Municipal bonds issues are regulated by constitutional provisions, general statutes, special acts, and local charters.
Compliance with legal requirements is essential; minor errors may result in delays, expensive litigation, and possible invalidation of the issue or sale.
Preliminaries to Marketing
A popular referendum is required in most states to authorize general obligation bonds.
Bond ordinances or resolutions should identify the nature and limits of the security offered.
Notice of Sale
The following information should be published in The Daily Bond Buyer at least two weeks in advance of the date set for opening bids:
(1) The legal name of the issuing body, the special law (if any) under which it was organized, and the authority for the sale.
(2) Type of bonds to be issued.
(3) Amount and purpose of the issue, the maturity schedule, denomination, call features (if any), and registration privileges.
(4) Date, time, and place of sale; manner of bidding (sealed or oral); and basis for bidding (e.g., at par, discounts allowed, etc.).
(5) Interest rate limitations, interest payment dates, and where principal will be paid.
(6) Amount of good faith check.
(7) Name of approving attorney.
(8) Source of funds for the payment of principal and interest, e.g., from ad valorem taxes, special assessments, revenues of particular enterprise.
(9) Total tax rate in the governmental unit, rate for each levying body, and constitutional or statutory limits restricting debts or the taxes levied for their payments.
Bidders should be allowed to bid different rates on various maturities or groups of bonds--known as split-rate bids--in order to obtain the most favorable overall net interest cost.
If municipal bonds must be sold at par, supplemental coupons--covering the same interest period as one or more regular coupons--may used to attract dealers.
Timing of an Issue
The bond market experiences minor fluctuations every few months due to an excess of supply over demand, as well as economic and political trends.
The date of the sale should not be set in the midst of a rush of new offerings or immediately following large sales by other municipalities.
An issue should be scheduled so that interest and principal payments come due at times when funds are available to pay them.
The four-page bond prospectus form, approved by the Investment Bankers Association and the Municipal Finance Officers Association, provides the information that most investors seek
Miscellaneous Requirements
Principal and interest should be payable in a large financial center where there is a Federal Reserve Bank.
The bond owner should have the privilege of registering bonds as to both principal and interest or principal only.
Bonds should be printed by a firm that specializes in such work to protect against counterfeiting.
Costs Involved in Marketing Municipal Bonds
The cost of borrowing also involves:
(1) expense of conducting a referendum, fees for various legal and financial advisors, and
(2) miscellaneous costs, including: preparation and publication of bond notices and the bond prospectus; printing the bonds; obtaining a bond rating; renting signature machines; filing fees; court fees; registration or recording fees; certification costs; and costs of delivering the bonds.
No single cost is large, but in the aggregate, these costs can amount to a considerable sum.
Ratings for Municipal Bonds
Bond ratings appraise two basic risk factors:
(1) the risk that bond quality will be diluted by an inordinate increase in debt, and
(2) the risk that the issuer's ability to meet principal and interest payments may be impaired under depressed economic conditions.
Rating analysts evaluate a wide range of information concerning economic, debt, financial, and governmental considerations.
The rating service fees vary according to the size of the prospective bond issue.
Moody's Investors Service, Inc., Standard and Poor's Corporation, Fitch Investor's Service and Duff & Phelps rate a wide variety of bonds.
o The rating services use symbols, arranged in order from bonds with the least credit risk to those with the greatest risk (see Table 2).
o The bond rating process followed by Standard and Poor's Corporation is shown in Table 3 (Moody's and Fitch use similar processes).
o The type of information required by the rating service is shown in Table 4.
Economic factors include the area's economic prospects, locational advantages, population, wealth, labor factors, and diversity of employers.
Debt factors assess the likelihood of meeting commitments to the bondholders, including the jurisdiction's debt policy, debt structure, debt burden, debt history, and prospective borrowing.
Governmental considerations include continuity in management and good fiscal control.
Fiscal trends are determined through reviews of financial reports and budgets.
The Bond Sale and Delivery
Bonds should be awarded to the bidder on the basis of the lowest net interest cost. or total interest cost.
o All papers required to complete the bond transcript should be forwarded to the bond attorneys as soon as possible.
o Information required to establish the bond register (sometimes called the bond and interest record) should be recorded before the bonds are delivered.
o The interest due on each date of maturity recorded at the time a bond issue is sold, as should the payments of principal or payments into a sinking fund.
Bonds should be delivered at the earliest practical date after the sale (no later than thirty days).
o The winning bidder usually has the option to cancel the obligation if delivery is not made on or before the date specified in the contract.
o Large bond issues usually are signed at the place of delivery because the travel expenses of officials frequently are less than the insurance on the delivery of signed bonds.
o Insurance policies, underwritten by private insurers, guarantee the bond issue in the event of a default.
Municipal Bond Investors
Four categories of investors purchase most municipal bonds: (1) mutual funds; (2) commercial banks; and (3) property and casualty insurance companies; and (4) households.
o Commercial banks dominated the market for municipal bond buyers in the 1960s and 1970s.
o Households and mutual funds superseded banks in the 1980s.
o By 1994, mutual funds, bank personal trusts, and money market funds held 38.9% of the municipal bonds; households held 35.5%; property and casualty insurance companies held 12%; and commercial banks held 8.2%.
The Tax Reform Act of 1986 eliminated many long-standing loopholes, leaving municipal bonds as the last significant remaining tax shelter.
Other provisions of the Act made municipal bonds less attractive to banks and insurance companies.
Investment syndicates underwrite municipal bonds by providing the funds to the issuing jurisdictions and, in turn, re-offering the bonds to individual investors.
o The spread is the underwriter's compensation for distributing the bonds and for assuming the risk of a change in market value of the bonds.
o Municipal bonds may be purchased by underwriters: (a) through a private negotiated purchase, or (b) as the highest bidder at competitive bidding.
Current Trends in Municipal Bond Underwriting
Many Wall Street firms have recently closed their municipal departments.
o Many local politicians have become reluctant to raise taxes or charge the user fees necessary to back new bonds to finance new projects.
o The Securities and Exchange Commission has crackdown on inadequate financial disclosures to investors and political payoffs
The need of billions of dollars to finance schools, sewage treatment facilities, parks, roads, and other public improvements still exists.
The conversion of public assets to private ventures will put a premium on investment bankers with government skills.
Many Wall Street firms are pursuing deals once considered the "bread-and-butter" of the regional brokerage firms.
Competitive Bid and Negotiated Sale
Competitive bidding is generally used in selecting underwriters for general obligation bonds.
o The issuer, usually with the assistance of a financial advisor, structures the bond issue and publishes a notice of sale requesting bids from underwriters.
o The bonds are awarded to the underwriting syndicate that submitted the best bid, i.e. the lowest true interest cost to the issuer.
o No allegations of preferential treatment can be made since bonds are awarded solely on the basis of lowest bid.
o Competitive bidding is inflexible with respect to restructuring maturity schedules and interest rates after the bonds are awarded and not encourage underwriters to participate in substantial pre- marketing efforts.
In a negotiated sale, a single underwriting syndicate is selected based on factors such as past relationships, special expertise, and the size and nature of the underwriters' sales efforts.
o The senior manager of the syndicate will assist in structuring the bond issue, preparing the official statement, and obtaining a bond rating.
o The syndicate will engage in pre-sale marketing and will negotiate interest rates.
o Negotiated sales are common with revenue-bond offerings.
o Historically, the underwriter's spread has tended to be higher on negotiated bids.
Establishing the Investment Syndicate
Each member of a syndicate (or joint account) has a share in the account, called participation, and shares in the profits (and losses, if any) of the syndicate according to this participation; the account is said to be "undivided" in terms of selling and liability.
If bonds in the account are distributed at the outset to each member according to participation (known as a divided account), a syndicate member is required to sell only its obligated percentage of the issue and is not held responsible for other's unsold bonds.
The account manager will suggest a bid scale and profit margin that can be underwritten.
On the date of the sale, officials of the issuing jurisdiction receive the bids from the bidders in person or through the mail.
The Yield Curve
The yield curve illustrates the term structure of interest rates by plotting bond yield as a function of years to maturity and indicating the average rate of return on a bond if it is held to maturity.
Three theories describe the shape of the yield curve and the predominance of the upward-sloping yield curve.
(1) The expectation hypothesis states that expectations of future inflation influence the shape of the yield curve.
(2) The liquidity preference theory holds that investors are willing to accept lower rates for shorter term maturities because they perceive them to be less risky than long term issues.
(3) The market segmentation theory posits that different markets exist for maturities of different lengths; the positive yield curve is explained by different equilibriums for each segment of the market.
Net Interest Cost and Total Interest Cost
Failure to take proper account of the general money market and the desired investment yield of potential buyers will result in a smaller spread or gross profit for the underwriters.
The net interest cost is the bid that the underwriters will make on the bonds and can be calculated as follows:
Net Interest Cost = Gross Interest Cost less Premium (divided by) Total "Bond Years
True interest cost (TIC) is the present value, expressed as a nominal annual rate, compounded semiannually, which discounts the future cash flows of the issue to equal thre bid amount for the issue.
o In financial analysis, this techniques is called the internal rate of return.
o TIC is computed by a mathematical technique called successive approximations.
Production
The production of a given issue may be calculated by first multiplying the reoffering price (yield or par value) times the face amount of each maturity date.
This figure is then multiplied times the amount being offered with a given maturity, and the results are summed for all maturity periods.
Investment Banker's Profits
Underwriters do not charge a commission when they sell municipal bonds, since they are acting as principals, rather than as agents.
The profit of an investment banker is the spread between the purchase price paid to the issuer and the sale price to investors.
For both competitive and negotiated bids, the spread is made up of four separate components:
(1) The management fee compensates the underwriters for their efforts in creating and implementing the financing package and depends on the complexity of the issuance.
(2) The underwriting fee, also known as the "risk" component of the spread, is designed to compensate the underwriter for the risk incurred by buying the entire issuance before it has received orders from investors for all the bonds.
(3) The takedown, usually the largest part of the underwriter's spread, represents the discount at which the members of the syndicate buy or "take down" bonds from the overall underwriting account.
(4) The issuer must also reimburse the underwriter for expenses incurred during the development of the financing package and the actual sale of the bonds.
The expected profit on a $1,000 bond will vary from around $2.50 to $20 (0.25 to 2.0 percent of face value).
o The profit on municipal issues in the early 1990's averaged $11 per $1,000.
o The average profit for an underwriting firm is now around $8 per $1,000.
Bonds are sold on a "plus accrued interest" basis from the date of the issue or from the last interest payment date.
Over-the-counter trading markets encompasses all types of securities, including U. S. government bonds, foreign bonds, corporate bonds, railroad stocks, common and preferred stocks, script, rights, warrants, and municipal bonds.
Secondary trading is very competitive, with spreads ranging from 1/4 of a point ($2.50 per bond) to two points ($20.00) in the case of obscure issues or odd lots.
Three types of dealers in the secondary market
(1) Securities dealers manage specific areas of the municipal bond market (e.g., short-term notes or public utility bonds).
(2) Dealer banks handle general obligation bonds in which they have no direct connection.
(3) Dealers' brokers facilitate trades exclusively among dealers.
Access to up-to-date information is critical to a dealer's ability to trade effectively and efficiently.
o The Blue List is a 100-page compilation of securities, along with their yields, offered for trade by dealers.
o Blue List Ticker records up-to-the-minute additions and deletions of bond offerings.
o Municipal dealer offering sheets are weekly inventories of bond holdings that individual dealers are offering for sale and include the names of investors, the type of bond, and its yield or sale price.
Two measures are especially watched as indicators of where the market is headed:
(1) the placement ratio, which shows the proportion of all bonds (competitive and negotiated) over $1 million that were distributed during the week;
(2) the 30-day visible-supply volume which shows all securities scheduled to be offered within a 30-day calendar period.
The Municipal Securities Rulemaking Board (MSRB) is an independent oversight agency, established by the Securities Act of 1975 to regulate the practices of municipal securities dealers, dealer banks, and brokerage firms.
In October 1994, the Securities and Exchange Commission (SEC), which oversees the MSRB, released new rules mandating public disclosure in the secondary market.
Tax Treatment of Discount
The discount on municipal bonds is considered to be compensation which the obligor has contracted to pay for the use of the money loaned.
o The discount is equivalent to interest for federal tax purposes.
o The yield in excess of the purchase price is taxable as a capital gain when realized.
Tax Exempt Bond Funds
Tax exempt bond funds are registered investment companies, the assets of which are invested in a diversified portfolio of tax-exempt bonds.
o The objective is to provide tax-free income consistent with the preservation of capital and diversification of risk.
o Each fund is a closed-end trust created under the terms of a trust indenture by an investment banking firm that acts as the "sponsor."
o Some funds include only bonds issued within a particular state, thereby gaining exemption from state income taxes as well as federal income taxes.
o Most tax-exempt mutual funds hold a mix of bonds of varying maturities and rates to smooth out the ups and downs in the market.
o They also hold complicated derivatives, which are securities based on parts of a bond, such as principal payment or interest, which have complex rules and often move differently in price from the actual bond.
o Bond prices move in the opposite direction from interest rates: as rates on new bonds increase, the price of older, lower-yielding bonds in a mutual fund decline, and the fund shareholders experience a loss of principal.
Bond Ladder Investing
A laddered bond portfolio is designed for investors who hold their bonds to maturity.
o Bonds or other fixed income instruments scheduled to come due at different future dates are purchased to create an income portfolio.
o Each group of bonds represents a rung on the investment ladder.