonds, bonds issued by smaller governmental units not
widely known in the financial community, bonds that have a sound though complex and
difficult-to-understand security structure, and bonds issued by infrequent local-government
borrowers who do not have a general market following among investors.
10. Explain the different types of refunded bonds.
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Although originally issued as either revenue or general obligation bonds, municipals are
sometimes refunded. Two types of refunded bonds are prerefunded and escrowed-to-maturity
bonds. These types are described below.
A refunding usually occurs when the original bonds are escrowed or collateralized by direct
obligations guaranteed by the U.S. government. By this it is meant that a portfolio of securities
guaranteed by the U.S. government is placed in trust. The portfolio of securities is assembled
such that the cash flow from all the securities matches the obligations that the issuer must pay.
When this portfolio of securities whose cash flow matches that of the municipality’s obligation is
in place, the refunded bonds are no longer secured as either general obligation or revenue bonds.
The bonds are now supported by the portfolio of securities held in an escrow fund.
The escrow fund for a refunded municipal bond can be structured so that the refunded bonds are
to be called at the first possible call date or a subsequent call date established in the original bond
indenture. Such bonds are known as prerefunded municipal bonds. Although refunded bonds are
usually retired at their first or subsequent call date, some are structured to match the debt
obligation to the retirement date. Such bonds are known as escrowed-to-maturity bonds.
12. Answer the following questions.
(a) What are the three basic types of bank support for a bank-backed municipal security?
Since the 1980s, municipal obligations have been increasingly supported by various types of
credit facilities provided by commercial banks. The support is in addition to the issuer’s cash
flow revenues. There are three basic types of bank support: letter of credit, irrevocable line of
credit, and revolving line of credit.
(b) Which is the strongest type of support available from a commercial bank?
A letter-of-credit agreement is the strongest type of support given by a commercial bank. Under
this arrangement, the bank is required to advance funds to the trustee if there is a default. An
irrevocable line of credit is not a guarantee of the bond issue, although it does provide security.
A revolving line of credit is a liquidity-type credit facility that provides a source of liquidity for
payment of maturing debt in the event that no other funds of the issuer are available. Because a
bank can cancel a revolving line of credit without notice if the issuer fails to meet certain
covenants, bond security depends entirely on the credit worthiness of the municipal issuer.
14. Why has there been a decline in the issuance of tax-exempt commercial paper?
As with commercial paper issued by corporations, tax-exempt commercial paper is used by
municipalities to raise funds on a short-term basis ranging from one to 270 days. The dealer sets
interest rates for various maturity dates and the investor then selects the desired date. Provisions
in the 1986 tax act have restricted the issuance of tax-exempt commercial paper. Specifically, the
act limits the new issuance of municipal obligations that is tax exempt, and as a result, every
maturity of a tax-exempt municipal issuance is considered a new debt issuance. Consequently,
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very limited issuance of tax-exempt commercial paper exists. Instead, issuers use either variablerate demand obligations (VRDOs) or a commercial paper/VRDO hybrid.
16. For years, observers and analysts of the debt market believed that municipal securities
were free of any risk of default. Why do most people now believe that municipal debt can
carry a substantial amount of credit or default risk?
Although municipal bonds at one time were considered second in safety only to U.S. Treasury
securities, today there are new concerns about the credit risks of municipal securities.
The first concern came out of the New York City billion-dollar financial crisis in 1975. This
financial crisis sent a loud and clear warning to market participants in general —regardless of
supposedly ironclad protection for the bondholder, when issuers such as large cities have severe
financial difficulties, the financial stakes of public employee unions, vendors, and community
groups may be dominant forces in balancing budgets. This reality was reinforced by the federal
bankruptcy law that took effect in October 1979, which made it easier for the issuer of a
municipal security to go into bankruptcy.
The second reason for concern about municipal securities credit risk is the proliferation in this
market of innovative financing techniques to secure new bond issues. It is not possible to
determine in advance the probable legal outcome if the newer financing mechanisms were to be
challenged in court. This is illustrated most dramatically by the bonds of the Washington Public
Power Supply System (WPPSS), where bondholder rights to certain revenues were not upheld by
the highest court in the state of Washington. The two major commercial rating companies gave
their highest ratings to these bonds in the early 1980s. While these high-quality ratings were in
effect, WPPSS sold more than $8 billion in long-term bonds. By 1986 more than $2 billion of
these bonds were in default.
18. Answer the following questions.
(a) What is typically the benchmark yield curve in the municipal bond market?
In the municipal bond market, several benchmark curves exist. In general, a benchmark yield
curve is constructed for AAA-quality-rated state general obligation bonds.
(b) What can you say about the typical relationship between the yield on short-term and
long-term municipal bonds?
In the Treasury and corporate bond markets, it is not unusual to find at different times either
upward, downward or flat shapes for the yield curve. In general, the municipal yield curve is
positively sloped indicating that short-term bonds have lower yields than long-term bonds. The
most likely explanation is a maturity premium although other reasons could be present including
expectations about inflation and supply versus demand considerations.
20. Explain why the market for taxable municipal bonds competes for investors with the
corporate bond market.
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Like the corporate bond market, taxable municipal bonds are bonds whose interests are taxed at
the federal income tax level. Thus, investors are going to look at the risk and return trade-off to
determine which bond they prefer. Because there is no tax advantage, investors will expect a
higher return for a lower rated bond regardless of whether it is a municipal or corporate bond.
For either a municipal or corporate bond, their yields must be higher than for another tax-exempt
municipal bond. Also, their yields must be higher than the yield on U.S. government bonds
because an investor faces credit risk by investing in either bond.
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