In 1975, New York City was about to become the first major American city to default. The city's finances were so dire that it couldn't pay its bills. President Ford initially refused federal assistance, leading to the famous headline: "Ford to City: Drop Dead."
The lesson was clear: municipal bonds are not risk-free. But their unique tax advantages make them attractive to investors in high tax brackets. Understanding how they work is essential.
Section 1: Characteristics of Municipal Debt
Municipal securities are exempt from federal regulations. The Municipal Securities Rulemaking Board (MSRB) regulates broker-dealers, but has no authority over municipal issuers.
Instead of a prospectus, municipal issuers provide an official statement containing information about the bonds and issuer's financial condition.
Tax Status
Municipal bond interest is exempt from federal income tax. If the purchaser is a resident of the issuing state, state and local taxes may also be exempt. When exempt at all levels, the bond is triple tax-exempt.
| Type of Debt | Federal Tax | State Tax |
|---|---|---|
| U.S. Government | Subject | Exempt |
| Corporate | Subject | Subject |
| Municipal | Exempt | Subject* |
*Unless purchased by a resident of the issuing state.
Test Tip: Issues of U.S. territories (Puerto Rico, Guam, Virgin Islands) are always triple tax-exempt, no matter where the purchaser resides.
Credit Enhancement
Bonds that are insured will automatically be rated AAA. The credit rating is that of the insurance company, not the issuer. This is called credit enhancement.
Types of Calls
| Call Type | Description |
|---|---|
| Optional call | Issuer's discretion; typically when rates fall |
| Extraordinary/Catastrophe | If certain events occur (earthquake, fire) |
| Mandatory/Sinking fund | Required periodic payments to retire debt |
Section 2: Types of Municipal Debt
General Obligation (GO) Bonds
GO bonds are backed by the full faith, credit, and taxing power of the issuer. They require voter approval and are subject to statutory debt limits.
An ad valorem tax (Latin for "according to value") is a tax based on value. When the exam mentions ad valorem taxes, it means property taxes. The amount owed is typically based on a mill rate per $1,000 of assessed value.
- High and growing property values
- Diversified economy with many employers
- High income levels
- Ability to increase taxes
Revenue Bonds
Revenue bonds are backed by revenue from a specific source (hospital, toll bridge, arena). They are NOT backed by taxing power, do NOT require voter approval, and are NOT subject to debt limits.
| Feature | GO Bonds | Revenue Bonds |
|---|---|---|
| Backing | Taxing power | Project revenues |
| Voter approval | Required | Not required |
| Debt limits | Apply | Don't apply |
| Safety | Typically safer | Typically riskier |
Protective Covenants
Revenue bonds include covenants in the indenture:
- Additional bonds: New bonds must not burden revenue stream
- Insurance: Must carry adequate insurance
- Operations/Maintenance: Must maintain facility
- Rate covenant: Must set fees to cover debt service
A ratio of 2 or more is generally acceptable.
Other Types
| Type | Description |
|---|---|
| Double-barreled | Backed by both revenues AND taxing power |
| Special tax | Secured by excise taxes (cigarette, liquor, gasoline) |
| CABs | Municipal zero-coupon; only discounted amount counts against debt limit |
| COPs | Backed by lease payments; allows issuing past debt limit |
| IDBs | For private company facilities; may be taxable |
Section 3: Money Market Instruments
Short-term debt instruments (under 1 year maturity) are considered money market debt. Their short maturity makes them less volatile.
| Instrument | Description |
|---|---|
| T-Bills | Government-backed; 1-12 month maturities |
| Commercial paper | Corporate; max 270 days to avoid SEC registration |
| Banker's acceptances | Finance imports/exports; bank guaranteed |
| Negotiable CDs | Jumbo CDs; $100K minimum (typically $1M) |
| Repos | Dealer sells securities with agreement to buy back |
Anticipation Notes
Short-term municipal notes issued pending expected revenues:
- BANs (Bond): Paid off by long-term bond issuance
- TANs (Tax): Pending tax collection
- RANs (Revenue): Pending non-tax revenues
- TRANs: Pending both taxes and revenues
- GANs (Grant): Pending grant monies
| Concept | Key Details |
|---|---|
| Municipal bonds | Interest exempt from federal tax |
| GO bonds | Taxing power; debt limits; voter approval |
| Revenue bonds | Project revenues; no debt limits; riskier |
| Official statement | Disclosure document (not prospectus) |
| MSRB | Regulates broker-dealers, not issuers |
Chapter 5 Key Terms Glossary
| Term | Definition |
|---|---|
| GO bond | Backed by full faith, credit, taxing power |
| Revenue bond | Backed by specific project revenues |
| Ad valorem | Tax based on value (property tax) |
| Official statement | Municipal bond disclosure document |
| MSRB | Regulates municipal broker-dealers |
| Triple tax-exempt | Exempt from federal, state, local taxes |
| Debt limit | Maximum GO debt municipality can issue |
| Credit enhancement | Insurance that raises rating to AAA |
| Coverage ratio | Net income ÷ debt payments |
| Double-barreled | Backed by revenues AND taxing power |
| CAB | Capital appreciation bond (muni zero-coupon) |
| COP | Certificate of participation (lease-backed) |
| BAN/TAN/RAN | Anticipation notes (short-term) |
Chapter 5 covers municipal bonds and money market instruments. Understanding GO vs. revenue bonds and their tax advantages is heavily tested on the Series 7 exam.