| GENERAL
DESCRIPTION
Municipal securities
are interest-bearing obligations issued by local governments or their
political subdivisions (such as cities, towns, villages, counties, or
special districts) or by state governments, agencies, or political subdivisions.
These governmental entities can borrow at favorable rates because the
interest income from most municipal securities generally receives advantageous
treatment under federal income tax rules. There are important restrictions
on these tax advantages, however, and banks are subject to different tax
treatment than other investors.
The two principal classifications of municipal securities
are general obligation bonds
and revenue bonds. General obligation bonds are secured by the full
faith and credit of an issuer with taxing power. General obligation bonds
issued by local governments are generally secured by a pledge of the issuer's
specific taxing power, while general obligation bonds issued by states
are generally based on appropriations made by the state's legislature.
In the event of default, the holders of general obligation bonds have
the right to compel a tax levy or legislative appropriation to satisfy
the issuer's obligation on the defaulted
bonds.
Revenue bonds are
payable from a specific source of revenue, so that the full faith and
credit of an issuer with taxing power is not pledged. Revenue bonds are
payable only from specifically identified sources of revenue. Pledged
revenues may be derived from operation of the financed project, grants,
and excise or other taxes. Industrial
development bonds are a common example of revenue bonds. These bonds
are municipal debt obligations issued by a state or local government (or
a development agency) to finance private projects that generate tax revenues.
The debt service on these bonds is dependent on the lease income generated
by the project or facility. In certain instances, industrial development
bonds may be categorized as loans .
In addition to municipal and industrial development bonds,
state and local governmental entities issue short-term obligations in
the form of notes. These debt obligations are generally issued to bridge
the gap between when expenses are paid and tax revenues are collected.
The types of notes issued include tax anticipation notes (TANs), revenue
anticipation notes (RANs), tax and revenue anticipation notes (TRANs),
grant anticipation notes (GANs), and bond anticipation notes (BANs).
CHARACTERISTICS
AND FEATURES
Municipal bonds are typically issued in denominations of
$5,000, known as the par value or face value amount of the bond. Municipal
bonds are generally issued in serial maturities. A typical offering is
made up of different maturities which allow the issuer to spread out debt
service and stay within financial requirements. In recent years, however,
term bonds have become increasingly
popular. Term bonds are bonds comprising a large part or all of a particular
issue which comes due in a single maturity. The issuer usually agrees
to make periodic payments into a
sinking fund for mandatory redemption of term bonds before maturity
or for payment at maturity. Most municipal bonds are issued with call
provisions which give the issuer flexibility in controlling its borrowing
costs through the early retirement of debt.
A prime feature of municipal securities had been the exemption
of their interest from federal income taxation. However, two significant
restrictions have been imposed on the tax benefits of owning municipal
securities. First, beginning in 1986, all taxpayers became subject to
the alternative minimum tax (AMT),
which was intended to provide an upper limit on the degree to which individuals
and corporations can protect their income from taxation. Interest income
from private-activity securities issued since then is potentially subject
to the AMT. Second, investors became unable to deduct interest expense
incurred in funding tax-advantaged securities, a measure that was intended
to remove the benefit of borrowing funds from others to invest in municipal
securities. In this regard, special federal tax rules apply to bank holdings
of municipal securities, including the manner in which the amount of nondeductible
interest expense is calculated. Exceptions to these vari-ous limitations
apply only to tax-exempt obligations issued after August 1986 that are
issued by small entities and are not private-activity bonds.
The state and local income taxation treatment of municipal
securities varies greatly from state to state. Many states and local governments
exempt interest income only on those bonds and notes issued by government
entities located within their own boundaries.
USES
Municipal securities have traditionally been held primarily for investment
purposes by investors who would benefit from income that is advantaged
under federal income tax statutes and regulations. This group includes
institutional investors such as insurance companies, mutual funds, commercial
banks, and retail investors. The value of the tax advantage and, therefore,
the attractiveness of the security increase when the income earned is
also advantaged under state and local tax laws. Wealthy individuals and
corporations face the highest marginal tax rates and, therefore, stand
to receive the highest tax-equivalent
yields on these securities. Private individuals are the largest holders
of municipal securities, accounting for three-fourths of these securities
outstanding.
DESCRIPTION
OF MARKETPLACE
Issuing Practices
State and local government entities can market their new
bond issues by offering them publicly or placing them privately with a
small group of investors. When a public offering is selected, the issue
is usually underwritten by
investment bankers and municipal bond departments of banks. The underwriter
may acquire the securities either by negotiation with the issuer or by
award on the basis of competitive bidding. The underwriter is responsible
for the distribution of the issue and accepts the risk that investors
might fail to purchase the issues at the expected prices. For most sizable
issues, underwriters join together in a syndicate to spread the risk of
the sale and gain wider access to potential investors. Standards and practices
for the municipal securities activities of banks and other market participants
are set by the Municipal Securities
Rulemaking Board (MSRB), a congressionally chartered self-regulatory
body that is overseen by the SEC. Examination and enforcement of MSRB
standards is delegated to the NASD
for securities firms and to the appropriate federal banking agency (Federal
Reserve, OCC, or FDIC) for banking organizations.
Secondary Market
Municipal securities are not listed on or traded in exchanges;
however, there are strong and active secondary markets for municipal securities
that are supported by municipal bond dealers.
These traders buy and sell to other dealers and investors and for their
own inventories. The bond broker's
broker also serves a significant role in the market for municipal
bonds. These brokers are a small number of interdealer brokers who act
as agents for registered dealers and dealer banks. In addition to using
these brokers, many dealers advertise municipal offerings for the retail
market through Bondtrac or The Blue List. Bondtrac publishes prices and
yields and descriptions on the Internet for municipal,
corporate, agency, and
treasury securities offered by dealers. The Blue List is published
by Standard & Poor's Corporation
and lists securities and yields or prices of bonds and notes being offered
by dealers.
Market Participants
Market participants in the municipal securities industry
include underwriters, broker-dealers, brokers' brokers, the rating agencies,
bond insurers, and investors. Financial advisors, who advise state and
local governments for both competitive and negotiated offerings, and bond
counsel, who provide opinions on the legality of specific obligations,
are also important participants in the industry. The underwriting business
primarily consists of a small number of large broker-dealers, typically
with retail branch systems, and a large number of regional underwriters
and broker-dealers with ties to local governments and who specialize in
placing debt in their individual regions. Market Transparency Price transparency
in the municipal securities industry varies depending on the type of security
and the issuer. Prices for public issues are more readily available than
prices for private placements.
PRICING
Municipal securities are priced either on a yield or dollar
basis depending on the issue. Securities that are priced on a dollar basis
are quoted as a percentage of the par value. A bond that is traded and
quoted as a percentage of its par value is called a "dollar
bond." Municipal securities, however, are generally traded and quoted
in terms of yields because there are so many issues of different maturities.
A bond quoted at 6.751-6.50 percent means that a dealer is willing to
purchase the bond to yield 6.75 percent and will sell it to yield 6.50
percent.
To compare the yield of a municipal security with that
of a taxable bond, the yield of the maturity must be adjusted to account
for a number of factors that may be unique to the individual investor.
For example, a fully-taxable-equivalent (FTE) yield would consider the
relevant federal, state, and local marginal tax rates of the investor;
specific characteristics of the security; the applicability of the alternative
minimum tax (AMT); the ability to deduct interest expense associated with
funding the acquisition; and other elements of the institution's tax status.
(These factors are discussed more fully in "Characteristics and Features"
above.)
HEDGING
Generally, the special features and unique potential tax
advantages of municipal securities make it difficult to construct an ideal
hedge. The municipal bond futures contract from the Chicago Board of Trade
(and corresponding options) is frequently used to hedge positions in municipal
bonds. These contracts are cash settled to the value of the Bond Buyer
Index, an index of actively traded municipal bonds, whose composition
changes frequently. The market for these exchange contracts is not very
liquid, however, and the possibility of basis risk may be large.
Municipal securities also can be hedged using more-liquid
Treasury securities, futures, and options. Treasury securities can be
used to mitigate exposure to yield curve risk; however, the significant
basis risk present in the municipal/ Treasury securities price relationship
would remain unhedged. Some dealers use over-the-counter municipal swaps
to hedge interest-rate risk. This would reduce basis risk to the relationship
between the security being hedged and the municipal index employed in
the swap transaction. Municipal swaps are relatively new and are not widespread
in the industry. As a result, their use as hedging vehicles is limited
RISKS
Credit Risk
Municipal securities activities involve differing degrees
of credit risk depending on the financial capacity of the issuer or economic
obligor. Noteworthy cases in which municipal securities have been unable
to perform as agreed range from New York City in the 1970s and WPPSS (a
Washington state power utility) in the 1980s to more recent examples.
For revenue bonds, the ability to perform depends primarily on the success
of the project or venture funded by the bond. Trends in real estate values,
fiscal management, and the size of the tax base bear directly on the issuer's
ability to service general
obligation bonds.
An important starting point in performing a credit review
of a potential issuer is to obtain a legal opinion that the issuing entity
has the legal authority to undertake the obligation. The entity must also
have the capacity to repay as well as the willingness to perform, both
influenced not only by financial factors but by political factors. Since
some issuers depend on legislatures or voters to approve bond issues or
new funding, credit analysis can become problematic; issuers could default
on their bond obligations despite having the funds to service debt. These
political issues may reach beyond the direct jurisdiction of the issuing
entity, including decisions made by state legislatures or Congress. Therefore,
to fully evaluate market risk, market participants must monitor how political
and legislative factors may affect a security's default risk.
The lack of standardized financial statements and the large
number of different issuers (as many as 50,000 entities issue municipal
bonds) also make credit analysis of municipal securities more difficult.
This heightens the importance of the role of the rating agencies and bond
insurers in comparison to other markets. Larger issuers of municipal securities
are rated by nationally recognized rating agencies. Other issues achieve
an investment-grade rating through the use of credit enhancements such
as insurance from a municipal bond insurance company or a letter of credit
issued by a financial institution.Credit enhancements are often used to
improve the credit rating of a security, thereby lowering the interest
that the issuer must pay.
Liquidity Risk
One of the problems in the municipal market is the lack
of ready marketability for many municipal issues. Many municipal bonds
are relatively small issues, and most general obligation issues are sold
on a serial basis, which in effect breaks the issues up into smaller components.
Furthermore, a large percentage of municipal securities are purchased
by retail investors and small institutions that tend to hold securities
to maturity. Overall, smaller issues and those with thin secondary markets
often experience liquidity difficulties and are therefore subject to higher
risk.
Interest-Rate Risk and Market Risk
Like other fixed-income securities, fixed-income municipal
securities are subject to price fluctuations based on changes in interest
rates. The degree of fluctuation depends on the maturity and coupon of
the security. Variable-rate
issues are typically tied to a money market rate, so their interest-rate
risk will be significantly less. Nonetheless, since bond prices and interest
rates are inextricably linked, all municipal securities involve some degree
of interest-rate risk. Holders of municipal securities are also affected
by changes in marginal tax rates. For instance, a reduction in marginal
tax rates would lower the tax-equivalent yield on the security, causing
the security to depreciate in price. Prepayment or Reinvestment Risk Call
provisions will also affect a bank's interest-rate exposure. If the issuer
has the right to redeem the bond before maturity, the risk of an adverse
effect on the bank's exposure is greater. The security is most likely
to be called when rates have moved in the issuer's favor, leaving the
investor with funds to invest in a lower interest-rate environment.
LEGAL LIMITATIONS FOR
BANK INVESTMENT
The limitations of 12 USC 24 (section 5136 of the Revised
Statutes) apply to municipal secu-rities. Municipal securities that are
general obligations are type I securities and may be purchased by banks
in unlimited amounts. Municipal revenue securities, however, are either
type II or type III securities. The purchase of type II and III securities
is limited to 10 percent of equity capital and reserves for each obligor.
That limitation is reduced to 5 percent of equity capital and reserves
for all obligors in the aggregate when the judgment of the obligor's ability
to perform is based predominantly on reliable estimates versus adequate
evidence.
REFERENCES: Feldstein, Sylvan
G., Frank J. Fabozzi, and T. Dessa Fabozzi. "Chapter 8: Municipal Bonds."
The Handbook of Fixed Income Securities. 4th ed. Chicago: Irwin Profes-sional
Publishing, 1995.
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