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Chapter 8 Municipal BondsIssued by StateCountiesCitiesAuthoritiesTo pay for infrastructureNot operationsSchool district can issue bonds to pay for buildings but not teacher salariesWhy? (economic reason and tax reason)Muni Bonds:Over 50,000 Issuers Over 1.5 million issuesAbout 5,000 corporate issuesAbout 1,000 treasury issuesFederal Tax Exemption of Interest PaymentsState tax exemption can varyEquivalent Taxable YieldEquivalent Taxable Yield (1 - T) = Tax Exempt YieldYM = Y(1 - T)Example: 8% Equivalent Taxable Yield and 20% tax rateYM = Y(1 - T) = 8%(1 – 0.2) = 6.40% 8% Equivalent Taxable Yield and 30% tax rateYM = Y(1 - T) = 8%(1 – 0.3) = 5.60%What will be the coupon?In other words, for whom will the bonds be priced?Yield Ratio = YM/YTMTreasuriesGo to FREDMuni Bond TypesOften describes where the money comes from to pay the bondGeneral Obligation of the issuer (GO Bond)Unlimited tax obligationLimited tax obligationRevenue bonds (Rev Bond)Revenue from a specific projectE470, DIAMuni bonds finance capital projectsThe assets are consumption assetsSo muni bonds are issued as a seriesLooks like a mortgage to the issuer (borrower)But a bullet bond to the holder (lender)Go to BloombergMunicipal Credit EnhancementBecause there are so many muni bond issuers, it is difficult for bond buyers to know the credit of every issuerAlso, many muni bond issuers lack sufficient credit to issue investment grade bonds Two kinds:Insurance – from a monoline insurance companyCredit Facility – from a bankBond InsuranceBacked by a monoline insurance companyIssuer pays a premium to the insurance company Insurance company guarantees the bond paymentsPayments are obligation of monoline Insurance company - so AAA ratedAssociation of Financial Guaranty Insurers - Why would the issuer do this?Non-investment grade so can’t issue bonds without itNet costs are lowerCredit Facilities Provided by commercial banksThree types:Letter of Credit (LOC)Strongest credit supportLOC provider is a bankBank required to advance funds to pay bondIrrevocable line of creditLine of credit granted to the issuer, not the bondholdersFunds available to the bond issuer, so bank must lend money to the issuerBankruptcy can complicate thisRevolving line of creditAgain, funds Available to the bond issuer But this type can be canceled by the bank if issuer does not meet certain covenantsTypes of muni bond productsCapital market – to finance long-lasting infrastructure Coupon bondsZero couponFloating couponInverse-floating rate bondsMoney market - Short term notes in anticipation of money due to the municipalityTax Anticipation Notes (TAN) Revenue Anticipation Notes (RAN) Bond-proceed Anticipation Notes (BAM)Variable Rate Demand Obligations (VRDO)Long-term obligation of the municipalityBacked by an LOC Coupon resets every day or every one, four or five weeks An auction is held to reset the couponSo VRDOs trade at parVRDOs “Putable”The lender can sell back the VRDOMake the borrower repay the loanSimilar to Auction Rate Security (ARS)These were not putableDuring the 2008 financial (liquidity) crisis, the ARS auction markets failedHow Refunding Non-Callable Muni BondsCalled “Defeasance”The issuer simultaneously:Issues new muni bonds (at the new lower rate)Uses the proceeds of the new issue to buy a combination of Treasury bonds such that the cash flows of the Treasury bonds equal the CFs of the original issueSince the CFs of the Treasuries are “default risk free” And exactly match the CFs of the original bondsThe original issue is considered defeased And is no longer considered an obligation of the Municipality And does not affect its credit rating ................
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