Municipal bond questions, which include questions about the types of municipal bonds, the markets and rules, make up approximately 50 to 55 questions on the Series 7 exam. (For everything you need to know for the Series 7 Exam, see our Free Series 7 Online Study Guide.)
Much of the time, if a candidate analyzes these question by asking whether they refer to a general obligation (GO) bonds or to revenue bonds, they can probably eliminate at least two of the four possible answers. In some cases, determining the type of bond will answer the question.
In this article, we will approach municipal bonds by learning how to differentiate between GO and revenue bonds in several types of situations.
General Obligation or Revenue Bond?
A side-by-side comparison chart may be useful to have available for immediate review while working on practice questions. Refer each municipal's practice question to the appropriate chart and eliminate incorrect answers. Repeated use of the chart will be a helpful review of the subject.
There are two types of municipal bonds: general obligation and revenue. By comparing them side-by-side, it is clear that they are significantly different. (To learn more, see The Basics Of Municipal Bonds.)
General Characteristics - Revenue Vs. General Obligation Bonds
|Characteristics||General Obligation Bond||Revenue Bond|
|Issued by:||States and political subdivisions below the state level, including taxing districts||States and political subdivisions below the state level, but including commissions, authorities, agencies, etc.|
|Backed by:||Full faith and credit of issuer, or the taxing power of the issuer. Below state level, this primarily means ad valorem (property) taxes||Actual revenues generated by user fees from the project/facility|
|Voter Approval:||Required, e.g. by a bond referendum.||Voter approval not required|
|Special Types:||Double-barreled bonds: These have a direct funding source and the ultimate backing of the issuer\'s taxing power if necessary.||
- Special tax bonds – backed by special taxes (tobacco, gasoline, hotel/motel) for a specific project or purpose – not by ad valorem taxes.
- Special assessment bonds: Backed by assessments made to benefited properties -e.g. sewer and sidewalk bonds.
- Public housing authority (PHA)/ new housing authority (NHA) bonds: Backed by rental/lease revenues from low-income public housing, but guaranteed by the full faith and credit of the U.S. government.
Note: PHA/NHA bonds are not double-barreled bonds.
- Tax Anticipation Notes (TAN) - These are issued to smooth out a city's cash flow between tax collection periods.
- Revenue Anticipation Notes (RAN) - These are similar to TANs.
- Bond Anticipation Notes (BAN) - Notes to raise funds when a bond has been issued, but money has not yet been received. The proceeds of the bond issue will pay off the BAN.
- Tax and Revenue Anticipation Notes (TRAN)
The safety rating system for notes is the Moody's Investment Grade (MIG) rating system. The actual ratings have not been a part of the exam as of the time of this writing, but the name of the system and its association with municipal notes has been reported to show up in questions.
Trust Indentures and Revenue Bonds
A special characteristic associated with revenue bonds but not with GO bonds is the trust indenture (the individual elements are known as protective covenants). Remember, municipal bonds are not subject to federal laws such as the Trust Indenture Act of 1939.
Municipal issuers establish trust indentures as reassurance for bond buyers, not because of the federal law. This is one reason why the elements of the revenue bond's indenture are known as protective covenants.
Revenue Bond Covenants
|Rate Covenant||The issuer assures bondholders that user fees will be raised, as necessary, to assure coverage of debt service and expenses.|
|Non-Discrimination Covenant||All users of the facility must pay the same fees.|
|Additional Bonds||Two types of covenant:
- Closed-end: The issuer may not issue additional bonds with equal claim to assets unless funds are required to complete construction of the facility.
- Open-end: The issuer may sell additional bonds with equal claim to assets if permitted under the provisions of the additional bonds test described in the indenture
|Flow of Funds||The priority of payments under the indenture - what obligation is paid first and second - is described in one of two types of pledges:
- Net revenue pledge: Debt service is paid second from the net revenues. Operations and maintenance expenses take priority.
Hint: These pledges refer to when debt service is paid. If first: from the gross revenues. If second: from the net revenues. This distinction is a common exam question.
|Insurance Covenant||The trust indenture specifies the property/casualty insurance coverage for the facility for repairs or to make a total call on the bonds in case of catastrophic damage.|
|Call Provisions||This section of the indenture specifies when, at what price and by which method (in-whole or in part) calls may be made.|
|Put Provisions||This section describes the put provisions (if any) on the bond. It specifies the put period and put price at which the bonds may be sold back to the issuer.|
Because of the different nature of funding sources for GO and revenue bonds, the approach to analysis is quite different.
Recall that GO bonds are backed by the taxing power of the issuer, which at levels below the state is essentially money from property (ad valorem) taxes.
It is unlikely that Series 7 candidates will be required to compute property taxes, but knowing the pattern for computation is much more likely.
The basic formula for computation of property taxes is:
Estimated Market (Sale) Value x Aassessment Rate (%) = Assessed Value x Millage Rate (1 mill = $.001 or 1/10th of a cent) = Taxes Due
Analysis of municipal bonds provides another distinct delineation between GO and revenue bonds. This distinction is primarily because of the nature of their backing and the requirement that GO bonds be subject to voter approval
Comparing General Obligation and Revenue Bonds
General Obligation Revenue Major Factors and Tools
- Community attitude toward public debt and taxes (recall voter approval is required)
- Population base – growing or declining?
- Unemployment rate
- Economic diversity – is it a one-industry city?
- Tax base
- Assessed value of property (recall ad valorem taxes)
- Municipal debt statement – a major tool for analyzing GO bonds – the basic outline
- Estimated sale (market) value of taxable property
- Assessed value of taxable property
- Direct debt – i.e. debt specifically the liability of the city
- Debt limits (ceiling)
- Demographics and economic health
- Overlapping (coterminous) debt – shared by more than one jurisdiction (e.g. city and county)
- Self-supporting debt (double-barreled bonds)
- Net overall debt
- Is it reasonable to expect that a proposed facility can pay for itself?
- The beginning point. This study is conducted to explore costs and potential revenues from a proposed facility. Competitive facilities survey. A part of the feasibility study that assesses the impact of competing facilities on the potential revenues from the project.
- How many times do the current/expected revenues cover the bond's debt service requirements?
The Underwriting Process for GO and Revenue Bonds
Again, because GO bonds and revenue bonds differ, the process of bringing new bonds to market (the primary market) is different.
The exam tends to focus to a greater extent on the characteristics of the GO process.
The principal underwriter (broker/dealer) is selected by the issuer in revenue bond issues – known as a negotiated process. Recall, however, that GO bonds depend on the taxing power of the issuer and voter approval.
For these reasons, GO bond underwriting contracts are awarded by a competitive sealed bid sale.
Prior to issuing any municipal bond, the issuer will have an attorney, who is then referred to as the bond counsel, render a legal opinion. The firm that prepares the legal opinion is usually a tax attorney firm, because for buyers, the tax implications of the bond are of major concern. The legal opinion will include:
- The authority to borrow, demonstrating that it is legal for this entity to borrow money via municipal bonds under state and federal laws.
- 1933 Act exemption, which states that municipal issuers are exempt from filing registration statements with the SEC – the exemptions are cited.
- Tax exemption, which states that the interest from municipal bonds is normally exempt from federal taxation. The legal opinion cites the appropriate laws.
A copy of the legal opinion must accompany delivery of all municipal bonds and will be one of two types:
- Unqualified opinion: The bond counsel has no reservations about the issuer's authority to borrow, the nature of the bond and the tax exemption. This is usually called an approving opinion of counsel.
- Qualified opinion: The bond counsel has concerns about some aspects of the bond.
The following chart refers to GO bonds, because the primary market in these bonds is the principle focus of the Series 7 exam.
General Obligation Bond Underwriting Process
|Notification of Potential Bidders||The issuer publishes an ad in the Bond Buyer (the principal source of information in the municipal bond primary market) The ad is known as a notice of sale. Elements of the notice of sale include:
- Amount and type of bonds to be sold and their purpose
- Identification of the bond counsel (law firm) that prepared the legal opinion
- The invitation to bid, which gives the specifics of exact location and time for bids to be delivered
- The good faith deposit, which specifies the amount of a check (which will be credited toward the purchase of bonds for the winning bidder), which are returned to unsuccessful bidders after the bid is awarded
|Award of Underwriting Contract||
Potential underwriters obtain a copy of the official bid form from the issuer or through the Bond Buyer. The firm then writes a scale that shows the coupon rate and yield to maturity of each maturity date.
The underwriting contract is awarded to the municipal dealer that submitted the lowest net interest cost (NIC).
Once a municipal dealer has won the bidding, it is now at risk for the sale of the bonds. This is the reason that dealers routinely form underwriting syndicates – to share the risks with other dealers.
|Syndicate Formation||An underwriting syndicate is formed by a document known as a syndicate letter or an agreement among underwriters.|
|Types of Syndicates||
Divided: Also known as Western – once the syndicate member has sold the bonds for which it accepted a liability, there is no further liability for any unsold bonds.
Undivided: Also known as Eastern – these are often called joint accounts in which the member firm has a continuing liability for unsold bonds at the same percentage rate as the firm's original commitment. Be certain to know the difference in the types of syndicates. This is a common exam concept.
Orders for the Purchase of Municipal Bonds
Orders for the purchase of municipal bonds are filled in a priority sequence specified in the syndicate's priority allocation provisions specified in the underwriting agreement and provided to all members of the syndicate.
Municipal issues are frequently very popular and may be oversubscribed, which means that there are more orders for bonds than there are bonds.
The order period in which the syndicate solicits and accepts orders for bonds is set by the syndicate manager, and is frequently the day after the syndicate wins the bid. Orders are allocated for fill according to the following sequence, regardless of the time sequence in which they were received.
- Pre-Sale: These orders are entered before the syndicate wins the bid. Customers are willing to commit to buying bonds without specific information on exact price/yield.
- Group Net: The proceeds of sales from these orders are placed in the syndicate bank account and distributed to members of the syndicate according to their participation upon completion of the underwriting.
- Designated: These orders specify which member of the syndicate is to receive credit for the order. Note that they are filled after the group orders.
- Member: Last place in the priority sequence are member orders. These are orders placed by members of the syndicate that want to buy bonds for their own proprietary inventory.
Very frequently the Series 7 exam asks questions about this priority sequence. A quick memory key is the phrase, Pro Golfers Don't Miss, or PGDM. A reminder for pre-sale, group net, designated and member orders.
The syndicate buys the bonds from the issuer and sells (re-offers) the bonds to the public at a markup. The markup is known as the underwriting spread.The typical allocation of the spread is shown in the following example of a 1-point ($10) spread:
When the bonds are delivered to buyers and settlement is made, the buyer will receive a final confirmation and a copy of the official statement if it has been completed. If the final official statement is not ready, the buyer will receive a copy of the preliminary official statement, which is subject to amendment.
The official statement and the preliminary official statement are disclosure documents about a municipal offering. They serve similar purposes as the prospectus and preliminary prospectus in corporate offerings. The language is different because municipal issuers are not required to follow the Act of 1933 or other federal laws relating to the issuance of securities.
If the bonds themselves are not ready for delivery, the customer will receive a temporary confirmation known as a when issued confirm. This document does not show:
The Bottom Line
Municipal bond questions make up about 20% of the 260 questions on the Series 7 exam. Learn to master these questions and you'll be well on your way to achieving a passing score. Also, see our free Series 7 Study Guide for everything you need to to know for the Series 7 exam.