Municipal bonds are a great way for investors to preserve capital and generate tax-free income. They are backed by the full faith and credit of governments or revenue-generating projects implemented by governments. Investors interested in municipal bonds should familiarize themselves with the basic terminology used in the market. In this article, we will define many of the most common terms and provide some examples of their everyday usage.
Accrued interest is the interest that has accumulated on a bond since its latest interest payment up to, but not including, the settlement date. When buying or selling municipal bonds, accrued interest is added to the price of the bond since it hasn’t been distributed yet to the owner.
For example, suppose that an investor holds a $100 municipal bond that pays 10% interest at the end of each year. If the investor decides to sell after the first six months, there would be about $5.00 of accrued interest and the bond would sell for approximately $105.
Ad Valorem Tax
Ad valorem tax is the amount of municipal property tax that is assessed by a public tax assessor and subsequently owed by the property owner. Since property taxes are a major source of revenue for municipal governments, ad valorem taxes can play a big role in the muni market.
For example, falling property prices in a municipality might precipitate lower ad valorem taxes as nearby property values are assessed lower. As a result, the municipality may receive less property tax income and its muni bonds may be riskier to hold or lose some value.
Advanced Refunded Funds
Advanced refunded funds are bond issuances used to pay off other outstanding bonds, where the new bond is often issued at a lower interest rate than the old bond. But importantly, the new bond is not tax exempt by the federal government (to prevent unlimited debt issuance).
For example, suppose that a municipality would like to lower its interest payments by issuing new lower-rate bonds to pay off its older higher-rate bonds; these new muni bonds may help reduce its current debt burden, but they would not be exempt from federal taxes.
Amortization of Debt
Amortization of debt is the accounting method that systematically reduces the cost value of a limited-life, intangible asset, such as a municipal bond. For tax purposes, muni bondholders treat the bonds as an amortized asset over its lifespan, although not in actual buying and selling.
For example, suppose that an investor buys a muni bond at a premium, although that premium will eventually move to face value over time. As a result, the bond is amortized to reflect the premium or discount for tax and accounting purposes (but not necessarily market price).
Arbitrage involves taking advantage of the difference between two or more markets by buying and selling two related assets at the same time. Oftentimes, arbitrage opportunities are considered risk-free , since they should involve very little or no negative cash flow.
For example, many muni bondholders will purchase a portfolio of high-quality, tax-exempt muni bonds and simultaneously short sell a portfolio of equivalent taxable corporate bonds in order to profit from the tax rate in much the same way as an interest rate swap. Investors should note, however, that Federal income tax laws generally restrict the ability to earn arbitrage in connection with tax-exempt bonds or other federally tax-advantaged bonds.
Assessed valuation is the value of a property for the purposes of taxation, particularly when it comes to municipal property taxes. These valuations take into account a number of different factors, including overall quality, market conditions, and nearby property values.
For example, suppose that many houses in a municipality have begun selling at a premium due to a new large employer setting up shop in the area. The assessed valuation of the properties in the area could result in greater property tax income for the municipality.
Average life refers to the length of time that the principal of a bond is expected to be outstanding before it is repaid through amortization or sinking fund payments. The average life can be calculated by multiplying the date of each payment by the percentage of principal paid.
For example, suppose that a municipality has a $100 outstanding bond and pays $10 during the first year, $40 during the second year, and $50 during the third year. The average life of the bond would be 2.4 years or 240 divided by 100 by this calculation.
Balloon maturity is a repayment schedule in which a large number of bonds come due at the final maturity date. Problems can occur when municipalities issuing bonds haven’t properly planned to make the final large payments that may be significantly higher than prior payments.
For example, suppose that a municipality issues three $100 bonds that pay interest only for the majority of their lifespan with a final $100 principal payment due at the end. The large balloon maturity of $300 owed at the maturity date could cause liquidity problems.
Bond Anticipation Note
Bond anticipation notes are short-term securities that are issued ahead of larger future bond issues. When the larger future bonds are issued, the proceeds are used to pay off these bond anticipation notes and ultimately finance the entire project.
For example, suppose that a city would like to build a new toll way but must complete some feasibility studies beforehand. The municipality may choose to issue bond anticipation notes to finance these feasibility studies ahead of a larger issuance that would finance the toll way.
Bond insurance is a product offered by insurance companies that guarantees the scheduled payments of interest and principal on a bond in the event of a default by the issuer. In exchange for the bond insurance, investors or issuers pay lump sums or installment premiums.
For example, suppose that a municipality would like to issue bonds, but its poor credit rating would mean a higher interest rate. By purchasing bond insurance for its offering, the municipality could enhance its credit rating to AAA and reduce its interest rate.
Bond premiums occur when bonds trade above their par value, which happens when their coupon rate is higher than the prevailing interest rate. Bonds may also trade at a premium when they are in high demand, such as when a financial crisis forces a flight to safety.
For example, a bond offering a 5% coupon when prevailing interest rates are at 2% will trade at a premium to match its yield to maturity. As the bond approaches maturity, the premium will dissipate to zero since it must be redeemed at par value at the maturity date.
Bonded debt represents the portion of a municipality’s debt that is represented by bonds that it has issued or debt that it contracted under the obligation of a bond. Oftentimes, these levels are used to assess a municipality’s solvency or ability to issue additional debt.
For example, a municipality that has $100 million in outstanding bond principal and owed interest might have difficulty issuing additional debt if that amount is roughly equal to its total assets, since new bondholders wouldn’t be secured by any assets.
Certificates of Participation
Certificates of participation are a type of financing where investors receive a share of revenue instead of buying a bond that is simply backed by those revenues. Unlike municipal bonds, these COPs may have uneven payments over time and may not be fully secured investments.
For example, suppose that a municipality would like to build a new library, but wouldn’t like to take on debt to do so. Certificates of participation may be issued whereby investors receive lease payments from the municipality over time rather than interest payments.
Conduit bonds are municipal bonds issued to fund private entities engaged in furthering public efforts, such as building hospitals or affordable housing. By having the government issue the bonds, the private entities often realize far lower interest rates than they would otherwise.
For example, suppose that a municipality would like to encourage developers to build a new affordable housing project. The city may offer conduit bonds and use the proceeds to subsidize developers’ costs to build the affordable housing project that ultimately helps citizens.
The coupon rate is the amount of interest paid per year, expressed as a percentage of a bond’s face value. Coupon rates can be calculated by dividing the sum of the bond’s coupon payments for the year by its par value. When a bond is first issued, the coupon rate is equal to the yield.
For example, suppose that a $100 face value bond is issued and pays a $5 semi-annual coupon payment. Bondholders can calculate the coupon rate by adding up the annual coupon payments – and dividing it by the face value – $100 to reach 10%.
Coverage represents the cash flow or capital used to ensure repayment of a bond, coming from tax revenues, project revenues, or separate loans. Covered bonds are securities backed by separate groups of loans that usually carry two to 10 year maturities and have high credit ratings.
For example, a municipality might issue covered bonds in order to reduce their interest expenses as opposed to issuing potentially less secure general obligation or revenue bonds. After all, higher coverage ratios equate to greater safety and a reduced interest rate.
Current yield represents the yield that a bond is paying at its current price rather than the total return over the life of the bond. Bondholders can calculate the current yield by dividing the sum of the bond’s interest payments each year by its current value excluding accrued interest.
For example, suppose that a $100 face value bond has a 5% coupon rate and is selling at $90. Bondholders can calculate the current yield by multiplying $100 by 5% to get $5 and then dividing that by $90 to get the current yield of about 5.6%.
Cushion bonds are callable bonds with coupon rates that are higher than the market interest rate. These bonds sell at a premium and tend to be resilient to fluctuations in interest rates, making them ideal for conservative investors looking for reduced volatility.
For example, cushion bonds are coming back into style after the dramatic fall in interest rates since these lower rates meant less appreciation for cushion bonds than traditional bonds. These bonds now offer bondholders the ability to mitigate the risk of rising interest rates.
The dated date is the date when interest begins to accrue on a bond, which is often the same as the date of issuance or issue date. On the final settlement date, bond issuers must pay bondholders the accrued interest in addition to the face value of the bond.
For example, an investor might buy a bond with a dated date of September 15, 2013 and a settlement date of September 15, 2023. In this case, the bond would begin paying or accruing interest on September 15, 2013 with the full interest and face value due in 2023.
Debt limited is the maximum amount of debt that a municipality can either issue or have outstanding at any given time. These limits are often put in place via statutes or constitutions on a state or municipal level in order to avoid taking on excessive risks of any kind.
For example, a municipality may be debt limited at $50 billion of issued or outstanding general obligation bonds. The municipality is therefore unable to issue any new general obligation bonds after it hits this limit and may be forced to issue revenue bonds or raise taxes to make up for it.
Debt ratio refers to the percentage of a municipality’s assets that are provided via debt rather than cash and equivalents, capital equipment or other types of assets. Oftentimes, this ratio is used to determine whether a bond issuer is overleveraged or able to take on more debt.
For example, suppose that one municipality has a debt ratio of 10% with debt of $1 billion and total assets of $10 billion, and another municipality has a debt ratio of 25%. All else equal, bondholders would assign less risk and a lower interest rate to the first municipality with a 10% debt ratio.
Debt service is the amount of cash required from a bond issuer to cover the repayment of principal and interest on a bond at a specific point in time. Bond issuers that are unable to pay are said to be unable to service their debt and may go into default on the bond.
For example, a municipality may have a large debt service payment due that consumes a significant portion of its current cash flow. This debt service would include the interest and principal payments due on outstanding general obligation or revenue bonds.
Debt Service Reserve Fund
Debt Service Reserve Funds (DSRFs) are mandatory accounts set up to pay principal and interest on revenue bonds in the event that revenues are unable to cover the obligations when they are due. Most DSRFs are 10% of the bond issue’s value or one year of debt service.
For example, suppose that a municipality issues a revenue bond backed by toll roads, but the toll revenues fall short of the interest payments after a year. Instead of defaulting on the bond, the government would draw DSRF funds in order to pay back bondholders.
Defaults occur when bond issuers fail to meet their legal obligations under the debt contract and can either be debt service defaults or a failure to pay bondholders, or technical defaults or a violation of an affirmative or negative covenant associated with the bond.
For example, suppose that a municipality has an outstanding bond that pays 5% annual interest. Failure to make one of the annual payments would result in a debt service default, while a working capital shortage could put it in a technical default even if payments are being made.
Defeasement occurs when an outstanding bond issue is made void, both legally and financially, typically as the result of a refund transaction. Defeased bonds are therefore typically bonds that are either refunded or repurchased by a municipality in cash or with another bond.
For example, a municipality may want to remove debt from its balance sheet by purchasing government securities and pledging them to pay outstanding bond issues. It’s original bond debts are then defeased with the risk-free government securities covering the amount due.
Delinquency occurs when a bond issuer fails to make a payment or perform an action required under the debt contract. While delinquent bonds may technically be in default, the term is most commonly used to represent near-term missed payments rather than long-term non-payment.
For example, a municipality may have a temporary budget shortfall that limits its working capital and makes it 30-days delinquent on payments to bondholders. The bond is considered a delinquent bond, while an ongoing failure to pay may result in a default.
Delivery represents the action of provisioning the underlying asset covering a bond tendered and received by the bondholder. While the term is typically used in the futures market, bondholders can receive delivery of assets used to secure bonds that have defaulted.
For example, suppose that project revenues and additional collateral back a revenue bond and the municipality ends up in default. If it were unable to pay, bondholders could go to court and ultimately receive delivery of the pledged assets to cover their losses.
A bond’s denomination is its stated or face value, which is most often $1,000 for traditional bonds or $5,000 for municipal bonds. Denominations are typically the par value that is paid at the bond’s maturity to bondholders as the principal in addition to the interest.
For example, a general obligation bond may have a $5,000 denomination, which means that the government will owe $5,000 at maturity in addition to principal payments along the way.
Direct debt represents the amount of debt that a specific local unit of government has incurred in its own name or assumed in the event of annexation. In other words, this is the debt that was specifically the liability of a specific city or town within a municipality.
For example, a statewide general obligation bond issuance may have direct debt that is associated with an individual city within the state.
A bond’s discount is the difference between the market price of the bond and the principal amount due at maturity that is higher than the market price. Bonds can trade at a discount for many reasons, including higher or lower federal interest rates.
For example, suppose that a municipal bond pays a fixed interest rate and has a $100 par value at maturity. If interest rates begin to rise, the bond may start to trade at a discount of perhaps $2 at $98, meaning that it trades at a 2% discount.
Escrowed to Maturity
Escrowed to maturity bonds are refunded municipal bonds that are repaid ahead of time with funds drawn from an escrow account. Often, the escrow account holds low-risk government securities to hedge against potential inflationary risks.
For example, suppose that a municipality wants to deleverage its balance sheet in order to qualify for a federal subsidy. By setting up an escrow account with U.S. Treasuries, the government can refund the bond issues and reduce its debt to equity ratio.
Feasibility studies assess a municipality’s ability to successfully complete a project by considering economic, legal, technical, scheduling, and other factors. Often, bondholders use feasibility studies to determine the risk-to-reward profile of a project.
For example, suppose that a municipality wants to build a new bridge that connects two major thoroughfares. Rather than simply asking for the money, the government can reduce the risk premium demanded by investors by first completing a feasibility study.
Full Faith and Credit
“Full faith and credit” is a phrase that refers to an unconditional guarantee on the principal and interest payments made on a bond. Oftentimes, general obligation bonds issued by municipalities are backed by the full faith and credit of the municipality.
For example, suppose that a municipality issues a general obligation bond in order to finance its next fiscal year budget. Even if there is a budget crunch, the municipality will make every effort to repay the principal and interest, since it’s backed by full faith and credit.
Gross debt refers to the total amount of outstanding debt that a municipality may owe investors or other creditors. Often, muni bondholders look at a municipality’s gross debt and compare it to its gross assets in order to determine its liquidity ratios.
For example, suppose that a municipality has $1 billion in gross debt. While this would not be an issue for a municipality with $100 billion in assets, it would be a significant problem for a municipality with less than $1 billion in assets, as it may be unable to cover the debts.
Gross revenue refers to the total amount of revenues that a municipality takes in from tax receipts and other income sources. Often, muni bondholders compare these gross revenues to spending in order to determine the sustainability of that spending.
For example, suppose that a municipality has gross revenues of $1 billion per year from tax receipts and other income sources. These levels could become problematic if gross spending exceeds that amount over a prolonged period of time.
Indenture of Trust
Indentures of trust are agreements made between issuers and bondholders and/or their trustees. Often included within the bond contracts, they discuss the rules and responsibilities of each party, as well as from where the bond’s income stream is derived.
For example, indentures of trust may contain clauses that dictate what happens when the issuer of the bond defaults, particularly in the event of unforeseen incidents. Bondholders and issuers can then reference these agreements in order to determine the remedy.
Interim borrowing involves taking out a short-term loan that is repaid using additional revenue sources that are expected to materialize in the short-term. Municipalities often use interim borrowing, like bridge loans, as a way to finance the early stages of projects.
For example, suppose that a municipality would like to build a new school, but needs to prepare a feasibility study before that happens. Interim borrowing can provide the funding needed to finance this study and then can be paid back using the proceeds of a longer-term bond.
Municipal bonds are rated between AAA and CCC, or lower, by ratings agencies based on their risk of default. Investment grade usually refers to bonds that have a relatively low risk of default, with ratings of AAA to BBB, with anything below being referred to as a junk bond.
For example, a municipality with solid finances might have its debt rated as AAA by a ratings agency like Standard & Poor’s. Bondholders would consider this debt investment grade since it carries a relatively low risk of default compared to riskier municipalities.
Municipal bonds that fall below investment grade, with credit ratings of BB or lower, are often referred to as junk bonds. Often, these bonds offer higher yields than investment grade bonds since they must compensate for the added risk.
For example, a municipality that has a weakening economy and shaky finances may issue debt that has junk bond status if its credit rating is below BB. Bondholders often purchase groups of these bonds to reduce the risk of individual defaults.
Before issuing a municipal bond, the issuer must have an attorney act as bond counsel and render a legal opinion that says the municipality has the authority to borrow, is exempt from filing registration statements with the SEC, and is tax exempt, if applicable.
For example, a municipality may be looking to issue a general obligation bond, but must first obtain a legal opinion stating that they are permitted to borrow, aren’t required to make an SEC filing under the 1933 Act, and that interest payments aren’t subject to taxation.
Letter of Credit
Letters of credit are letters issued by financial institutions or guarantors of municipal bonds stating that the issuer’s debt service payments will be received on time and for the correct amount. Often, these are considered credit enhancements to increase attractiveness.
For example, a municipality that has historically had a difficult time issuing bonds at a low interest rate may provide a letter of credit from a guarantor in order to reassure would-be bondholders and ultimately lower the interest rate that they must pay.
Level Debt Service
Level debt service is a municipal charter provision stating that debt payments must be relatively equal from year to year so that required revenue projections are easier to make. Bondholders can benefit from these provisions since their anticipated cash flows are guaranteed stable.
For example, a bondholder purchasing municipal bonds to generate retirement income might want to consider level debt service muni bonds in order to ensure they receive predictable payment amounts each month or quarter as they’re relying on that income.
Liens are legal rights assigned to creditors to sell collateral that has been pledged as part of a contract. In the case of municipal bonds, all revenue bonds are senior lien bonds where the bondholders have the first right on all pledged revenues securing the bonds.
For example, suppose that a municipality issues a revenue bond to support a new toll road project being built. Bondholders in this case will have first rights to all of the tolls collected since these revenues are used to secure the revenue bond.
Limited Tax Bond
Limited tax bonds are muni bonds that are backed by the full faith and credit of the municipality but are secured by only a percentage of revenue from a specific tax or group of taxes. As a result, these bonds are typically slightly higher risk than normal general obligation bonds.
For example, suppose that a municipality wants to issue new bonds to finance new parks in a residential neighborhood. The government may decide to issue limited-tax bonds that are secured by the property taxes of that specific neighborhood.
Maximum Annual Debt Service
Maximum annual debt service is the upper limit of available capital to make principal and interest payments on municipal bonds over a one-year period. Often, municipalities set aside cash to cover the maximum annual debt service to avoid any interruptions.
For example, a municipality with a maximum annual debt service of $50 million will not be able to issue municipal bonds that have principal and interest obligations of greater than $50 million over a one-year period, otherwise it may be at risk of defaulting on those payments.
Municipal Bonds vs. Notes
Municipal bonds and notes are both debt instruments used by municipalities to raise capital from investors. The difference between the two is that notes tend to be smaller and shorter in duration, with lower interest rates than bonds, which tend to be longer term and larger in nature.
For example, suppose that a municipality needs to raise a small amount of money to complete a project and plans to repay that money within a year. Instead of issuing a bond to finance the project, the municipality could opt to issue a note that is still backed by full faith and credit.
Net Asset Value
Net asset value is the difference between a fund’s assets and liabilities often used to calculate its intrinsic value. Funds can trade at a premium or discount to their net asset value based on investor perception of where the underlying assets are heading in the future.
For example, a municipal bond fund might hold a portfolio of bonds from 10 different states. If one of these states has been troubled lately, the entire fund may trade at a discount to its net asset value since investors are expecting the troubled state’s asset to decline in value.
Net Bonded Debt
Net bonded debt is the portion of a municipality’s debt that is contracted under the obligation of a bond, as opposed to loans or other forms of financing. Oftentimes, this metric is used to determine a municipality’s capital structure to assess default risks or borrowing capacity.
For example, suppose that a municipality has a high proportion of bonded debt relative to other forms of more lenient financing. In this case, the municipality may be at greater risk since bonds are more difficult to restructure than other forms of debt, such as a bank loan.
Net Interest Cost
Net interest cost refers to the overall interest expense that is associated with a municipal bond, based on the average coupon rate weighted to years to maturity and adjusted for any discounts of premiums that may be associated with the bond issue over time.
For example, a municipality may use the net interest cost calculation to determine which underwriters are offering the lowest cost options. The formula is simply the total interest payment (including discounts and premiums) divided by the number of bond-year dollars.
Net Revenue Available for Debt Service
Net revenue available for debt service refers to the amount of municipal revenues from taxes or other sources that are available for debt service. Oftentimes, debt service payments represent a significant portion of a municipality’s total revenues over time.
For example, suppose that a municipality generates $100 million in revenue, but requires $75 million for payroll, refunds, and other commitments, with another $5 million put into a slush fund. The remaining $20 million could be net revenue available for debt service.
Original Issue Discount
Original issue discount is the discount from par value at the time that a municipal bond is issued by a municipality. That is, the original issue discount is the difference between the redemption price when the bond matures and the issue price that investors must pay now.
For example, a municipality might issue a $100 face value bond at $80, representing a 20% original issue discount. The municipality might do this in order to justify a lower interest rate or even issue a zero-coupon bond, although the discount itself is taxable in most cases.
Overlapping debt occurs when a single financial obligation falls into numerous different jurisdictions when it comes to taxation or other legal matters. Oftentimes, municipalities experience overlapping debt when taxpayers in each jurisdiction must pay their fair share.
For example, suppose that a municipal bond is issued to finance a new school that is located in City A but serves Cities A and B. In this case, City A is only required to pay its proportional share of the overlapping debt, with City B being responsible for the remainder of that debt.
A municipal bond’s par value is the same as its face value or value at maturity. While most bonds have a $1,000 par value, modern municipal bonds are issued in denominations of $5,000 since mutual funds rather than individuals purchase them most of the time.
For example, suppose that a 15-year municipal bond is issued with a $5,000 par value and a 3% coupon. In this case, the bondholder would receive 3% annual interest rate payments with the face value of the bond being paid back at the maturity date in 15 years.
Parity bonds are bonds that have equal rights to one another sold by the same issuer. Since municipalities back most of their bonds with tax revenues, municipal bonds are commonly considered parity bonds because the same tax base secures multiple different bonds.
For example, a city might issue a new 10-year general obligation bond each year that is backed by the full faith and credit of the municipality and its taxing abilities. In this case, the bondholders are assuming that these rights will be sufficient to cover all other parity bonds.
Premium bonds are those trading above their par value, which usually happens when they’re offering an attractive relative yield. Since investors are always seeking higher risk-adjusted returns, they are willing to pay more for a bond that offers it, even if they get less at maturity.
For example, suppose that a AAA-rated municipal bond offers an 8% coupon when U.S. Treasuries are offering just a 3% coupon. In this case, investors may be willing to pay more than the bond is worth in order to profit from the 5% per year difference in interest rates.
Price to Call
The price to call, or redemption price, refers to the price at which an issuing municipality can redeem a municipal bond. Oftentimes, these prices are set when the securities are first issued in order to inform potential investors of the added risk of a callable bond.
For example, a municipality can issue a general obligation bond with a face value of $5,000 and a price to call of $5,500. If the municipality wanted to reduce its future payment obligations, it could repurchase the outstanding bonds for $5,500.
Primary markets are those that issue new securities at an exchange, as opposed to secondary markets where they are traded by individual investors and institutions. Primary market transactions are conducted by underwriters such as investment banks.
For example, a municipality may sell its general obligation bonds to the primary market via a process known as the retail order period. Over the course of a couple of days, the bonds are sold to high-net-worth individuals and institutions that then resell them in the secondary market.
The principal of a bond is the amount that was borrowed or owed apart from the interest payments that must be made over time. The principal is also referred to as the face value or par value of the bond since it is the same as the amount borrowed in the beginning.
For example, suppose that a 10-year general obligation bond is issued with a face value of $5,000 and a 3% annual coupon. In this case, the principal would be $5,000 since the interest payments over time of 3% are not included in the calculation.
A rate covenant is a legal commitment in a revenue bond designed to specify rates to generate a specified debt service coverage. Rate covenants are commonly used to assure bondholders that the revenue bond will be repaid using the proceeds from the project.
For example, suppose that a municipality issues a revenue bond to finance a wastewater utility project. A rate covenant may be included within that revenue bond defining the rates that the utility will charge consumers in order to cover its debt service to bondholders.
A redemption is a return of a bondholder’s principal investment either at par value or a premium price. These redemptions can occur either when a bond matures or when the bond is cancelled prematurely by an issuer.
For example, suppose that a municipality issues a 10-year general obligation bond that an investor purchases at the time of issue. After five years, the municipality may redeem the bonds and return the principal to the investor if it is permitted in the contract.
Repurchase agreements, or repos, are short-term borrowing agreements for dealers in government securities. Dealers looking to raise short-term capital may sell municipal bonds on an overnight basis and agree to repurchase them the following day.
For example, suppose that a municipal bond issuer has an immediate need for cash. The issuer may enter into a repo agreement, pledging the bond as collateral for cash received, and later repurchase the bond in order to balance out its position.
The secondary market is the trading market for outstanding bonds and notes. Traders buy and sell within this market for their own inventory as opposed to the primary market where institutional investors purchase securities directly from the issuer.
For example, a typical municipal bond issuer will sell bonds to a primary market consisting of large banks and other institutional investors. These institutions will in turn sell these bonds into the secondary market where individuals can buy and sell them in smaller increments.
Sinking Fund Schedule
A sinking fund schedule is a schedule of payments that is required by a general obligation bond to be placed each year into a special fund called a sinking fund. This fund can be used for retiring a specified portion of term bond issues prior to their maturity.
For example, a municipality may issue a 10-year general obligation bond that calls for $1 million per year to be placed into a sinking fund via a sinking fund schedule. After the first five years, the municipality may opt to use the $5 million to redeem some of the bonds early.
Swapping occurs when one bond is exchanged for another bond. Often, investors do this to realize losses on a bond just before the end of the year. The benefit is that tax write-offs can then be used to minimize the amount owed on the current year’s taxes.
For example, suppose that a municipal bondholder owns a $1,000 Michigan GO bond that is trading at a 10% loss. By selling the bond and swapping it for another $1,000 Michigan GO bond, the investor can realize the loss in the current tax year without modifying his or her exposure.
The tax base is the collective of citizens and resources that can be taxed. Tax bases are important for municipalities because a larger tax base provides greater income potential. Larger tax bases can also increase the amount of debt service that a municipality can support.
For example, a municipality with a $10 billion tax base would likely have to pay a higher interest rate on $100 million in debt compared to a municipality with a $50 billion tax base. The latter may be a larger city or state with more citizens, houses and other taxable resources.
The taxable-equivalent yield is the yield that a bondholder would need on a taxable corporate or government bond to match the same after-tax yield that a municipal bond offers. Taxable equivalent yields are commonly used as a means of comparison between bonds.
For example, suppose that a municipal bond yields 5% and a corporate bond yields 6%. While the corporate bond technically pays more, the municipal bond’s taxable equivalent yield may actually be 7% when factoring in the tax savings that it enables, making it a better deal.
Technical defaults occur when an issuer fails to meet the requirements of a bond covenant other than making payments. Often, these defaults do not lead to a loss for the bondholder and can be remedied with policy changes, such as authorizing more funding.
For example, a municipality’s revenue bond covenant may require keeping up building maintenance. A failure to meet code would result in a technical default, even if the municipality was making regular payments to bondholders.
Thin markets are those with relatively few buyers or sellers. With few transactions taking place, thin markets are characterized by high volatility, lower liquidity, and greater risk. The spread between bid and ask prices is also higher in thin markets.
For example, suppose that a municipality has only issued a couple of bonds throughout its history and is relatively obscure to investors. Since there are few buyers and sellers, there is likely to be a thin market for these bonds.
A tombstone is a written advertisement placed by investment bankers when publicly offering a security for sale. Tombstones provide investors with basic details regarding the offering and the various underwriting groups involved with the deal.
For example, a new municipal bond issue will have a tombstone written advertising the new security. The black and white advertisement provides would-be investors with basic details such as the offering price, total offering value, and usually a reference to the full prospectus.
A trustee is a financial institution that serves as the custodian of funds and official representative of bondholders. Trustees are appointed to ensure that municipalities comply with the bond covenants and represent bondholders to enforce their contracts.
For example, a municipality that breaks a covenant and enters into a technical default will negotiate with a trustee to remedy any problems. The bondholders themselves are spared from having to appear in person or in court by the trustee.
Underlying debt is a term that encompasses the general obligation bonds of smaller units of local government with a larger issuer’s jurisdiction. There is an understanding that the debt of these smaller governments might also be backed by the larger government’s creditworthiness.
For example, a municipality may issue a general obligation bond to finance a new school in one of its school districts. If the school district becomes insolvent, it is unlikely that the larger municipal government will allow it to cease operations; it would likely be bailed out.
An underwriter agrees to purchase a municipality’s unsold bonds at a set price, thereby guaranteeing proceeds from the sale and a fixed borrowing cost. These underwriters participate in primary market transactions and sell into the secondary market.
For example, a municipality will work closely with an underwriter to determine the offering price of a security and then purchase them from the issuer in the primary market. The underwriter will then sell the securities into the secondary market via its distribution network.
A yield curve is a graph that shows the relationship between yields and the maturity dates for various bonds with the same default risk. The shape of a yield curve provides insights into future interest rate changes and economic activity.
For example, an inverted yield curve means that short-term yields are higher than long-term yields. This type of yield curve usually precedes recessions since bondholders are skeptical about long-term yields and predict lower interest rates.
The yield-to-call is the yield of a bond assuming that the bondholder were to buy and hold the security until the call date. The calculation is based on the coupon rate, length of time, and market price, and is only valid for bonds called prior to their maturity.
For example, suppose that a municipality issues a callable 10-year $1,000 par value general obligation bond with a call price of $1,500 that can be exercised after five years. The yield-to-call would provide an investor with the return they would receive if it were called after five years.
The yield-to-maturity is the yield of a bond assuming that the bondholder were to buy and hold the security until the maturity date. The calculation is based on the interest rate, length of time, and price paid, and assumes coupons could be reinvested at the same yield.
For example, suppose that a municipality issues a non-callable 10-year $1,000 par value general obligation bond that pays 3% per year. The yield-to-maturity would tell an investor what he or she would earn if the bond was purchased at the current market price and held until maturity.