Trading and Capital-Markets Activities Manual
Profiles: Municipal Securities
Municipal securities are interest-bearing obligations issued by local governments or their political subdivisions (such as cities, towns, villages, counties, or special districts) or by state governments, agencies, or political subdivisions. These governmental entities can borrow at favorable rates because the interest income from most municipal securities generally receives advantageous treatment under federal income tax rules. There are important restrictions on these tax advantages, however, and banks are subject to different tax treatment than other investors.
The two principal classifications of municipal securities are general obligation bonds and revenue bonds. General obligation bonds are secured by the full faith and credit of an issuer with taxing power. General obligation bonds issued by local governments are generally secured by a pledge of the issuer's specific taxing power, while general obligation bonds issued by states are generally based on appropriations made by the state's legislature. In the event of default, the holders of general obligation bonds have the right to compel a tax levy or legislative appropriation to satisfy the issuer's obligation on the defaulted bonds. Revenue bonds are payable from a specific source of revenue, so that the full faith and credit of an issuer with taxing power is not pledged.
Revenue bonds are payable only from specifically identified sources of revenue. Pledged revenues may be derived from operation of the financed project, grants, and excise or other taxes. Industrial development bonds are a common example of revenue bonds. These bonds are municipal debt obligations issued by a state or local government (or a development agency) to finance private projects that generate tax revenues. The debt service on these bonds is dependent on the lease income generated by the project or facility. In certain instances, industrial development bonds may be categorized as loans (see the instructions to the call report).
In addition to municipal and industrial development bonds, state and local governmental entities issue short-term obligations in the form of notes. These debt obligations are generally issued to bridge the gap between when expenses are paid and tax revenues are collected. The types of notes issued include tax anticipation notes (TANs), revenue anticipation notes (RANs), tax and revenue anticipation notes (TRANs), grant anticipation notes (GANs), and bond anticipation notes (BANs).
CHARACTERISTICS AND FEATURES
Municipal bonds are typically issued in denominations of $5,000, known as the par value or face value amount of the bond. Municipal bonds are generally issued in serial maturities. A typical offering is made up of different maturities which allow the issuer to spread out debt service and stay within financial requirements. In recent years, however, term bonds have become increasingly popular. Term bonds are bonds comprising a large part or all of a particular issue which comes due in a single maturity. The issuer usually agrees to make periodic payments into a sinking fund for mandatory redemption of term bonds before maturity or for payment at maturity. Most municipal bonds are issued with call provisions which give the issuer flexibility in controlling its borrowing costs through the early retirement of debt.
A prime feature of municipal securities had been the exemption of their interest from federal income taxation. However, two significant restrictions have been imposed on the tax bene-fits of owning municipal securities. First, beginning in 1986, all taxpayers became subject to the alternative minimum tax (AMT), which was intended to provide an upper limit on the degree to which individuals and corporations can protect their income from taxation. Interest income from private-activity securities issued since then is potentially subject to the AMT. Second, investors became unable to deduct interest expense incurred in funding tax-advantaged securities, a measure that was intended to remove the benefit of borrowing funds from others to invest in municipal securities. In this regard, special federal tax rules apply to bank holdings of municipal securities, including the manner in which the amount of non-deductible interest expense is calculated. Exceptions to these various limitations apply only to tax-exempt obligations issued after August 1986 that are issued by small entities and are not private-activity bonds.
The state and local income taxation treatment of municipal securities varies greatly from state to state. Many states and local governments exempt interest income only on those bonds and notes issued by government entities located within their own boundaries.
Municipal securities have traditionally been held primarily for investment purposes by investors who would benefit from income that is advantaged under federal income tax statutes and regulations. This group includes institutional investors such as insurance companies, mutual funds, commercial banks, and retail investors. The value of the tax advantage and, therefore, the attractiveness of the security increase when the income earned is also advantaged under state and local tax laws. Wealthy individuals and corporations face the highest marginal tax rates and, therefore, stand to receive the highest tax-equivalent yields on these securities. Private individuals are the largest holders of municipal securities, accounting for three-fourths of these securities outstanding.
DESCRIPTION OF MARKETPLACE
State and local government entities can market their new bond issues by offering them publicly or placing them privately with a small group of investors. When a public offering is selected, the issue is usually underwritten by investment bankers and municipal bond departments of banks. The underwriter may acquire the securities either by negotiation with the issuer or by award on the basis of competitive bidding. The underwriter is responsible for the distribution of the issue and accepts the risk that investors might fail to purchase the issues at the expected prices. For most sizable issues, underwriters join together in a syndicate to spread the risk of the sale and gain wider access to potential investors.
Standards and practices for the municipal securities activities of banks and other market participants are set by the Municipal Securities Rulemaking Board (MSRB), a congressionally chartered self-regulatory body that is overseen by the SEC. Examination and enforcement of MSRB standards is delegated to the NASD for securities firms and to the appropriate federal banking agency (Federal Reserve, OCC, or FDIC) for banking organizations.
Municipal securities are not listed on or traded in exchanges; however, there are strong and active secondary markets for municipal securities that are supported by municipal bond dealers. These traders buy and sell to other dealers and investors and for their own inventories. The bond broker's broker also serves a significant role in the market for municipal bonds. These brokers are a small number of inter-dealer brokers who act as agents for registered dealers and dealer banks. In addition to using these brokers, many dealers advertise municipal offerings for the retail market through the Blue List. The Blue List is published by Standard & Poor's Corporation and lists securities and yields or prices of bonds and notes being offered by dealers.
Market participants in the municipal securities industry include underwriters, broker-dealers, brokers' brokers, the rating agencies, bond insurers, and investors. Financial advisors, who advise state and local governments for both competitive and negotiated offerings, and bond counsel, who provide opinions on the legality of specific obligations, are also important participants in the industry. The underwriting business primarily consists of a small number of large broker-dealers, typically with retail branch systems, and a large number of regional underwriters and broker-dealers with ties to local governments and who specialize in placing debt in their individual regions.
Price transparency in the municipal securities industry varies depending on the type of security and the issuer. Prices for public issues are more readily available than prices for private placements. Two publications quote prices for municipal securities: The Bond Buyer and the Blue List.
Municipal securities are priced either on a yield or dollar basis depending on the issue. Securities that are priced on a dollar basis are quoted as a percentage of the par value. A bond that is traded and quoted as a percentage of its par value is called a ''dollar bond.'' Municipal securities, however, are generally traded and quoted in terms of yields because there are so many issues of different maturities. A bond quoted at 6.751-6.50 percent means that a dealer is willing to purchase the bond to yield 6.75 percent and will sell it to yield 6.50 percent.
To compare the yield of a municipal security with that of a taxable bond, the yield of the maturity must be adjusted to account for a number of factors that may be unique to the individual investor. For example, a fully taxable equivalent (FTE) yield would consider the relevant federal, state, and local marginal tax rates of the investor; specific characteristics of the security; the applicability of the alternative minimum tax (AMT); the ability to deduct interest expense associated with funding the acquisition; and other elements of the institution's tax status. (These factors are discussed more fully in the ''Characteristics and Features'' subsection.)
Generally, the special features and unique potential tax advantages of municipal securities make it difficult to construct an ideal hedge. The municipal bond futures contract from the Chicago Board of Trade (and corresponding options) is frequently used to hedge positions in municipal bonds. These contracts are cash settled to the value of the Bond Buyer Index, an index of actively traded municipal bonds, whose composition changes frequently. The market for these exchange contracts is not very liquid, however, and the possibility of basis risk may be large.
Municipal securities also can be hedged using more liquid Treasury securities, futures, and options. Treasury securities can be used to mitigate exposure to yield-curve risk; however, the significant basis risk present in the municipal/Treasury securities price relationship would remain un-hedged. Some dealers use over-the-counter municipal swaps to hedge interest-rate risk. This would reduce basis risk to the relationship between the security being hedged and the municipal index employed in the swap transaction. Municipal swaps are relatively new and are not widespread in the industry. As a result, their use as hedging vehicles is limited.
Municipal-securities activities involve differing degrees of credit risk depending on the financial capacity of the issuer or economic obligor. Noteworthy cases in which municipal securities have been unable to perform as agreed range from New York City in the 1970s and WPPSS (a Washington state power utility) in the 1980s to more recent examples. For revenue bonds, the ability to perform depends primarily on the success of the project or venture funded by the bond. Trends in real estate values, fiscal management, and the size of the tax base bear directly on the issuer's ability to service general obligation bonds.
An important starting point in performing a credit review of a potential issuer is to obtain a legal opinion that the issuing entity has the legal authority to undertake the obligation. The entity must also have the capacity to repay as well as the willingness to perform, both influenced not only by financial factors but by political factors. Since some issuers depend on legislatures or voters to approve bond issues or new funding, credit analysis can become problematic; issuers could default on their bond obligations despite having the funds to service debt. These political issues may reach beyond the direct jurisdiction of the issuing entity, including decisions made by state legislatures or Congress. Therefore, to fully evaluate market risk, market participants must monitor how political and legislative factors may affect a security's default risk.
The lack of standardized financial statements and the large number of different issuers (as many as 50,000 entities issue municipal bonds) also make credit analysis of municipal securities more difficult. This heightens the importance of the role of the rating agencies and bond insurers in comparison to other markets. Larger issuers of municipal securities are rated by nationally recognized rating agencies. Other issuers achieve an investment-grade rating through the use of credit enhancements such as insurance from a municipal bond insurance company or a letter of credit issued by a financial institution. Credit enhancements are often used to improve the credit rating of a security, thereby lowering the interest that the issuer must pay.
One of the problems in the municipal market is the lack of ready marketability for many municipal issues. Many municipal bonds are relatively small issues, and most general obligation issues are sold on a serial basis, which in effect breaks the issues up into smaller components. Furthermore, a large percentage of municipal securities are purchased by retail investors and small institutions that tend to hold securities to maturity. Overall, smaller issues and those with thin secondary markets often experience liquidity difficulties and are therefore subject to higher risk.
Interest-Rate Risk and Market Risk
Like other fixed-income securities, fixed-income municipal securities are subject to price fluctuations based on changes in interest rates. The degree of fluctuation depends on the maturity and coupon of the security. Variable-rate issues are typically tied to a money market rate, so their interest-rate risk will be significantly less. Nonetheless, since bond prices and interest rates are inextricably linked, all municipal securities involve some degree of interest-rate risk.
Holders of municipal securities are also affected by changes in marginal tax rates. For instance, a reduction in marginal tax rates would lower the tax-equivalent yield on the security, causing the security to depreciate in price.
Prepayment or Reinvestment Risk
Call provisions will affect a bank's interest-rate exposure. If the issuer has the right to redeem the bond before maturity, the risk of an adverse effect on the bank's exposure is greater. The security is most likely to be called when rates have moved in the issuer's favor, leaving the investor with funds to invest in a lower interest-rate environment.
The accounting treatment for investments in municipal securities is determined by the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 115, ''Accounting for Certain Investments in Debt and Equity Securities,'' as amended by SFAS 125, ''Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.'' SFAS 125 has been replaced by SFAS 140, which has the same title. Accounting treatment for derivatives used as investments or for hedging purposes is determined by SFAS 133, ''Accounting for Derivatives and Hedging Activities.'' (See section 2120.1, ''Accounting,'' for further discussion.)
RISK-BASED CAPITAL WEIGHTING
General obligations, BANs, and TANs have a 20 percent risk weight. Municipal revenue bonds and RANs have a 50 percent risk weight. Industrial development bonds are rated at 100 percent. For specific risk weights for quali-fied trading accounts, see section 2110.1, ''Capital Adequacy.''
LEGAL LIMITATIONS FOR BANK INVESTMENT
The limitations of 12 USC 24 (section 5136 of the Revised Statutes) apply to municipal securities. Municipal securities that are general obligations are type I securities and may be purchased by banks in unlimited amounts. Municipal revenue securities, however, are either type II or type III securities. The purchase of type II and type III securities is limited to 10 percent of equity capital and reserves for each obligor. That limitation is reduced to 5 percent of equity capital and reserves for all obligors in the aggregate when the judgment of the obligor's ability to perform is based predominantly on reliable estimates versus adequate evidence.
Feldstein, Sylvan G., Frank J. Fabozzi,
and T. Dessa Fabozzi. ''Chapter 8: Municipal Bonds.'' The Handbook of
Fixed Income Securities. 4th ed. Chicago: Irwin Professional Publishing,
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