FINRA Series 52 Municipal Securities Representative Exam Key Study Note

LTGO bonds and UTGO bonds both represent obligations backed by the taxing power of the issuing municipality, but they differ significantly in the extent of that backing. An LTGO bond is secured by a specific tax, and the issuer’s ability to levy that tax is limited by statute. A UTGO bond, on the other hand, is secured by the full taxing power of the issuer, without statutory limitations on the tax rate or amount. This distinction directly affects investor risk. UTGO bonds are generally considered safer because the issuer has greater flexibility to raise taxes to meet debt service obligations. LTGO bonds carry higher risk because their repayment is tied to a specific, potentially volatile, revenue source. Consequently, LTGO bonds typically offer higher yields to compensate investors for the increased risk. The legal basis for these distinctions lies in state constitutional and statutory provisions that define the taxing powers of municipalities.

A “net revenue pledge” and a “gross revenue pledge” dictate the order in which revenues generated by a project financed by revenue bonds are allocated. Under a gross revenue pledge, debt service is paid first, before operation and maintenance expenses. This structure offers greater security to bondholders because the issuer is legally obligated to prioritize debt repayment. Conversely, a net revenue pledge allows the issuer to pay operation and maintenance expenses before debt service. This provides the issuer with greater financial flexibility, particularly during periods of economic stress or unexpected expenses. However, it also increases the risk for bondholders, as the funds available for debt service may be reduced. The specific flow of funds is detailed in the bond indenture, including covenants related to revenue allocation, reserve requirements, and restrictions on the issuance of additional debt. Sections detailing the “flow of funds” and “rate covenant” are particularly relevant.

A feasibility study is a critical component in the issuance of revenue bonds, especially for projects lacking a proven track record. It provides an independent assessment of the project’s economic viability and its ability to generate sufficient revenue to cover debt service. A comprehensive feasibility study should include a detailed market analysis, engineering reports, financial projections, and an evaluation of potential risks and uncertainties. The market analysis assesses the demand for the project’s services or products, while the engineering reports evaluate the technical feasibility and cost-effectiveness of the project. Financial projections estimate future revenues, expenses, and debt service coverage ratios. The credit rating agencies heavily rely on the feasibility study to assess the creditworthiness of the revenue bonds. A well-prepared and positive feasibility study can significantly improve the bond’s credit rating, making it more attractive to investors and potentially lowering borrowing costs for the issuer.

Advance refunding, also known as pre-refunding, involves issuing new municipal bonds to refund an existing bond issue before its first call date. The proceeds from the new issue are placed in an escrow account, typically invested in U.S. government securities, which are then used to pay the debt service on the original bonds until their call date. This strategy is often employed when interest rates have declined, allowing the issuer to lower its borrowing costs. For the original bondholders, advance refunding effectively guarantees the repayment of their principal and interest, as the escrow account provides a secure source of funds. However, they may lose the potential for higher yields if interest rates subsequently rise. For the issuer, advance refunding can improve its long-term debt management by reducing its overall debt service burden and freeing up resources for other projects. However, it also involves additional transaction costs and may require voter approval in some jurisdictions.

A tax swap involves selling a municipal bond at a loss to generate a capital loss that can be used to offset capital gains, thereby reducing an investor’s tax liability. The investor then immediately repurchases a similar bond to maintain their investment position. The primary benefit of a tax swap is the potential for tax savings. However, there are also risks to consider. The wash sale rule, as defined by the IRS, prohibits an investor from claiming a loss if they repurchase substantially the same security within 30 days before or after the sale. To avoid violating the wash sale rule, investors must ensure that the repurchased bond is sufficiently different from the sold bond in terms of issuer, maturity, coupon, or other characteristics. Before engaging in a tax swap, an investor should carefully consider their individual tax situation, the potential tax savings, and the risks associated with the strategy.

The marketability and liquidity of municipal securities are influenced by several factors. Credit ratings assigned by rating agencies like Moody’s, S&P, and Fitch play a significant role, with higher-rated bonds generally being more marketable and liquid. Maturity also affects liquidity, with shorter-term bonds typically being more liquid than longer-term bonds. Call features can reduce liquidity, as investors may be hesitant to purchase bonds that could be called away before maturity. Issue size is another important factor, with larger issues generally being more liquid than smaller issues. Other factors include the coupon rate, the issuer’s name recognition, and the presence of credit or liquidity support. MSRB Rule G-15 governs fair pricing and disclosure requirements, aiming to enhance market transparency and protect investors.

In a competitive sale, the issuer solicits bids from multiple underwriting firms and awards the bonds to the firm that submits the lowest net interest cost (NIC) or true interest cost (TIC). This method is generally considered to be more transparent and can result in lower borrowing costs for the issuer. However, it offers less flexibility in structuring the bond issue. In a negotiated sale, the issuer selects a single underwriting firm to structure and market the bonds. This method allows for greater flexibility and customization but may result in higher borrowing costs. From the issuer’s perspective, a competitive sale offers potential cost savings, while a negotiated sale provides greater control over the process. From the underwriter’s perspective, a competitive sale offers a chance to win the deal based on price, while a negotiated sale provides an opportunity to build a long-term relationship with the issuer. MSRB Rule G-11 governs primary offering practices, including disclosure requirements for both competitive and negotiated sales.

Net Interest Cost (NIC) and True Interest Cost (TIC) are both methods used to evaluate bids in a competitive municipal bond sale, but they differ in their treatment of the time value of money. NIC is a simpler calculation that sums the total coupon interest payments over the life of the bond and subtracts any premium (or adds any discount) to arrive at a total interest cost. TIC, also known as the Canadian method, considers the time value of money by discounting future interest payments back to the present. This makes TIC a more accurate reflection of the actual cost of borrowing. An issuer might prefer NIC over TIC if they are primarily concerned with the simplicity of the calculation or if the difference between the two is minimal. Additionally, certain state laws or regulations might mandate the use of NIC. However, because TIC accounts for the time value of money, it is generally considered a more sophisticated and accurate measure of the cost of borrowing. Using TIC allows the issuer to compare bids on a more level playing field, especially when bids have different coupon structures or maturities. The MSRB does not explicitly endorse one method over the other, but emphasizes transparency in the bidding process, as outlined in Rule G-13 on quotations.

MSRB Rule G-37 addresses political contributions made by municipal securities dealers to officials of issuers. The rule aims to prevent “pay-to-play” practices, where contributions are made to influence the awarding of municipal securities business. Specifically, G-37 prohibits a firm from engaging in municipal securities business with an issuer for two years after a contribution is made to an official of that issuer by the firm, its municipal finance professionals (MFPs), or its political action committees (PACs). This prohibition applies to negotiated underwritings, where the issuer selects the underwriter, but not to competitive underwritings. The “de minimis” exception allows MFPs to make contributions of up to $250 per election to officials for whom they are entitled to vote, without triggering the two-year ban. This exception recognizes that small contributions are unlikely to be coercive and allows MFPs to participate in the political process. However, any contribution exceeding this amount triggers the prohibition. The MSRB enforces G-37 to maintain the integrity of the municipal securities market and ensure that underwriting decisions are based on merit, not political influence.

The “flow of funds” provision in a revenue bond indenture dictates how the revenues generated by the financed project are allocated. This provision is crucial for determining the security and credit quality of the bond. A “gross revenue pledge” directs that all gross revenues from the project are used to pay debt service before any other expenses. This means that bondholders have the first claim on revenues, enhancing the bond’s security. However, it can leave the issuer with limited funds for operation and maintenance. Conversely, a “net revenue pledge” allows the issuer to pay operation and maintenance expenses before debt service. While this provides more financial flexibility for the issuer, it reduces the security for bondholders, as debt service is paid from net revenues (revenues after expenses). Consequently, bonds secured by a gross revenue pledge are generally considered to have higher credit quality than those secured by a net revenue pledge, assuming all other factors are equal. The specific flow of funds is detailed in the bond indenture, which is a legally binding agreement between the issuer and the bondholders, and is a critical factor in assessing the creditworthiness of revenue bonds, as discussed in resources available through EMMA.

A legal opinion is a crucial component of a municipal bond offering, typically provided by a bond attorney. It assesses the legality and tax-exempt status of the bond issuance. An “unqualified opinion” (also known as an “approving opinion”) states that the bond issue is legal, valid, and binding on the issuer, and that the interest is exempt from federal income tax (and potentially state and local taxes, depending on the issue). This provides investors with assurance regarding the bond’s legal standing and tax benefits. A “qualified opinion,” on the other hand, expresses reservations or limitations regarding the legality or tax-exempt status of the bonds. This could be due to uncertainties about the issuer’s authority, potential legal challenges, or concerns about compliance with tax regulations. A qualified legal opinion raises red flags for investors, as it indicates potential risks and uncertainties that could negatively impact the bond’s value or tax benefits. Investors should carefully scrutinize the reasons for the qualification and assess the potential impact on their investment before purchasing bonds with a qualified legal opinion.

A debt service reserve fund (DSRF) is a fund established within a revenue bond indenture to provide a cushion for bondholders in case the issuer experiences temporary revenue shortfalls. The DSRF is designed to ensure that the issuer can continue to make timely debt service payments, even if project revenues are temporarily insufficient. The size of the DSRF is typically set at an amount equal to the maximum annual debt service (MADS) on the bonds, although other formulas may be used. The funding mechanism for the DSRF can vary. It may be funded upfront with proceeds from the bond issue, through a surety bond or letter of credit, or through a gradual accumulation of revenues over time. A well-funded DSRF enhances the creditworthiness of the bonds, as it provides an additional layer of security for bondholders. Rating agencies view a strong DSRF favorably, which can lead to a higher credit rating and improved marketability of the bonds. Conversely, an inadequately funded or poorly structured DSRF can negatively impact the credit rating and make the bonds less attractive to investors.

Tax anticipation notes (TANs), revenue anticipation notes (RANs), and bond anticipation notes (BANs) are all short-term municipal obligations issued to address temporary cash flow needs, but they differ in their source of repayment. TANs are issued in anticipation of future tax receipts. A municipality might issue TANs to cover expenses during periods when tax revenues are low, such as before property tax payments are due. RANs are issued in anticipation of future revenues other than taxes, such as federal or state aid, or user fees. A municipality might issue RANs to bridge the gap between when expenses are incurred and when the anticipated revenues are received. BANs are issued in anticipation of the sale of long-term bonds. A municipality might issue BANs to finance a project temporarily until long-term financing can be secured. BANs are typically repaid with the proceeds from the sale of the bonds. All three types of notes are generally considered lower risk than long-term bonds due to their short maturities, but their creditworthiness depends on the issuer’s ability to collect the anticipated revenues or issue the long-term bonds.

Original Issue Discount (OID) municipal bonds are bonds sold at a price significantly below their face value. “Accretion of discount” refers to the process by which the discount is treated as tax-exempt interest income over the life of the bond. Each year, a portion of the discount is added to the bond’s cost basis and is considered tax-exempt interest. This increases the investor’s basis in the bond, reducing the potential capital gain (or increasing the potential capital loss) upon sale or maturity. The de minimis rule provides an exception to this treatment for small discounts. If the discount is less than a certain threshold (defined as 0.25% of the face value multiplied by the number of years to maturity), the discount is treated as a capital gain upon sale or maturity, rather than as tax-exempt interest income over the life of the bond. This simplifies the tax reporting for investors holding bonds with small original issue discounts. The specific tax treatment depends on whether the discount exceeds the de minimis threshold.