Securities issued by states and local governments, such as cities and counties. Municipal securities’ investors are households (retail investors), commercial banks, property and casualty insurance companies. Municipal securities are considered attractive investments to such investors because of their tax treatment. In general, states apply tax exemption of interest from all municipal securities or alternatively exemptions may apply only for municipal securities where the issuer is in the state. Municipal securities may be used to cover temporary imbalances between outlays for expenditures and tax inflows, but the main scope is the financing of long-term projects, such as the provision of urban infrastructures. For example, a state can finance the construction of roads, schools, airports, bridges, tunnels, and sewer systems by issuing by issuing municipal securities. Municipal securities exist in two basic forms: tax- backed debt and revenue bonds.
1.Municipal securities' structures
Municipal securities exist in two basic forms: tax-backed debt and revenue bonds. The first category of municipal securities has the typical feature of being secured by some form of tax revenue and encompasses three different instruments: General Obligation Debt (GO), Appropriation-Backed Obligations and Debt Obligations Supported by Public Credit Enhancement Programs.
General Obligation Debt (GO) are securities backed not only by the revenue of the project to be financed but also by the issuer's unlimited taxing power. In particular, General Obligation Debt (GO) is unlimited when the issuers dispose of unlimited forms of tax revenues (taxes on income, sales, property, etc.) to secure the debt. This specific feature is commonly referred to as full faith and credit of the issuer. Alternatively, there can be a statutory limit on the tax rates that the issuer can levy to repay the debt. When the issuer secures the debt associated to the general tax revenues and funds raised by imposing fees and special charges and grants, he/she issues bonds called double-barrelled in security. Another type of tax-backed debt is the Appropriation-Backed Obligations that are backed by a non-binding appropriation of tax revenues by the state. The actual appropriation of funds needs to obtain the approval by the state legislature. The purpose of such non-binding obligation is to enhance the creditworthiness of the issuing entity. For their specific feature, these securities are also called moral obligations. The last instruments, Debt Obligations Supported by Public Credit Enhancement Programs, are backed by forms of public credit enhancements, which are legally enforceable as an obligation of the state to withhold and use state aid to pay a municipality’s debt, in the event of a default. The typical form of public credit enhancements legally enforceable is related to the education system. The second form of municipal securities is represented by revenue bonds. Revenue bonds are issued for enterprise financings and are secured by the revenues generated by the operating projects. There are several types of revenue bonds according to the different projects finances. Among others, this securities' structure comprises health care revenue bonds, utility revenue bonds, airport revenue bonds, housing revenue bonds, higher education revenue bonds, gas tax revenue bonds, seaport revenue bonds, multifamily revenue bonds, public power revenue bonds, water revenue bonds, and student loan revenue bonds. In general terms, the project must entirely cover the payment of the debt as to prevent the issuer from making additional payments. In order to ensure that the project will be self-supporting, a pre-emptive feasibility study is performed and the same analysis on the adequacy of the expected cash flow is carried out to determine its rating and satisfy the obligation toward bondholders. There are also hybrid and special bond structures presenting some of the features characterising both tax-backed debt and revenue bonds. For instance, insured bonds also present insurance policies and the commercial insurance company assumes the obligation to pay the bondholder on a determined date in case of default. Pre-refunded bonds, also called refunded bonds, are securities escrowed or collateralized by U.S. government obligations. Practically, this type of municipal securities has the highest possible rating because if the obligation is supported by cash flows from the portfolio of securities guaranteed by the U.S. government held in an escrow fund, the risk is at a very low level. Asset-backed bonds, also called dedicated revenue bonds and structured bonds, use only "dedicated" tax revenues to repay the bondholders, such as sales taxes, tobacco settlements payments, fees, and penalty payments. Municipal notes are short-term securities used principally by states, local governments and special jurisdictions to cover temporary imbalances between outlays for expenditures and tax inflows. Municipal notes are issued for a period of at least three months but not exceeding three years. The most important municipal notes are tax anticipation notes (TANs), revenue anticipation notes (RANs), grant anticipation notes (GANs) and bond anticipation notes (BANs). In recent years, we have assisted to a proliferation of new financial techniques to secure bond issues as opposed to the traditional tax-backed debt and revenue bonds. However, due to their recent introduction, some doubts may arise on the general obligation and rights of the parties for these innovative instruments as there is no case law in the jurisdiction that firmly confirm their legal outcome in case of litigation. Another problem is the determination of the effective credit risk of municipal securities. Although municipal securities are considered one of the safest investment offered on the market, the possibility of an issuer going bankrupt cannot be excluded, as it happened on 25 February 1975, when the New York’s Urban Development Corporation defaulted on an obligation of New York City. More recently, bondholders, especially after the bankruptcy of the Orange County (California) in 1994 on the collapse of the Orange County Investment Pool, are more concerned about the management of the funds. As a result, bondholders are particularly interested in obtaining information concerning not only the issuer’s debt structure and the overall debt burden, but also to have an informed judgment on the issuer’s ability to maintain a sound budgetary policy. Basically, investors have two ways to determine the safeness of the investment: they can rely on nationally recognized rating companies, or on their own in-house municipal credit analysts. In the evaluation of general obligation bonds, other information can regard the revenue sources of local governments and its overall socioeconomic environment (employment rates, population growth rates, real estate property valuation, personal income, etc.). Finally, investors in tax exempt municipal securities are exposed to "tax risk", as an increase in the marginal tax rate produces a decrease in the price of this kind of security, or another risk is that a tax- exempt issue may be eventually declared taxable by an interpretation of the Internal Revenue Service (IRS).
2. Yields on Municipal Bonds
The taxable municipal bonds are an alternative for investors to corporate bonds because they offer a higher yield on tax-exempt municipal bonds. Historically, the reason why many municipalities have issued taxable bonds was the opportunity to finance a large range of public projects before 1986, when the Tax Reform Act Restriction imposed some restrictions on the type of projects that could be financed by means of such instruments. In particular, the most common types of activities financed with taxable municipal bonds are local sport facilities, investor-led housing projects, and under-funded pension plan obligations of the municipality. Another reason behind taxable bonds outstanding can also be the need of the local government or state to have access to foreign capital, thus becoming issuers active outside the United States. The yield on tax-exempt municipal bonds is usually lower than the yield paid on Treasuries characterised by the same maturity. The yield ratio, which is inversely related to the tax rate, gives a measure of the percentage of the yield on a municipal security relative to a comparable Treasury security. In general, in the municipal bond market, a positively sloped yield curve is observed.
3. Debt Retirement Structures
Debt obligations associated to municipal bonds can be retired in portions each year, following a serial maturity structure, or at the end of the bond’s planned life, according to a term maturity structure. Typically, the maturity is in the interval of 20 to 40 years. Clauses that allow for the early redemption of term bonds, such as sinking fund provisions and call privileges are often used.
Fabozzi Frank J. (2002), The Handbook of Financial Instrument, John Wiley and Sons Inc.
Fabozzi Frank J., Modigliani F., Jones F. (2010), Foundation of Financial Markets and Institutions, Pearson International Edition.
Editor: Bianca GIANNINI
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