Understanding Municipal Bonds

How To Understand Municipal Bonds On The Series 7 Exam
to become a General Securities Registered Representative

One of the keys to passing the series 7 exam is to make sure that you have a complete understanding of how municipal bonds will be tested on the Series 7 Exam. This article which was produced from material contained in our series 7 textbook and will help you master the material so that you pass the series 7 exam.

Introduction

The Municipal Securities Rule Making Board or the MSRB is the organization responsible for overseeing the municipal securities industry. The MSRB has no enforcement arm and its only function is to write rules and test questions. As a result, the Series 7 exam will contain a large number of questions relating to municipal securities.

Municipal bonds

State and local governments will issue municipal bonds in order to help the local governments meet their financial needs. Most municipal bonds are considered to be almost as safe as Treasury securities issued by the federal government. However, unlike the federal government, from time to time an issuer of municipal securities does default. The degree of safety varies from state to state and from municipality to municipality. Municipal securities may be issued by:

• States
• Territorial possessions of The US, such as Puerto Rico
• Legally constituted taxing authorities and their agencies
• Public authorities that supervise ports and mass transit

Types of Municipal Bonds

General Obligation Bond

General obligation bonds also known as “GO’s” are full faith and credit bonds. The bonds are backed by the full faith and credit of the issuer and by their ability to raise and levy taxes. In essence tax revenues back the bonds. GO’s will often be issued to fund projects that benefit the entire community and the financed projects generally do not produce revenue of any kind. General obligation bonds would be issued, for example, to fund a local park, a new school building, or a new police station. General obligation bonds that have been issued by the state are backed by income and sales taxes while GO’s that have been issued by local governments or municipalities are backed by property taxes.

Voter Approval

General obligation bonds are a drain on the tax revenue of the state or municipality that issues them. The amount of general obligation bonds that may be issued must be within certain debt limits and requires voter approval. The maximum amount of general obligation debt that may be issued is known as the statutory debt limit. State and municipal governments may not issue general obligation debt in excess of their statutory limit.

Property Taxes

General obligation bonds issued at the local level are mostly supported by property tax revenue received from property owners. A property owner’s taxes are based on the assessed value of the property, not on its actual market value. Towns will periodically send an assessor to inspect properties and determine what the properties’ assessed values are.

Example

A homeowner whose home has a market value of $100,000 will not be taxed on the entire market value of the home. If the town uses a 75% assessment rate, the home’s assessed value would be $75,000

Example

Taxpayers are subject to the taxing authority of various municipal authorities. Municipal debt that is issued by different municipal authorities that draws revenue from the same base of taxpayers is known as overlapping debt or coterminous debt.

Overlapping Debt

The county water authority issued bonds that are supported by the property taxes levied in the county. The water authority’s debt overlaps the towns’ and county’s other general obligation debt by drawing support from the same tax revenue. State issues are not included when determining overlapping debt because they are supported by other revenue sources such as state sales taxes and income taxes.

Revenue Bonds

A revenue bond is a municipal bond that has been issued to finance a revenue-producing project such as a toll bridge. The proceeds from the issuance of the bond will construct or repair the facility, and the debt payments will be supported by revenue generated by the facility. Municipal revenue bonds are exempt from The Trust Indenture Act of 1939, but all revenue bonds must have an indenture that spells out the following:

• Rate Covenant
• Maintenance Covenant
• Additional Bond Test
• Catastrophe Clause
• Call or Put Features
• Flow of Funds
• Outside Audit
• Insurance Covenant
• Sinking Fund

Industrial Development Bonds / Industrial Revenue Bonds

An industrial revenue bond or an Industrial development bond is a municipal bond issued for the benefit of a private corporation. The proceeds from the issuance of the bond will go towards building a facility or towards purchasing equipment for the corporation. The facility or equipment will then be leased back to the corporation and the lease payments will support the debt service on the bonds. Interest earned by some high-income earners on industrial development bonds may be subject to the investor’s alternative minimum tax. States are limited as to the amount of industrial revenue bonds that may be issued, based on the population of the state.