Municipal Bond Types and Characteristics

Municipal Bond Types and Characteristics By Sean Hutchens and Jun Park

Contents • Municipal Bonds • History of Municipal Bonds • Characteristics of Muni Bonds • Types of Muni Bonds • Bond Rating • Muni Bond Tax Issues • Tax-free • Payback • Retirement • Current Issuers • Muni Bond Markets • Volume • Insured Bonds in Trouble • Summary • Question/Answer • Game

Municipal Bonds • In the United States, a municipal bond (or muni) is a bond issued by a city or other local government, or their agencies. Potential issuers of municipal bonds include: • Cities • Counties • School districts • Publicly owned airports and seaports • Any other governmental entity (or group of governments) below the state level.

History of Municipal Bonds • Municipal bonds were first issued by New York City in 1812. • In 1902, outstanding state and local government debt was $2.1 Billion • By 1927, the amount of debt had jumped up to $14.9 Billion • Post-depression government spending slowed progression until about 1981 when $361 Billion worth of munis were outstanding, which an increase of six-fold over 1960 which saw $66 Billion • By 2007, about $2.3 trillion in municipal bonds were outstanding, sold by more than 60,000 issuers.

Characteristics of Muni Bonds • Federal tax exempt • Pay lower interest compared to corporate • Have high degree of safety • Give dependable income

Types of Muni Bonds • G.O Bonds (General Obligation). • Long-term borrowing in which the state issues municipal securities and pledges its full faith and credit to their repayment. • ex: school bonds, city hall bonds, library bonds, etc….. • Low default rate • Backed by the Government • Does not generate profit

Types of Muni Bonds Cont’d • Revenue Bonds • Repayment solely from revenues generated by a specified revenue-generating entity associated with the purpose of the bonds. • ex: toll roads, airports, water/sewer, hospitals • Higher interest rates than G.O bonds • Not as safe as G.O bonds • Self-liquidating

Bond Rating • Bond rating: A grade given to bonds that indicates their credit quality. Private independent rating services such as Standard & Poor's, Moody's and Fitch provide these evaluations of a bond issuer's financial • strength. • The bond rate for a • state is determined • by tax rates.

Muni Bond Tax issues • Municipal bonds are exempt from federal taxes • Federal bonds are exempt from state taxes • If an investor resides within the same state in which the municipal bonds were issued, the investor is exempt from state taxes as well as Federal taxes • Corporate bonds have no tax-free provision

Tax-free Oregon investor

Muni Rate = Corp Rate x (1 – Tax Bracket)

Payback • Funding generated through project revenue or taxation • A muni generally pays interest semi-annually • Interest rate lower than corporate bonds • Principal repaid upon retirement of bond • Most muni bonds are retired before maturity

Retirement • Many munis are serial bonds, which means that a certain percentage will be retired each year after issuance so that the municipality can minimize interest rate risk • Retired bonds chosen based upon serial number • Callable nature makes munis an uncertain investment with respect to payback date

Current Issuers • Muni Bonds are issued by states, local governments, and associated agencies such as the police department, fire department, health department, etc. • Use municipal bond issues to fund capital projects and other operations for which they (municipalities) want to delay payment • Due to tax-exempt status, muni bonds allow local governments to issue debt at relatively low borrowing rates

Muni Bond Markets • Primary market dealings involve a public offering underwritten by investment bankers and can be sold through either competitive bidding (general obligation bonds) or direct negotiations • Secondary market dealings are bought and sold on an over-the-counter market consisting of nearly 2,700 securities dealers (banks and brokerage firms) who are registered with the Municipal Securities Rulemaking Board (MSRB)

Volume • Approximately $2.3 Trillion worth of municipal bonds and about 2 Million separate bonds outstanding • Decline in issuance with economic downturn of 2007/2008 • Daily trades average about $11 Billion

Insured Bonds In Trouble • Many AAA-rated munis are backed by monoline insurers, or insurers who specialize in one type of security • With the real-estate collapse, monoline insurers lost much of their capital due to investments in Collateralized Debt Obligations (CDOs) Ambac Financial Chart M.B.I.A. Financial Chart

Insured Bonds in Trouble Cont’d • These losses have bond rating companies such as Moody’s and Standard and Poor’s wondering whether or not monoline insurers have enough assets to back potential defaults • Lack of faith in a monoline’s ability to pay can lead to a devaluation in the ratings of all assets insured by said company • Were this to happen, all those holding securities insured by that company would realize deflated value in their asset as it increased in riskiness without increased return

Summary • Municipal bonds (Munis) are issued by state and local governments to fund projects and operations • These bonds are relatively secure, and offer tax benefits at both the state and federal level • Relatively cheap debt instrument for the issuing municipalities • Main types include General Obligation and Revenue Bonds • Total Volume (munis outstanding) has been continually growing

Question/Answer • Any questions before we start the game?

Around The World Trivia: Municipal Bond Edition • 2 Players at a time are asked a trivia question • 5 second time limit • First player with correct answer remains, and next player joins for another question • Single elimination • Last player standing wins • Poker suits, best to worst: spades, hearts, diamonds, clubs

Municipal Bond Types and Characteristics