Municipal Securities: Analysis
Consider the fundamental difference between lending money to a municipal government based on its absolute sovereign power to tax its citizens, versus lending money to that same government to build a toll bridge where your repayment relies entirely on how many cars cross it. This is the dichotomy at the heart of municipal finance. When you assess a municipality's credit, you are either analyzing a sovereign entity's ability to extract wealth from its constituents, or you are acting as a venture capitalist evaluating the economic viability of a standalone business enterprise.
For the general securities representative, understanding the mechanics of municipal bonds goes far beyond memorizing definitions. It is about understanding the physics of local government funding, the legal strictures that protect bondholders, and the nuanced language of a highly fragmented secondary market.
The municipal bond market consists of roughly one million unique securities. Because of this vast fragmentation, municipal bonds do not trade on centralized, highly liquid exchanges like equities. They trade over-the-counter through a network of dealers, requiring a very specific vocabulary for price discovery.
Most fixed-income securities are quoted by price. However, municipal bonds are typically quoted on a yield-to-maturity basis.
A yield-to-maturity quote for a municipal bond is called a basis quote. If a dealer quotes a bond at "4.25," they are offering the bond at a price that guarantees a 4.25% yield to maturity.
There is a notable exception. Some municipal revenue bonds are quoted as a percentage of par value. Because these are quoted in dollar price terms (e.g., "98" meaning 98% of a $1,000 par, or $980), municipal bonds quoted as a percentage of par are called dollar bonds.
When you look at a quote screen or call a dealer, you must understand the degree of commitment behind the number you are given. The liquidity risk in this market has created several distinct tiers of dealer quotation:
- Firm Quote: A firm quote is an actual price at which a municipal dealer is committed to buy or sell the security. It is a legally binding offer.
- Subject Quote: A subject quote requires further confirmation from the dealer before becoming a binding trade. Because market conditions can shift rapidly and dealers may be querying their own networks, most municipal bond quotes distributed in the secondary market are subject quotes.
- Workable Indication: If you are trying to value a client's portfolio but aren't looking to execute an immediate trade, you might ask for a workable. A workable indication is a non-binding estimate representing a likely price at which a dealer will execute a trade.
- Nominal Quote: A nominal quote is provided for informational purposes only. A nominal quote does not represent a commitment to trade under any circumstances.
The Mechanics of the Out-Firm Quote
Often, a purchasing dealer wants to pitch a specific bond to a client but does not want to buy the bond and hold it in inventory while waiting for the client to decide. To solve this, dealers use an out-firm quote.
An out-firm quote gives a purchasing dealer the exclusive right to buy bonds at a fixed price for a specific time period. Crucially, an out-firm quote allows a dealer to secure a buyer before taking inventory risk on the bonds.
However, the offering dealer doesn't want their capital tied up indefinitely. Therefore, they often issue an out-firm quote with a recall, which allows the offering dealer to cancel the quote after giving a warning period. The warning period for a recalled out-firm quote is typically five minutes. If the offering dealer triggers the recall, the purchasing dealer has exactly five minutes to buy the bonds at the quoted price, or the exclusivity evaporates.
Before we divide the world into General Obligation and Revenue bonds, we must address a unique legal classification of investment products. Certain investment vehicles structurally resemble mutual funds but are issued by state or local governments.
Section 529 savings plans are legally classified as municipal fund securities. Because states sponsor them, they fall under the regulatory purview of the Municipal Securities Rulemaking Board (MSRB). Similarly, Achieving a Better Life Experience (ABLE) accounts are legally classified as municipal fund securities.
Finally, municipalities themselves often need a place to park cash. Local Government Investment Pools (LGIPs) are legally classified as municipal fund securities. LGIPs provide short-term investment vehicles designed strictly for public entities, allowing local municipalities to pool their tax revenues for better yield and liquidity prior to spending.
When an investor buys a General Obligation bond, they are relying on the sheer fiscal willpower of the issuing government. General obligation bonds are backed by the full faith and credit of the issuing municipality. This means they are backed by the taxing power of the issuing municipality.
The source of those taxes depends entirely on the level of government issuing the debt:
- Local Level: General obligation bonds issued by local governments are primarily funded by ad valorem taxes. Ad valorem translates to "according to value." Therefore, ad valorem taxes are calculated based on the assessed value of real estate.
- State Level: State governments generally do not tax real estate. Instead, general obligation bonds issued by states are typically funded by income taxes and are typically funded by sales taxes.
Because a GO bond puts the taxpayers on the hook for repayment, issuing them cannot be done arbitrarily. Issuing new general obligation bonds requires voter approval. Furthermore, to prevent governments from borrowing their citizens into oblivion, statutory debt limits restrict the total amount of general obligation debt a municipality can legally issue.
Calculating the Millage Rate
When assessing local GO bonds, you must understand how property taxes are levied. The property tax rate of a local municipality is expressed in mills.
One mill equals one-tenth of one cent. Therefore, one mill equals $0.001.
If a town has a tax rate of 10 mills, they collect $0.01 for every $1.00 of assessed property value.
Analyzing a GO bond is an exercise in demographic and economic sociology. You are evaluating the health of the tax base.
Analysts look at several key indicators:
- Demographics: Analysts assess population trends to evaluate the economic health of a general obligation bond issuer. A growing population means a growing tax base; a shrinking population leaves a heavier debt burden on the remaining citizens.
- Tax Efficiency: Just because a city levies a tax doesn't mean citizens pay it. The collection ratio compares the property taxes actually collected by a municipality to the total taxes assessed. Naturally, a high collection ratio indicates a strong credit profile for a general obligation bond issuer.
- Future Burdens: You must look at off-balance-sheet pressures. Unfunded pension liabilities negatively impact the credit quality of a general obligation bond issuer, as future tax revenues will have to be diverted to pay retirees rather than bondholders.
- Economic Breadth: A diverse local tax base improves the creditworthiness of a general obligation bond issuer. A city reliant on a single factory or industry is dangerously exposed to macroeconomic shocks.
Dissecting the Debt Ratios
To truly measure a municipality's leverage, analysts calculate specific debt metrics.
First, we determine the net direct debt.
Net direct debt equals the total funded debt of a municipality minus self-supporting debt and sinking fund reserves. (Self-supporting debt refers to revenue bonds, which pay for themselves).
But a local taxpayer rarely pays taxes to just one entity. A resident might pay a city tax, a county tax, and a school district tax. This introduces the concept of coterminous debt, which is overlapping debt issued by different taxing authorities that share geographic boundaries. (Note: State governments never have overlapping debt, as they are the supreme geographic boundary).
To find the true burden on the taxpayer, we calculate net overall debt.
Net overall debt equals net direct debt plus overlapping debt.
With the total debt isolated, we apply it to two crucial ratios:
- Net Debt Per Capita: This ratio measures the total debt burden distributed across the population of the municipality. A lower net debt per capita indicates lower credit risk for a general obligation bond issuer.
- Ratio of Net Overall Debt to Assessed Property Value: This measures a municipality's debt burden against its tax base, revealing how leveraged the actual real estate within the municipality is.
If GO bonds are like lending money to a household backed by their salary, Revenue bonds are like financing a standalone business venture. Revenue bonds are backed by user fees generated by a specific facility, such as a toll road, hospital, or airport.
Because the taxpayers are not broadly responsible for the debt, revenue bonds do not require voter approval prior to issuance. For the same reason, revenue bonds are not subject to statutory municipal debt limits.
The Feasibility Study
Before a municipality breaks ground on a $500 million airport terminal, they must prove the math works. This is done via a feasibility study, which evaluates the economic viability of a proposed revenue bond project.
Because objectivity is paramount, an independent consulting engineer typically prepares the feasibility study for a revenue bond project. The study essentially does two things:
- It estimates the construction costs of a proposed revenue bond project.
- It projects the future operating revenues of a proposed revenue bond project.
Analyzing Revenue Bond Safety
When analyzing revenue bonds, demographic trends are secondary. What matters is cash flow.
The debt service coverage ratio divides a facility's net operating income by the total annual debt service.
If a toll bridge generates $10 million in net operating income and has $5 million in annual debt service, its coverage ratio is 2:1. Consequently, a higher debt service coverage ratio indicates a safer revenue bond investment.
Once a revenue facility starts generating cash, who gets paid first? The bondholders? The maintenance crew?
This is dictated by the flow of funds, which details the exact priority order for distributing facility revenues. The flow of funds is legally established in the revenue bond's trust indenture, the foundational legal contract between the issuer and the bondholder.
A critical component of this flow is Operations and maintenance (O&M) expenses, which include routine upkeep and labor costs for the revenue-generating facility. How O&M is prioritized dictates the type of pledge:
| Pledge Type | Description |
|---|---|
| Net Revenue Pledge | Under a net revenue pledge, operations and maintenance expenses are paid before debt service obligations. (Revenues - O&M = Net Revenues available for debt service). This is most common, as a facility must be maintained to keep generating revenue. |
| Gross Revenue Pledge | Under a gross revenue pledge, debt service obligations are paid before operations and maintenance expenses. The bondholders have first absolute claim on the gross dollars coming in the door. |
To further protect revenue bond investors, the trust indenture contains protective covenants, which are legally binding promises made by the issuer in the trust indenture.
These covenants act as the operational rulebook for the facility:
- Rate Covenant: Requires the issuer to maintain user fees high enough to cover all financial obligations. If revenues dip, tolls or fees must go up.
- Maintenance Covenant: Requires the issuer to keep the revenue-generating facility in good working order.
- Insurance Covenant: Requires the issuer to maintain adequate property and liability insurance on the facility.
- Books and Records Covenant: Requires the issuer to employ outside auditors to verify the facility's financial statements, ensuring transparency.
- Non-discrimination Covenant: Requires the issuer to provide equal access to the facility for all paying users (they cannot arbitrarily ban a specific commercial trucking company from a toll road, thereby suppressing revenue).
Structural and Capital Covenants
Beyond operations, the indenture outlines structural promises regarding capital:
- Sinking Fund Covenant: Requires the issuer to set aside money periodically to retire bonds before maturity, steadily reducing systemic risk.
- Catastrophe Call Covenant: Requires the issuer to retire bonds early if the facility is completely destroyed (usually paid for by the aforementioned Insurance Covenant).
Crucially, you must understand how the indenture treats future borrowing. An additional bonds test dictates the financial conditions an issuer must meet to issue more bonds backed by the same revenues.
- Open-End Indenture: An open-end indenture allows the issuance of additional parity bonds (new bonds with an equal claim on revenues as the old bonds). However, to protect existing bondholders, an open-end indenture requires the issuer to satisfy an earnings test before issuing parity bonds, proving the facility generates enough cash to support the heavier debt load.
- Closed-End Indenture: Conversely, a closed-end indenture prohibits the issuance of additional parity bonds backed by the same revenue stream. Any future bonds issued must be subordinated (junior) to the existing issue.
Finally, you will encounter variations of municipal debt that blend these concepts:
- Industrial Development Revenue Bonds (IDRs): A municipality builds a facility and leases it to a private corporation to spur local job growth. Therefore, industrial development revenue bonds are backed by lease payments from a private corporation. Because the municipality is merely a conduit, the credit rating of an industrial development revenue bond is based entirely on the creditworthiness of the leasing corporation.
- Special Tax Bonds: Special tax bonds are backed by taxes placed on specific items like tobacco or alcohol (excise taxes), rather than broad ad valorem taxes.
- Special Assessment Bonds: When a municipality installs new sidewalks or streetlights in a specific neighborhood, they issue these. Special assessment bonds are backed by taxes charged only to the properties directly benefiting from an infrastructure improvement.
- Moral Obligation Bonds: If a revenue bond project fails and faces default, a state might step in to save its reputation in the credit markets. Moral obligation bonds allow a state legislature to appropriate funds to prevent a municipal default. However, this is merely an option, not a guarantee. As a registered representative, you must warn clients that a state legislature is not legally required to appropriate funds for a moral obligation bond.
