Series 52 – Municipal Securities Representative Exam Key Study Note Set Two

Limitations on the issuance of GO bonds, including voter approval and statutory or constitutional debt limits, serve as crucial safeguards for taxpayers. Voter approval ensures that citizens directly consent to increased debt and the associated tax burden, promoting fiscal responsibility. Statutory or constitutional debt limits restrict the amount of debt a municipality can incur, preventing over-borrowing and potential financial distress. These limitations directly impact the creditworthiness of the municipality. Stringent limitations can enhance creditworthiness by demonstrating a commitment to fiscal discipline and reducing the risk of default. Conversely, overly restrictive limitations might hinder the municipality’s ability to fund essential infrastructure projects, potentially impacting long-term economic growth. The balance between responsible debt management and the need for capital investment is a key consideration for both issuers and investors. These limitations are often detailed in the bond indenture and are subject to legal opinions, ensuring compliance with relevant laws and regulations.

The “flow of funds” provision in a revenue bond indenture dictates the order in which revenues generated by the project are allocated. This provision is critical for bondholder security. A gross revenue pledge allocates revenues to debt service first, before operating and maintenance expenses. This structure provides a higher degree of security for bondholders, as debt repayment has the highest priority. However, it can leave the issuer with limited funds for essential operational needs. Conversely, a net revenue pledge allocates revenues to operating and maintenance expenses before debt service. While this allows the issuer greater financial flexibility, it increases the risk for bondholders, as debt repayment is subordinate to operational needs. The choice between a net or gross revenue pledge significantly impacts the perceived risk and, consequently, the yield demanded by investors. The flow of funds is a key component of the bond indenture, a legally binding agreement that outlines the rights and responsibilities of the issuer and the bondholders.

A moral obligation bond is a type of municipal security where the issuer pledges to seek legislative appropriation to cover potential shortfalls in debt service. Unlike general obligation or revenue bonds, the pledge is not legally binding. If the revenue stream supporting the bond is insufficient, the issuer is morally, but not legally, obligated to request funds from the state legislature to make up the difference. The legal enforceability of the pledge is a significant concern for investors, as the legislature is not required to approve the appropriation. This lack of legal recourse increases the risk associated with moral obligation bonds. Consequently, the issuer’s credit rating may be negatively impacted, and future borrowing costs could increase. Investors demand a higher yield to compensate for the added risk. The use of moral obligation bonds is often viewed skeptically by rating agencies and the investment community, potentially signaling financial stress or a reluctance to commit to a legally binding obligation.

Tax swaps, also known as bond swaps, involve selling one municipal bond and simultaneously purchasing a similar bond to realize a capital loss, which can be used to offset capital gains or up to $3,000 of ordinary income, thereby reducing the investor’s tax liability. The potential benefit lies in the tax savings, while maintaining a similar investment profile. However, there are risks. The replacement bond must be sufficiently different from the original to avoid the “wash sale” rule under IRS regulations. A wash sale occurs when an investor sells a security at a loss and repurchases the same or substantially identical security within 30 days before or after the sale. If deemed a wash sale, the loss is disallowed for tax purposes. Investors must also consider transaction costs and the potential for the replacement bond to underperform the original. Careful consideration of maturity, credit quality, coupon rate, and call features is essential to ensure the replacement bond meets the investor’s objectives.

A bond attorney plays a crucial role in a municipal bond issuance, ensuring the legality and validity of the bonds. Their primary responsibilities include determining the issuer’s legal authority to issue the bonds, verifying compliance with all applicable laws and regulations, and rendering a legal opinion. The legal opinion is a critical document that expresses the attorney’s professional judgment on the validity and tax-exempt status of the bonds. An unqualified legal opinion, stating that the bonds are legally sound and tax-exempt, significantly enhances the marketability and creditworthiness of the bonds. Conversely, a qualified legal opinion, which expresses reservations or limitations, can negatively impact investor confidence and increase borrowing costs. The bond attorney’s due diligence and expertise are essential for protecting the interests of both the issuer and the investors, ensuring a smooth and legally compliant bond issuance process.

In a competitive sale of municipal bonds, underwriters submit bids based on the interest rates they are willing to offer. Issuers use different methods to evaluate these bids, with Net Interest Cost (NIC) and True Interest Cost (TIC) being the most common. NIC is calculated by simply totaling all interest payments over the life of the bond and subtracting any premium or adding any discount. TIC, also known as the Canadian method, considers the time value of money by discounting future interest payments back to the present. TIC is generally considered a more accurate measure of the cost of borrowing because it accounts for the timing of cash flows. Issuers might prefer NIC for its simplicity, especially when comparing bids with similar structures. However, when bids have significantly different maturities or call features, TIC provides a more comprehensive comparison. The choice between NIC and TIC can impact which underwriter wins the bid, influencing the overall cost of borrowing for the municipality.

Net overall debt to assessed valuation is a municipal debt ratio that compares the total debt of a municipality (including direct and overlapping debt) to the assessed value of the property within its jurisdiction. This ratio provides a measure of the municipality’s debt burden relative to its tax base. However, assessed valuation may not accurately reflect the true market value of the property, especially if assessments are outdated or inconsistent. Net overall debt to estimated real valuation, on the other hand, uses the estimated real market value of the property instead of the assessed value. This ratio is generally considered a more accurate reflection of an issuer’s debt burden because it is based on a more realistic valuation of the property. The estimated real valuation is typically derived by applying a conversion factor to the assessed valuation to approximate the market value. A lower ratio of net overall debt to estimated real valuation suggests a more manageable debt burden for the municipality. Both ratios are important indicators of a municipality’s financial health and are used by investors and analysts to assess the creditworthiness of general obligation bonds.

A rate covenant in a revenue bond indenture is a pledge by the issuer to maintain rates or charges for the services provided by the financed project at a level sufficient to meet certain financial obligations. These obligations typically include operating and maintenance expenses, debt service payments (principal and interest), and reserve requirements. The rate covenant is a crucial protection for bondholders, ensuring that the project generates enough revenue to repay the debt. Failure to maintain adequate rates can have severe ramifications. If the issuer fails to comply with the rate covenant, it may trigger events of default under the indenture. This could lead to acceleration of the debt, allowing bondholders to demand immediate repayment of principal and accrued interest. Bondholders may also have the right to pursue legal remedies, such as seeking a court order to compel the issuer to raise rates or appointing a receiver to manage the project. MSRB Rule G-17 emphasizes that municipal securities professionals must deal fairly with all persons and not engage in deceptive, dishonest, or unfair practices. Misleading investors about the strength of a rate covenant would violate this rule.

A crossover refunding is a type of advance refunding where the debt service on the refunding bonds is initially paid from the proceeds of the refunding issue itself, typically held in escrow. The escrowed funds are structured to cover interest payments on the new bonds until a specified “crossover date.” On this date, the refunded bonds are called, and the source of debt service payments switches (crosses over) to the revenues originally pledged to the refunded bonds. In contrast, a current refunding involves calling the old bonds immediately with the proceeds of the new bonds. An advance refunding (excluding crossover) involves placing the proceeds of the new bonds in escrow to pay the debt service on the old bonds until their call date, which is more than 90 days in the future. Crossover refunding is attractive when interest rates are expected to decline in the future. The issuer can issue refunding bonds at current rates and use the proceeds to pay interest until the crossover date. If rates decline as expected, the issuer can then call the old bonds and benefit from the lower interest rates on the refunding bonds. This strategy allows issuers to take advantage of anticipated future market conditions.

A tax swap is a strategy where an investor sells a bond with a capital loss and simultaneously purchases a similar bond to maintain their market position. The primary benefit is to realize a capital loss that can be used to offset capital gains or up to $3,000 of ordinary income, thereby reducing the investor’s tax liability. Risks include transaction costs, potential for lower yields on the replacement bond, and the possibility that the replacement bond may not perform as well as the original bond. The “wash sale” rule, as defined by the IRS, disallows a capital loss deduction if the investor purchases a “substantially identical” security within 30 days before or after the sale date. In the context of municipal bonds, “substantially identical” is interpreted strictly, considering factors like issuer, coupon rate, maturity date, and call features. To avoid triggering the wash sale rule, investors can purchase bonds from a different issuer, with a significantly different coupon rate or maturity date, or with different call features. Alternatively, they can wait more than 30 days before repurchasing a substantially identical bond. Careful planning is essential to ensure the tax swap achieves its intended tax benefits without violating the wash sale rule.

A significant decline in a municipality’s tax base due to a major employer relocating can severely impact the creditworthiness of its outstanding general obligation (GO) bonds. The loss of a major employer typically leads to reduced property tax revenues, which are the primary source of repayment for GO bonds. This can strain the municipality’s ability to meet its debt service obligations. Several municipal debt ratios would be negatively affected. The “net overall debt to assessed valuation” ratio would increase, indicating a higher debt burden relative to the reduced tax base. Similarly, the “net overall debt to estimated real valuation” ratio would also likely increase. The “per capita net debt” might rise if the population decreases due to job losses. Furthermore, the “debt service to annual revenues” ratio would increase, reflecting a larger proportion of the municipality’s revenues being allocated to debt repayment. Credit rating agencies would likely downgrade the municipality’s GO bonds, making it more expensive for the municipality to borrow in the future.

The “flow of funds” in a revenue bond indenture outlines the order in which revenues generated by the financed project are allocated to various funds. This structure is crucial for determining the security and priority of bondholders’ claims. Under a “gross revenue pledge,” all revenues generated by the project are first used to pay debt service (principal and interest) before any other expenses, including operation and maintenance (O&M). This provides the highest level of security for bondholders, as debt service is paid before any other claims. However, it limits the issuer’s operational flexibility, as they must ensure sufficient revenues are available for debt service before allocating funds to other essential services. Under a “net revenue pledge,” revenues are first used to pay O&M expenses, and only the remaining “net revenues” are used to pay debt service. This provides less security for bondholders compared to a gross revenue pledge, as debt service is subordinate to O&M expenses. However, it gives the issuer greater operational flexibility, as they can prioritize essential services and infrastructure maintenance before allocating funds to debt repayment. The choice between a net revenue pledge and a gross revenue pledge depends on the specific circumstances of the project and the issuer’s financial priorities.

A financial advisor (FA) in a municipal bond issuance acts as an advisor to the issuer, providing guidance on structuring the bond issue, assessing market conditions, and negotiating terms with the underwriter. The FA’s primary duty is to represent the issuer’s best interests. In contrast, the bond underwriter purchases the bonds from the issuer and resells them to investors. The underwriter’s role involves assessing the market demand for the bonds and pricing them accordingly. The underwriter’s primary duty is to sell the bonds at a profit. MSRB Rule G-23 regulates the activities of financial advisors to prevent conflicts of interest and ensure they act in the best interests of the issuer. The rule requires FAs to disclose any potential conflicts of interest to the issuer and obtain the issuer’s informed consent before providing advice. It also prohibits FAs from acting as both an FA and an underwriter on the same bond issue, unless certain conditions are met. This separation of roles helps to ensure that the issuer receives unbiased advice and that the bond issue is structured in a way that benefits the issuer, not just the underwriter.

MSRB Rule G-37, often referred to as the “pay-to-play” rule, significantly restricts municipal securities firms from engaging in negotiated underwriting business with issuers if certain political contributions have been made to officials of that issuer. The rule aims to prevent firms from securing municipal securities business based on political influence rather than merit. Specifically, Rule G-37 prohibits a municipal securities firm from engaging in negotiated municipal securities business with an issuer within two years after a contribution to an official of such issuer has been made by the firm, its municipal finance professionals (MFPs), or any political action committee (PAC) controlled by the firm or its MFPs. The rule defines an “official of such issuer” broadly, including any person who is directly or indirectly responsible for, or can influence the outcome of, the selection of municipal securities professionals. The implications are far-reaching. Firms must meticulously track political contributions made by themselves and their associated persons. Even small contributions can trigger the two-year ban. The rule includes exceptions for certain de minimis contributions (up to \$250 per election to officials for whom the MFP is entitled to vote). The intent is to ensure that municipal securities business is awarded based on qualifications and competitive pricing, rather than political favoritism. This promotes fairness, transparency, and protects the interests of both the issuer and the investing public. Violations of Rule G-37 can result in significant penalties, including fines, censure, and suspension from the municipal securities business. The rule is enforced by FINRA and the SEC.