How Do You Conquer Municipal Bond Questions on the Series 7 Exam?
Municipal bond topics comprise approximately 50 to 55 questions on the Series 7 exam, also known as the General Securities Representative Exam (GSRE), which is the test all stockbrokers must pass, to trade securities.
Municipal bonds fall under the following two broad categories:
- General obligation (GO) bonds, which are backed by the credit and taxing power of the jurisdiction that issues them.
- Revenue bonds, which finance income-producing projects and are secured by a specified revenue source.
Testers who can clearly differentiate between these bonds stand a greater chance of correctly answering muni bonds questions. This article sheds light on both bond types.
- General obligation (GO) bonds are backed by the credit and taxing power of the jurisdiction that issues them.
- Revenue bonds finance income-producing projects and are secured by a specified revenue source.
- Trust indentures, which are legally binding contracts between bond issuers and trustees that represents bondholder interests, are present with revenue bonds, but not with GO bonds
General Characteristics – Revenue vs. General Obligation Bonds
When working on practice questions, a comparison chart can greatly help distinguish GO bonds from revenue bonds. (To learn more, see The Basics Of Municipal 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.||
– Industrial development revenue bonds (IDRBs): These are backed by corporate lease payments, or corporate credit.
– 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.
– Moral obligation bonds: backed by state legislature’s assurance that, in case of a shortfall in revenues, the necessary funds will then be appropriated.
– 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.
Municipal debt instruments that are not classified as bonds, due to their short maturities are called “municipal notes.” These short-term cash-flow instruments come in the following variations:
Moody’s Investment Grade (MIG) rating system rates bond notes. And although actual ratings have never surfaced on the Series 7 exam, MIG itself has reportedly been referenced on certain questions.
Trust Indentures and Revenue Bonds
Trust indentures, which are legally binding contracts between bond issuers and trustees that represents bondholder interests, are present with revenue bonds, but not with GO bonds. Trust indentures are essentially a set of terms that both parties must adhere to, that may also indicate where the bond’s income source derives from.
Because municipal bonds are exempt from federal regulations, trust indentures go a long way in protecting bondholders, and are hence sometimes referred to 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:
– Gross revenue pledge: Debt service is paid first from the gross revenues, operations and maintenance expenses are paid second.
– 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.|
GO and revenue bonds demand unique analytical approaches, due to their different funding sources. Recall that GO bonds are backed by the taxing power of the issuer. Pointedly: the money essentially comes from property taxes called “ad valorem” taxes, where the amount is based on the value of a transaction or of property.
Series 7 candidates most likely will not ever be required to compute property taxes, however they may be required to know the following basic property tax computation formula:
Estimated Market (Sale) Value x Aassessment Rate (%) = Assessed Value x Millage Rate (1 mill = $.001 or 1/10th of a cent) = Taxes Due
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—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 that is 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)
- Is it reasonable to expect that a proposed facility can pay for itself?
- This study, which explores costs and potential revenues from a proposed facility, typically contains a competitive facilities section, which assesses the impact of competing businesses that sell similar goods or services, on a project’s potential long-term revenues.
- How many times do the current/expected revenues cover the bond’s debt service requirements?
The Underwriting Process for GO and Revenue Bonds
The processes of bringing new bonds to market widely differ, between GO bonds and revenue bonds. For revenue bonds, the principal underwriter is chosen by the issuer of the bonds, while GO bond underwriting contracts are awarded by a competitive sealed bid sale.
Prior to issuing any municipal bond, issuers commission attorneys known as “bond counsels” to render legal opinions. Tax lawyers are frequently tapped for the gig, because tax implications are such a looming concern to most bond investors.
The legal opinion will include the following:
- The authority to borrow, demonstrating the legality 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.
- Tax exemption, which states that the interest from municipal bonds is normally exempt from federal taxation. The legal opinion cites the appropriate laws that support this position.
A copy of the legal opinion, which must accompany delivery of all municipal bonds, come in one of the following 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 expresses concerns about some or many aspects of the bond.
Another chief distinguishing factor between the two bond types, is that GO bonds are subject to voter approval, which is not the case with revenue bonds.
The following chart refers to GO bonds, which are of greater import to the Series 7
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.
– Interest payment dates, including the dated date from which the bonds begin accruing interest.
– 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.
– A maturity schedule—in the case of GO bonds, maturities are normally serial, while maturity for a revenue bond is usually term.
|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).
– Many issuers also require that the bidders also provide the true interest cost (TIC). This calculation takes the time value of money into account.
– 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, which is specified in the underwriting agreement and is provided to all syndicate members. These often popular municipal issues may be oversubscribed, meaning there are more orders for bonds than there are bonds themselves.
The order period in which the syndicate solicits and accepts orders for bonds is established
by the syndicate manager, and orders are filled 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: The last to be filled in the priority sequence, these orders are placed by members of the syndicate looking to buy bonds for their own proprietary inventory.
The Series 7 exam frequently asks about this priority sequence, therefore it’s worth learning the mnemonic: Pro Golfers Don’t Miss (PGDM), which help testers remember: 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, known as the “underwriting spread.” The typical allocation of the spread is shown in the following example of a 1-point ($10) spread:
The total takedown earned by syndicate members for their own sales is the selling concession plus the additional takedown. In this example, the total takedown is $9 per bond.
When the bonds are delivered to buyers and a settlement is made, the buyer receives 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.
Note: 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 differs 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 following:
- Settlement date, because that has yet to be determined
- Accrued interest, because the exact settlement has not been determined
- Total dollar amount, because the accrued interest must be added to the purchase price to produce the total dollar amount
The Bottom Line
Municipal bond questions comprise some 20% of the 260 questions on the Series 7 exam. Mastering these questions is key to achieving a passing score and achieving Series 7 glory!
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