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124 Cards in this Set

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An investor is in the 28% tax bracket. Which of the following investments would afford him the best after-tax yield?
a. A 5% municipal bond
b. A 5 3/4% corporate bond
c. A 6 1/2% yankee bond
d. A 6 3/4% convertible bond
A
The 5% municipal bond would offer the best after-tax yield because the interest income is completely free from federal income taxes. The other investments are types of corporate debt subject to federal income taxes and 28% of the income received would be taxable. The taxable equivalent yield of the 5% municipal bond is 6.94%. This is calculated by dividing the 5% municipal yield by the complement of the tax bracket which is 72%. The result is greater than the other choices. (8-26)
All of the following may be used to pay the debt service on general obligation bonds EXCEPT:
a. Income taxes
b. Property taxes
c. Licensing fees and traffic fines
d. Tolls collected at a tunnel located in the municipality
D
A general obligation (GO) bond is backed by the full faith and credit of the municipality. Items that may be used to pay the debt service on GO bonds include fines, sales taxes, property taxes, income taxes, and licensing fees. Items such as tolls, concessions, and lease rental payments would be used to back a revenue bond. (8-2, 8-10)
All of the following may be used to pay the debt service on general obligation bonds EXCEPT:
a. Income taxes
b. Property taxes
c. Licensing fees and traffic fines
d. Tolls collected at a tunnel located in the municipality
D
A general obligation (GO) bond is backed by the full faith and credit of the municipality. Items that may be used to pay the debt service on GO bonds include fines, sales taxes, property taxes, income taxes, and licensing fees. Items such as tolls, concessions, and lease rental payments would be used to back a revenue bond. (8-2, 8-10)
Accrued interest for municipal bonds is computed on:
a. A 30-day month and a 360-day year
b. A 30-day month and a 365-day year
c. Actual days elapsed and a 360-day year
d. Actual days elapsed and a 365-day year
A
Accrued interest for municipal bonds is computed in the same manner as for corporate bonds which is based on a 30-day month and a 360-day year. Accrued interest for U.S. government bonds is figured on a 365-day year counting actual days elapsed. Accrued interest on all bonds is calculated from the last interest payment, up to but not including settlement date. (8-24)
An ad valorem tax is based upon:
a. Property values
b. Population growth
c. Family income
d. Debt per capita
A
An ad valorem tax is based upon property values. The tax is based on the assessed value of the property and the millage rate (tax rate). It may also be referred to as a real estate or property tax. (8-2)
When computing "coverage" for revenue bonds, the ratio used is:
a. Net revenue to debt service
b. Gross revenue to operating expenses
c. Gross revenue to annual interest payments
d. Net revenue to operating expenses
A
The term "coverage" is used when discussing revenue bonds. It is an indication of the number of times by which the earnings generated over a period of time will exceed the debt service for a period of time. The debt service is the required payments for interest and retirement of principal. The coverage is computed by comparing the ratio of net revenue (gross revenue minus operating and maintenance expense) to debt service. (8-12)
COVERAGE (S7) : The number of times income will meet (or exceed) fixed charges.
(1) Municipal bonds: Net revenues divided by annual debt service.
(2) Corporate interest coverage: Earnings Before Interest and Taxes (EBIT) divided by interest expense.
(3) Preferred dividend coverage: Net Income divided by preferred dividends.
DEBT SERVICE (S7) : The yearly amount of interest and principal payable on a bond issue.
An investor in the 35% tax bracket can buy a 5.10% tax-free municipal bond at par. What yield would the investor need in a taxable corporate bond to receive the same after-tax yield in the municipal bond?
a. 6.90%
b. 7.85%
c. 8.80%
d. 10.22%
B
If an investor in a particular tax bracket would like to compare the benefit of tax-free interest income to after-tax income of a corporate bond, it is necessary to find the equivalent taxable yield. The formula is:
Municipal Bond Yield / 100% - investor's tax bracket = Equivalent Taxable Yield
The customer is in the 35% tax bracket. The municipal bond has a 5.10% coupon rate and since it is purchased at par, the yield is also 5.10%.
5.10% (municipal bond yield) / 65% (100% - 35%)= 7.85% Equivalent Taxable Yield
(8-26)
A revenue bond is backed by a pledge of net revenues. This indicates that:
a. All revenues are pledged to pay debt service on the bonds
b. Net revenues are pledged to pay operating and maintenance expenses
c. The first use of net revenues is to pay the debt service on the bonds
d. The issuer guarantees that net revenues from the facility will be sufficient to pay debt service on the bonds
B
The flow of funds for a municipal net revenue issue requires that operation and maintenance expenses are paid first from gross revenues. Gross revenues minus operating and maintenance expenses leaves net revenues. Debt service (also called bond service) would then be the first item paid from net revenues. (8-12)
Accrued interest on new municipal bonds is calculated from the:
a. Purchase date
b. Settlement date
c. Dated date
d. Last interest payment
C
Interest on new municipal bonds is calculated from the dated date, which is the date from which interest starts to accrue on a municipal bond. (8-25)
An analysis of the quality of a general obligation bond to be issued would include all of the following EXCEPT:
a. The tax base of the community
b. The economic character of the community
c. The dollar denominations of the bonds to be issued
d. The makeup of the population of the community
C
An analysis of the quality of a general obligation bond to be issued would include all of the following except the dollar denominations of the bonds to be issued. (8-2)
All of the following would affect an outstanding airport revenue bond EXCEPT:
a. Tourism
b. Debt per capita
c. Airport traffic
d. Energy costs
B
Debt per capita is used when analyzing a general obligation bond and would not be considered for a revenue issue. (8-12, 8-3)
A level debt service bond issue is one in which:
a. Combined annual interest and principal payments are equal
b. Annual interest payments are equal
c. Annual principal payments are equal
d. All principal is paid at the issue's final maturity
A
A level debt service bond issue is one in which combined annual interest and principal payments are equal. (8-2)
LEVEL DEBT SERVICE (S7) : Yearly interest and principal payments which remain relatively constant for the life of the bond issue.
The interest paid on special assessment bonds is derived from:
a. Ad valorem taxes
b. Toll road revenues
c. Charges on the benefitted property
d. Excise taxes
C
The interest paid by the issuer to holders of special assessment bonds are derived from charges made to the users of the benefitted property. These bonds are issued to finance the construction of water and sewer systems, sidewalks, and streets. (8-11)
A municipal bond pays interest on February 1st and August 1st. How many days of accrued interest will the buyer pay the seller if the bond is purchased on Wednesday, May 31st?
a. 96 days
b. 120 days
c. 124 days
d. 125 days
C
The trade date is Wednesday, May 31st. The bond pays interest on February 1st and August 1st. Accrued interest is calculated from the last interest payment date, up to but not including the settlement date. The settlement date is Monday, June 5th. The following calculation illustrates the answer:
February 30 days
March 30 days
April 30 days
May 30 days
June 4 days
Total 124 days
(8-24)
In most cases, municipal bond investors may obtain which TWO of the following?
I. Reduced interest rate risk by investing in issues with different maturities
II. Federal tax exemption by investing in private activity bonds
III. State and local tax exemption by investing in bonds in their state of residency
IV. Reduced risk of default by investing in bonds in their state of residency
a. I and III
b. I and IV
c. II and III
d. II and IV
A
Municipal bond investors can obtain reduced interest rate risk by investing in issues with different maturities. Bonds with short-term maturities will only experience a small decline in price if the general level of interest rates increase. Although most municipal bonds are exempt from federal income tax, they are not exempt from state income tax unless the owner is a resident of the state that issued the bonds, and the state elects not to tax the purchaser of the bond. The interest on municipal private activity bonds would be subject to federal income tax if the investor is subject to the alternative minimum tax (AMT). The risk of default would not be reduced by investing in bonds in the investor's state of residency. (8-1)
All of the following are of importance with regard to the debt structure when analyzing a municipal bond EXCEPT:
a. Total bonded debt
b. Total direct debt
c. Overlapping debt
d. Matured debt
D
Matured debt is debt of the municipality that is no longer outstanding and therefore is not included in analyzing the debt structure of a municipal bond. Total bonded debt is all of the general obligation debt issued by a municipality, regardless of the purpose. Total direct debt is the sum of the total debt and any unfunded debt (i.e., short-term notes) of a municipality. Overlapping debt is that portion of the debt of other government units for which residents of a particular municipality are responsible, such as services or facilities shared by several municipalities. (8-4)
To determine what would happen to the coverage of revenue bonds when more bonds are to be issued in the future, one should examine:
a. The rate covenants of the bond
b. Feasibility studies
c. The refunding procedure of the bond
d. The additional bonds test
D
The additional bonds test sets a minimum level of coverage of debt service for interest and principal for all outstanding bonds and for future debt. The additional bonds test protects original bondholders against the dilution of the debt service coverage. Rate covenants insure that rates will increase in line with costs to insure proper revenues for the maintenance of the facility or project and payment of the debt service. Feasibility studies are conducted to insure the proper need of the project being developed. Refunding is used to lower interest expense on bonds through the issuance of new bonds at lower coupon rates. The proceeds of the new bond sale would be used to repurchase the already outstanding high coupon bonds. (8-13, 6-1)
ADDITIONAL BONDS TEST (S7) : A requirement that before additional bonds, which will be secured by assets or revenues already pledged to existing bonds, can be issued, that specific financial requirements must be met. Generally, the main requirement is that debt service coverage for the original and new bonds must be at a specific level. See also: Open-end Indenture.
When considering the credit strength of a municipal issuer, one should include in the analysis:
I. The condition of the local economy
II. The current financial status of the municipality
III. Money supply figures
IV. The general capability of the fiscal officers of the municipality
a. I and II only
b. I, II, and III only
c. I, II, and IV only
d. I, II, III, and IV
C
The state of the local economy is an important factor in determining a municipality's worthiness. For example, communities at different stages of growth may require more or less debt and this must be understood in the analysis. The current financial status is also important to determine the credit strength of a municipality. The management capability of the fiscal officers is also important to insure they are able to implement the plans of the municipality. Money supply figures which are published by the Federal Reserve Board are irrelevant with regard to the credit strength of a municipality. (8-2)
An individual in the 28% tax bracket can purchase an 8 1/2% municipal bond at par. What taxable yield would be required to equal the yield on the municipal bond?
a. 3.0%
b. 8.5%
c. 11.8%
d. 20.2%
C
The taxable equivalent yield of a municipal bond equals the municipal yield divided by the complement of the tax bracket (100% minus the tax bracket). In this example, the municipal yield (8 1/2%) divided by the complement of the tax bracket (72% or 0.72) equals 11.8%. (8-26)
Which of the following would not be available to pay interest on a revenue bond issue?
a. Special taxes
b. Lease payments
c. Ad valorem taxes
d. Capitalized interest
C
Ad valorem (property) taxes secure a general obligation bond, not a revenue bond. (8-2)
REVENUE BOND (S7) : A bond issue that is secured by a pledge of the revenues of a specific project.
A municipal bond is currently trading at 92 and is callable in 10 years at par. What would be the effective yield that must be disclosed on a customer's confirmation?
a. Yield to call
b. Yield to maturity
c. Fixed yield
d. Current yield
B
The MSRB regulates the effective yield that must be disclosed on a client's confirmation. The effective yield on a bond trading at a discount is the yield to maturity. (8-24)
A new municipal bond issue is dated January 1st and pays interest each April 1st and Oct. 1st. An investor purchased bonds from the issuer with a Thursday, January 31st settlement date. How many days of accrued interest did the investor owe?
a. 29
b. 30
c. 33
d. 34
B
Accrued interest on a new municipal issue is calculated from the dated date up to but not including settlement date. Since the investor's settlement date was January 31st, he owes from the 1st to the 30th of January (30 days). (8-24)
A double-barreled security is a municipal security that:
a. Is exempt from federal and state taxes
b. Is exempt from state and local taxes
c. Can be paid from the revenues of a project and is a general obligation of the U.S. government
d. Can be paid from the revenues of a project and is a general obligation of a municipal government
D
A double-barreled security is a municipal security that can be paid from the revenues of a project and is also a general obligation of a municipal government. (8-11)
Industrial Development Revenue Bonds are backed by:
a. The local municipal district in which the facility is domiciled
b. The state in which the facility is domiciled
c. The corporate guarantor
d. Both the corporate guarantor and municipality
C
The corporation that uses the facility that was built by the industrial development revenue bond becomes the party that is backing the bonds. The credit rating of these bonds is dependent upon that corporation, not on the municipality issuing the bonds. (8-10)
A corporate bond has a 12% nominal yield. To be equivalent, an investor in the 28% tax bracket would need a municipal bond with a yield of:
a. 7.9%
b. 8.6%
c. 9.4%
d. 10.2%
B
To determine the net yield of a taxable bond, multiply the yield times the complement of the tax bracket. The net yield would be 8.6% (12% yield times 72%, which is the complement of the tax bracket). (8-26)
The three bonds listed have the same maturity. Place them in their order of yield, from highest to lowest.
I. Treasury bond
II. Aaa utility bond
III. Aaa municipal bond
a. I, II, and III
b. II, I, and III
c. II, III, and I
d. III, I, and II
B
The municipal bond will typically have the lowest yield since it is exempt from federal income tax. The utility bond (a corporate bond) is of lower quality than the Treasury bond (a U.S. government obligation) and will therefore have a higher yield. (8-1, 6-15, 7-8)
A municipal bond issue is called due to an event beyond the control of the issuer which affects the use of property (i.e., earthquakes, hurricanes, condemnation of property). This is known as:
a. A catastrophe call
b. Defeasance
c. Advance refunding
d. A market out clause
A
A catastrophe call allows an issuer to call an entire issue in situations which are beyond its control, such as condemnation. (8-13)
Which of the following insure municipal bonds?
I. AMBAC
II. SIPC
III. MBIAC
IV. FDIC
a. I and III only
b. I and IV only
c. II and III only
d. II and IV only
A
The Municipal bond Investors Assurance Corporation (MBIAC) and AMBAC Indemnity Corporation (AMBAC) are two insurance companies that insure new municipal issues. The insurance policy guarantees that should the issuer fail to pay interest or principal, the insurance company will meet all interest and principal payments when due. S&P and Moody's typically assign a higher rating to any insured issue. Another insurer is Financial Guarantee Insurance Company (FGIC). (8-20)
A municipality borrowing for a short-term period to finance a capital project would issue:
a. Commercial paper
b. Tax anticipation notes
c. Debentures
d. Bond anticipation notes
D
A municipality borrowing for a short-term period to finance a capital project would issue bond anticipation notes . Commercial paper is primarily issued by corporations and some municipalities to raise short-term funds for working capital, but not to finance capital projects. Tax anticipation notes are used to meet operational expenditures. (8-18)
BOND ANTICIPATION NOTE (BAN) (S7) : A short-term security issued by a municipality. Payment of the note at maturity will be accomplished with the proceeds of a bond issue.
A customer purchases a municipal bond for settlement on Tuesday, October 10th. The bond pays interest on January 15th and July 15th. The number of days of accrued interest the buyer owes to the seller is:
a. 85 days
b. 86 days
c. 88 days
d. 90 days
A
Interest is figured from the last interest payment date, July 15th, up to but not including the settlement date (which is given as October 10th). Therefore, accrued interest is figured up to and including October 9th.
The customer buying the bonds would have to pay accrued interest for 85 days. Corporate and municipal bond interest is computed on the basis of a 30-day month and a 360-day year. If interest is paid on the first of the month, there will be 30 days of accrued interest to calculate. If interest is paid on the fifteenth of the month, there will be 16 days of accrued interest to calculate for that particular month.
July 16 days
August 30 days
September 30 days
October 9 days
TOTAL DAYS 85 days
(8-24)
All of the following are TRUE regarding the computation of accrued interest payments on municipal bonds EXCEPT:
a. Interest is computed using a 30-day month and a 360-day year
b. Regular way settlement is three business days
c. Interest is computed using actual days that have transpired and a 365-day year
d. Interest is figured up to but not including the settlement date
C
All of the choices given are true except interest is computed using actual days that have transpired and a 365-day year. This is used when computing accrued interest for government bonds. (8-24)
Property in Boca Raton, Florida is assessed at 10 million dollars. If the millage rate is 7, what is the property tax?
a. $70
b. $700
c. $7,000
d. $70,000
D
A mill (.001) is $1 per $1,000 of assessed value. Multiply .007 times $10,000,000. This will equal a property tax of $70,000. (8-2)
Which of the following sources of income are used by a municipality to meet its debt service for general obligation bonds that it has issued?
I. License fees
II. Uncollected taxes
III. Fines
IV. Property taxes
a. I and II only
b. II and IV only
c. I, II, and III only
d. I, II, III, and IV
D
General obligation bonds are backed by the full faith, credit, and taxing power of the municipality that issues the bonds. The income to pay debt service on these bonds is derived from taxes and other general revenues. These include license fees, uncollected taxes, fines, property taxes, income taxes, sales taxes, and school taxes. (8-2)
All of the following are short-term municipal notes EXCEPT a(n):
a. RAN
b. TAN
c. BAN
d. AON
D
All of the choices given are the symbols for short-term municipal notes except AON, which is the symbol for an all-or-none order. RAN is the symbol for a revenue anticipation note, BAN is the symbol for a bond anticipation note, and TAN is the symbol for a tax anticipation note. (8-18)
The taxing power of an issuer of a limited tax bond is limited to a specified:
a. Minimum rate
b. Maximum rate
c. Tax source
d. Collateral
B
The taxing power of an issuer of a limited tax bond is limited to a specified maximum rate. A special tax bond is a type of revenue bond backed by a specific tax source, such as a gasoline tax. (8-2)
If general obligation bonds are to be analyzed, the credit analysis would be affected by which of the following factors?
I. Feasibility studies
II. The tax collection record of the municipality
III. Debt Service Coverage Ratio
IV. Evaluation of the debt to real estate values in the municipality
a. I and II
b. I and III
c. II and III
d. II and IV
D
The tax collection record and the debt to real estate value ratios are two factors that would be considered when analyzing general obligation bonds. The tax collection record informs the analyst of the tax bases being used by the municipality as a comparison of prior years tax bases and against other municipalities. The debt to real estate value ratios help the analyst study the relationship of debt to real estate valuation of the municipality and the municipality's ability to meet its debt compared with the real estate wealth of the municipality. Choices I and III apply to revenue bonds and would not be considered when analyzing general obligation bonds. (8-4)
The dated date of a municipal bond is January 1, 2010. The first coupon date is August 1, 2010. The first coupon will represent how many months of interest?
a. 5 months
b. 6 months
c. 7 months
d. Cannot be determined
C
The first coupon will be paid in 7 months. This is known as an odd (in this case, long) first coupon payment. The interest will begin to accrue from the dated date but will be paid on the first coupon date. (8-25)
If an investor was primarily interested in safety of principal, which of the following would you least likely recommend?
a. State GO Bond
b. GNMA Security
c. Railroad Equipment Trust Bond
d. Industrial Development Revenue Bond
D
Industrial Development Revenue bonds are secured by a lease agreement with a corporation and are only as secure as the corporation. State GOs are generally of high quality and GNMA is secured by the U.S. government. The holder of an Equipment Trust bond has a lien on the equipment that secures the issue. (8-10)
A woman will be retiring in 2030. She is interested in income and having her principal available at retirement. Which of the following municipal bonds would you recommend?
a. Aaa rated GO maturing in 2025
b. Aaa rated GO maturing in 2034 which is callable in 2023 at 105
c. PHA maturing in 2030
d. Ba rated revenue bond maturing in 2024
C
Since the woman wants her principal available at retirement, a bondmaturing in 2030 (the year of her retirement) would be the best choice. PHA (Public Housing Authority) bonds are secured by the U.S. government and are of the highest quality. (8-11)
An increase in personal income tax rates would MOST likely result in an increased demand for:
a. Municipal securities
b. AAA-rated-corporate bonds
c. Mortgage-backed securities
d. Treasury bonds
A
An increase in personal income taxes would result in more investor demand for municipal bonds. This is because the interest income is exempt from federal income taxes. (8-25)
A Water & Sewer revenue project has $15,000,000 in total revenues. The operating and maintenance expenses are $9,000,000, bond interest is $2,000,000, and principal repayment is $1,000,000. How much is available for debt service?
a. $3,000,000
b. $6,000,000
c. $9,000,000
d. $15,000,000
B
Revenue issues are referred to as being net revenue issues since expenses are deducted from income prior to paying debt service. (The one exception to this are hospital revenue issues which are gross revenue issues). The amount available to pay debt service (interest and principal due) is $6,000,000 ($15,000,000 gross income minus $9,000,000 operating and maintenance expenses).
If the question had asked for the coverage or debt service ratio, you would compare the amount available, $6,000,000, to the debt service of $3,000,000 ($2,000,000 interest + $1,000,000 principal). The coverage would have been 2:1. (8-12)
Which of the following would NOT indicate a deteriorating credit situation for a municipality?
a. An increase in municipal assessed valuations
b. An increase in per-capita debt
c. An increase in tax delinquencies
d. An increase in personal bankruptcies
A
All of the items listed would be indications of a deteriorating credit situation except an increase in municipal assessed valuations. This indicates that property values have increased, thereby generating a higher tax base. (8-2)
On a municipal revenue issue, money put aside for the betterment and improvement of the facility would be placed in the:
a. Sinking fund
b. Renewal and replacement fund
c. Operating and maintenance fund
d. Debt service fund
B
The renewal and replacement fund holds monies put aside for the improvement of the facility. (8-13)
All of the following statements about municipal revenue bonds are trueEXCEPT:
a. There is no debt limitation set by the issuing municipality
b. The maturity of the revenue bond usually coincides with the useful life of the facility being built
c. They can be issued by states, political subdivisions, interstate authorities, and intrastate authorities
d. The interest and principal are paid from the revenue received from the facility
B
Municipal revenue bonds do not have maturity schedules that coincide with the usefulness of the facility being built. They mature prior to the useful life of the facility. Municipal revenue bonds do not have debt limitations as do general obligation bonds. A debt limitation is the statutory or constitutional maximum debt that an issuer can legally incur. Revenue bonds can be issued by states, political subdivisions (such as counties or townships), interstate authorities and intrastate authorities. The interest and principal are paid from the revenue received from the facility. (8-10)
Tax-free municipal bonds would be least attractive to a(n):
a. Pension fund
b. Insurance company
c. Individual who has just inherited $1,000,000
d. Officer of a corporation who is in the 28% tax bracket
A
A pension fund does not pay tax on its investments. Therefore, it would not find municipal bonds as attractive an investment as it would other higher yielding investment instruments. (8-25)
The federal tax exemption of municipal bonds was established by:
a. The Internal Revenue Service
b. The U.S. Treasury Department
c. An Act of Congress
d. Supreme Court decisions
D
The federal tax exemption of municipal bonds was established by Supreme Court decisions. The decisions stated that a state government could not tax the federal government and the federal government could not tax a state government. (8-1)
All of the following would be found in a municipal revenue bond resolution EXCEPT:
a. Restrictions on the sale of additional bonds
b. Rate covenants
c. Sinking fund provisions
d. The yields-to-maturity of the bonds
D
The indenture or resolution is basically the contract between the issuer and the bondholder. It will specify the rights of the bondholders and the provisions to protect the bondholders' interest. One of the provisions included is a rate covenant in which the issuer pledges to charge rates that are sufficient to cover expenses and debt service. An additional bonds test is included which sets requirements that must be met before additional bonds could be issued. The method of funding and the operation of the sinking fund (used to retire some bonds prior to maturity) would also be included. Another important provision is flow of funds which states how the income generated by the project will be utilized. (8-12)
The debt of other districts which the residents of a particular municipal district may be responsible for is called:
a. Funded debt
b. Floating debt
c. Overlapping debt
d. Unsecured debt
C
The debt of other districts which the residents of a particular municipal district may be responsible for is called overlapping debt. (8-4)
The number of times the earnings of a municipal facility exceeds the interest charges and principal payments of a revenue bond for a period of time is called the:
a. Working capital ratio
b. Dividend payout ratio
c. Debt service coverage ratio
d. Price-earnings ratio
C
The number of times the earnings of a revenue bond of a municipal facility exceeds the interest charges and principal payments (debt service) for a period of time is called the debt service coverage. (8-12)
All of the following issue securities which are exempt from state and local taxes EXCEPT the:
a. U.S. Government
b. Federal Home Loan Bank
c. Commonwealth of Puerto Rico
d. State of Hawaii
D
The securities of the State of Hawaii are not exempt from state and local taxes unless the investor is a resident of Hawaii. All of the others listed are exempt. The interest is exempt from federal taxes because Hawaii is a state, but not exempt from state and local taxes. The securities issued by the federal government are exempt from state and local taxes. Securities issued by Puerto Rico, through a special Act of Congress, are exempt from federal, state, and local taxes (triple-tax exempt). (8-1)
When a municipality is allocating funds for a net revenue issue, the first priority will be to satisfy the:
a. Operation and maintenance of the facility
b. Debt service
c. Reserve for retirement of the bonds
d. Surplus for expansion of the facility
A
The first priority for a net revenue issue will be for the operation and maintenance of the facility. It indicates how a municipality distributes revenues received. The order will be as follows:
1. Operation and maintenance
2. Debt service
3. A reserve for retirement of bonds
4. A surplus for expansion of the facility (8-14)
A MIG rating applies to a:
a. Convertible bond
b. Pre-refunded utility bond
c. ADR
d. BAN
D
MIG (Moody's Investment Grade) ratings apply to municipal notes. A BAN (Bond Anticipation Note) is the only municipal note given. (8-18)
An investor purchased $100,000 face value of a 12% municipal bond that matures December 1, 2010. The transaction settled on August 1st. The investor owed accrued interest of:
a. $200
b. $800
c. $2,000
d. $8,000
C
The bonds purchased by the investor will generate yearly interest of $12,000 ($100,000 par multiplied by 12%). The fact that the bonds mature on December 1, 2010 signifies that interest payments are made every December 1st and June 1st. The investor would therefore owe 60 days of accrued interest (from June 1st, the last coupon, up to but not including the settlement date of August 1st). Since the yearly interest is $12,000, accrued interest would be $2,000 (60/360 x $12,000). (8-24)
Which of the following may be reasons for a revenue bond issue to be called?
I. A change in the tax status of the issuer
II. Surplus funds are available
III. Interest rates rise dramatically
IV. Destruction of the facility by fire
a. III and IV only
b. II, III, and IV only
c. I, II, and IV only
d. I, II, III, and IV
C
Destruction by fire would be included in a catastrophe call provision and permit the issue to be called. Any surplus monies may typically be used to retire a portion of outstanding bonds. If the tax status of an issuer is in doubt at the time of issuance, there is usually a provision requiring that the issue be called if the tax status of the issuer changes and the bonds become taxable. An issuer may refund an outstanding issue if interest rates are declining, not rising. (8-13, 5-17)
The State of North Carolina is offering $50,000,000 5 1/2% sewer improvement bonds.
The bonds are:
I. Exempt from the margin requirements of Regulation T
II. Exempt from the Securities Act of 1933
III. Exempt from the Trust Indenture Act of 1939
a. I only
b. I and II only
c. II and III only
d. I, II, and III
D
The bonds are municipal revenue bonds which are exempt from all federal acts and regulations except antifraud provisions. (8-1)
All of the following are TRUE concerning private activity bonds EXCEPT:
a. The interest on these bonds might not be tax-exempt for some investors
b. The interest on these bonds might be subject to the alternative minimum tax
c. The possibility that the bonds might be subject to taxation would be reflected in the yield at which the bond trades
d. These types of municipal bonds are generally GOs
D
Private activity bonds are issued to finance the construction of a facility that will be used by a private corporation. Interest earned on such bonds is often subject to the Alternative Minimum Tax (AMT).
The AMT is a second method of calculating federal income tax liability. Taxpayers must pay the larger of the AMT or the result of the regular (Form 1040) income tax calculation. In theory, this is true for all taxpayers, but in reality, the AMT is only an issue for higher income taxpayers or those with special tax preference items on their returns. When calculating the alternative minimum tax, certain items may have to be included in taxable income that normally would not be. One of these items is the interest on many private activity bonds. Therefore, a taxpayer who is subject to the AMT, may lose the tax exemption on these bonds. Since this is a disadvantage, these bonds generally trade with higher yields than regular municipal bonds to reflect that the interest received might be taxable.
Choice (D) is the correct choice because private activity bonds are generally revenue bonds, not general obligation bonds. (8-11)
PRIVATE ACTIVITY BONDS (S7) : A category of municipal bonds, where the funds will generally be used for a private enterprise. The interest may (or may not) be taxable for federal income tax purposes.
Municipal notes are used for:
a. Interim financing
b. Long-term financing
c. Taxable financing
d. Permanent financing
A
Municipal notes are used for interim (temporary) financing. (8-18)
The federal tax exemption for interest earned on an industrial revenue bond is NOT available if the:
a. Holder of the bond is a substantial user of the facility
b. Issuer does not subscribe to equal opportunity employer standards
c. Bonds are not approved by the MSRB
d. Underwriter has a control relationship with the issuer
A
If the holder of an industrial revenue bond is a substantial user of the facility, then the federal tax exemption on the interest earned would not apply. (8-10)
All of the following are types of overlapping debt EXCEPT:
a. The issuance of debt for an adjoining road district
b. The issuance of debt for an adjoining school district
c. Debt issued between two counties
d. Debt issued between two states
D
Debt issued between two states is not considered to be overlapping debt. Overlapping debt is general obligation debt of other governmental units for which residents of a particular municipality are responsible. It is the debt shared by residents of a municipality for services or facilities shared by several municipalities. Examples of overlapping debt would be for an adjoining road district or school district, or debt issued between two counties. (8-4)
An investor purchases, on Monday, June 15, for regular way settlement, $20,000 face value of 8% municipal bonds that mature on November 1, 2015.
How many days of accrued interest is the investor required to pay?
a. 17
b. 47
c. 48
d. 227
B
Since the bonds mature on Nov. 1, we know the semiannual interest payments are made on Nov. 1 and May 1. The bonds were purchased in June, so accrued interest must be calculated from the last interest payment date, May 1 up to, but not including settlement. And since the transaction would settle on June 18, we would count 17 days in June. So the total number of days of accrued interest would be 30 days for May (remember, in calculating accrued interest for municipal bonds, a 30-day month and 360-day year are used) and 17 days for June. Accrued interest of 47 days is owed to the seller. (8-24)
In reference to the previous question, what is the dollar amount of accrued interest that the investor is required to pay?
a. $75.55
b. $208.88
c. $213.33
d. $1,008.88
B
Accrued Interest Formula = (Principal x Rate x Days of Interest) / 360
= ($20,000 x 8% x 47) / 360
= $208.88
(8-25)
The most detailed financial information regarding a municipal securities issuer is found in the:
a. Official Statement
b. Prospectus
c. Notice of Sale
d. Registration statement
B
Municipal securities are exempt from the registration provisions of the SEC. Therefore, a registration statement and prospectus are not required. Municipal issuers voluntarily provide the same financial information that would be found in a prospectus. This detailed financial information is found in the Official Statement. The Notice of Sale contains information pertaining to a competitive offering of bonds such as the time, place, date of sale, and type of offering. (8-1, 10-2)
OFFICIAL STATEMENT (S7) : A disclosure document prepared for a new municipal issue by or for the issuer. It contains a complete description of the issue and financial details about the issuer. MSRB rules require that a copy of the official statement be given to each purchaser of a new issue, if one has been prepared.
A client wishes to make a purchase based on his belief that interest rates will decline over the next fifteen years. The recommendation of which of the following securities would NOT be consistent with the client's belief?
I. A 5-year noncallable bond
II. A TAN
III. Floating rate notes
IV. A 15-year bond with a 5-year put feature
a. I and IV only
b. II and III only
c. I, III, and IV only
d. II, III, and IV only
B
Since the client believes interest rates will decline, he wants to lock in a high yield for the next 15 years. A TAN is a short-term security and a floating rate note's interest rate would be adjusted downward with prevailing interest rates. Neither would lock in the high return. The 5-year noncallable bond would lock in a high return without the possibility of being redeemed prior to maturity. The 15-year bond locks in the high return and the 5-year put feature permits the investor to redeem the bond after 5 years or keep it to maturity. This decision would depend on the prevailing rates in 5 years. (8-18, 5-18, 8-20)
An investor purchases a municipal bond on Monday, June 6th. The bond's interest payment dates are November 1st and May 1st. The buyer will have to pay the seller of the bond the purchase price plus accrued interest for:
a. 35 days
b. 36 days
c. 38 days
d. 39 days
Accrued interest is calculated from the last interest payment date (May 1st) up to but not including the settlement date. The purchase was made Monday, June 6th. The settlement date is three business days later which would be Thursday, June 9th. Accrued interest is calculated up to but not including the settlement date, which would be from May 1st to June 8th. This would equal 38 days as follows.
May 1st to May 30th 30 days
June 1st to June 8th 8 days
Total 38 days
Municipal and corporate bond interest is computed on a 30-day month and a 360-day year. If the interest payment date is on the 15th of the month, the first month will have 16 days because the 15th of the month is counted. If the interest payment date is on the 1st, the first month will have 30 days. (8-24)
If the federal tax exemption for municipal bond interest were eliminated, one would expect yields on newly issued municipal bonds to:
a. Increase
b. Decrease
c. Remain the same
d. Decrease temporarily but remain stable over a period of time
A
If the tax exempt status was eliminated, yields on newly issued municipal bonds would have to increase to compete with the higher yields of non-tax exempt bonds. (8-25)
Treasury arbitrage restrictions generally prohibit issuers of municipal securities from:
a. Selling municipal securities with coupon rates that are lower than treasury securities
b. Selling municipal securities with coupon rates that are higher than treasury securities
c. Investing bond proceeds into higher yielding treasury securities
d. Investing bond proceeds into lower yielding treasury securities
C
Due to the tax exemption allowed on municipal bond interest, municipalities are normally able to issue bonds with coupon rates below those of treasury securities. This presents an excellent arbitrage opportunity. A municipality can borrow at a low rate of interest and invest the money into higher yielding "risk free" treasury securities. Congress has enacted laws, known as Treasury Arbitrage Restrictions, that prevent state and local governments from misusing the tax exemption. (8-1)
All of the following are true of revenue bonds EXCEPT:
a. Revenue bonds can be issued without voter approval
b. Revenue bonds can be issued even though local debt limits have been reached
c. Revenue bonds usually pay lower rates of interest than general obligation bonds
d. Revenue bond interest is exempt from federal income taxes
C
All of the choices listed regarding revenue bonds are true except the statement indicating revenue bonds usually pay lower rates of interest than general obligation bonds. This is generally not true because revenue bonds, which are backed by the earning power of the facility backing the bonds, are typically riskier than general obligation bonds and usually have higher coupon rates. (8-10)
A city and school district are coterminous. When evaluating the debt of the city, the school district's debt issues would be considered:
a. Overlapping debt
b. Separate debt
c. Double-barreled debt
d. Underlying debt
A
An issue of bonds by a political entity, such as a school district, where another entity, such as a city, is liable is known as overlapping debt. Since the city and school district are coterminous (occupy the same boundaries), the debt of the school district overlaps that of the city. (8-5)
A municipality could issue revenue bonds for:
I. Hospitals
II. Electric systems
III. Turnpikes
IV. Sewer systems
a. I and II only
b. II and III only
c. I, III, and IV only
d. I, II, III, and IV
D
A municipality could issue revenue bonds for all of the choices listed. (8-10)
A municipality's debt limit is:
a. The maximum amount of interest a municipality can pay out in one year
b. The maximum amount of bonds a municipality can redeem in one year
c. The maximum amount of debt a municipality can incur
d. None of the above
C
A municipality's debt limit is the maximum amount of debt a municipality can incur. (8-2)
A project financed through revenue bonds is experiencing difficulty in that revenues are not sufficient to meet debt service payments. If, through legislative approval, the state pays interest and principal in a timely manner, the issue is most likely a:
a. Double-barreled bonds
b. Moral obligation bonds
c. Bond anticipation notes
d. Limited tax bonds
B
Moral obligation bonds are municipal revenue bonds which are payable by the state if revenues from the project do not satisfy debt service payments. However, in order for the state to service the debt, approval of the state legislature is required. Double-barreled bonds are issued as general obligations backed by the full faith and credit of the issuing municipality. (8-11)
The provisions for the flow of funds of a revenue bond issue appear in the:
a. Syndicate letter
b. Account summary statement
c. Notice of Sale
d. Indenture
D
The indenture contains all the agreements and covenants pertaining to a bond issue, and would contain the provisions for the application and allocation of funds of a revenue bond. (8-13)
A customer is most interested in safety of principal and wishes to avoid risk. List the securities you would recommend to the customer from those with the least risk to those with the most risk.
I. General obligation bonds
II. Treasury notes
III. Treasury bills
IV. Revenue bonds
a. III, I, II, and IV
b. II, III, I, and IV
c. III, II, I, and IV
d. I, IV, III, and II
C
The safest security with the shortest maturity would be Treasury bills, followed by the longer-term Treasury notes followed by general obligation bonds and then revenue bonds. (8-10, 7-1, 7-3)
When comparing an Albany, New York hospital revenue bond to a Buffalo, New York hospital revenue bond, you notice that they have similar maturities but the Buffalo bond has a higher yield. A possible reason for this is:
a. Income taxes in Buffalo are higher than in Albany
b. The cost of living is greater in Buffalo than in Albany
c. Per capita debt is higher in Buffalo than in Albany
d. There are more hospitals located in Buffalo than in Albany
D
Competing hospitals could affect the project's revenue and therefore reduce the bond's security. Each of the other choices relate to taxes which do not secure revenue bonds. (8-10)
An engineering report would be used for which of the following?
a. General obligation bond
b. Hospital revenue bond
c. Limited tax GO
d. School bond
B
An engineering report and a feasibility report are necessary for a revenue bond. The other choices represent general obligation securities. (8-12)
ENGINEERING REPORT (S7) : A study followed by a report that is done by an engineering firm. It is done as part of the feasibility study for a proposed municipal revenue issue.
A double-barreled municipal bond is backed by:
a. The revenues of a project
b. The taxes of a municipality
c. The revenues of a project and taxes of a municipality
d. The revenues of the U.S. government
C
A double-barreled municipal bond is backed by two sources of income, which would be the revenues of a project and taxes of a municipality. (8-11)
State governments receive the least amount of revenues from:
a. Sales taxes
b. Gasoline taxes
c. Excise taxes
d. Property taxes
D
State governments receive the least amount of revenues from property taxes. States raise money primarily from income taxes, sales taxes, excise taxes, and license fees. Very little is raised from property taxes. Local municipalities raise most of their funds from property taxes (real estate taxes). (8-2)
Which of the following is TRUE of revenue bonds?
a. They are secured by real estate.
b. They are backed by the taxing power of the municipality.
c. Their credit rating will always be lower than general obligation bonds.
d. The municipality will agree to keep rates high enough to cover debt service obligations.
D
The only true statement given regarding revenue bonds is the municipality will agree to keep rates high enough to cover debt service obligations (known as a rate covenant). Revenue bonds are not secured by real estate, they are not backed by the taxing power of the municipality, and their credit rating is not always lower than general obligation bonds. (8-10, 8-12)
A municipal revenue bond is secured by the revenues of a toll road system showing the following:
Annual Debt Service $3,000,000
Annual Gross Revenues $6,000,000
Annual Operating and Maintenance Expenses $2,000,000
Based upon the information shown above, the annual debt service coverage would be:
a. .667 to 1
b. 1.33 to 1
c. 2 to 1
d. 3 to 1
B
The debt service coverage ratio for the municipal revenue bond is 1.33 to 1. The formula for the debt service coverage ratio is net revenues divided by the annual debt service. The information listed in the question is as follows:
Annual Debt Service $3,000,000
Annual Gross Revenues $6,000,000
Annual Operating and Maintenance Expenses $2,000,000
Step 1: Calculate the net revenue for the municipal revenue bond.
Annual gross revenues $6,000,000
- Annual O/M Expenses $2,000,000
Net Revenue $4,000,000
Step 2: Divide net revenue of $4,000,000 by the debt service of $3,000,000 to calculate the debt service coverage ratio. The debt service coverage ratio is 1.33 to 1. (8-12)
Which of the following is NOT TRUE of industrial development revenue bonds?
a. They are issued by local municipal governments.
b. They may be used to finance the construction of commercial property that will be used by private corporations.
c. Their credit rating is determined by an analysis of the municipal government issuing the bonds.
d. Interest is paid from rents received from private corporations.
C
Industrial development revenue bonds are issued by local municipal governments to build factories or other commercial properties. The plant or property is leased by the municipality to a corporation. The interest on the bonds is paid from the lease rental payments made by the corporation. The credit rating of the bond is based upon the credit rating of the corporation and not by an analysis of the credit rating of the municipal government issuing the bonds. (8-10)
Which of the following would an analyst be most concerned with when evaluating a revenue bond?
a. The population growth of the municipality
b. Debt to assessed valuation
c. A rate covenant
d. Property taxes
C
An analyst would be most concerned with rate covenants. This is an agreement made by the municipal issuer to maintain rates high enough to cover maintenance and operating charges and to meet annual debt service requirements. (8-12)
The additional bonds covenant for a revenue bond would normally be found in the:
a. Official notice of sale
b. Prospectus
c. Bond indenture
d. Syndicate agreement
C
All protective covenants for a revenue bond would be found in the bond's indenture. Also included in the indenture would be the rights and obligations of the issuer and the bondholders.
The official notice of sale contains the information and procedures necessary for syndicates who wish to bid on a competitive issue of bonds.
The syndicate agreement is a contract among the underwriters which defines their working relationship and addresses such items as the priority of orders and sharing of the underwriting spread.
A prospectus is a disclosure document for issues that are registered under the Securities Act of 1933; municipal revenue bonds are exempt from that Act. (8-12)
The marketability of a municipal bond would NOT be affected by the:
a. Rating
b. Block size
c. Maturity date
d. Dated date
D
The dated date of a municipal bond is the date that interest begins to accrue and will not affect its marketability. The marketability of a municipal bond would be affected by the rating it received by either Moody's or Standard and Poor's. The marketability of a municipal bond would also be affected by the block size. A block is considered to be a large quantity of municipal bonds (minimum of $100,000 par value). The maturity of the bond would also affect the marketability of the bond. The closer the bond is to maturity, the more liquid it becomes. (8-25)
All of the following municipal securities would have a flow of funds provision EXCEPT:
a. Merrick, NY Union Free School District bonds
b. New Jersey Sports and Exposition Authority bonds
c. Battery Park City Authority bonds
d. Metropolitan Transit Authority bonds
A
A flow of funds provision details the manner in which the funds backing a municipal revenue bond will be applied. Revenue bonds are normally issued by authorities and agencies created by state and local governments. School district bonds would not have a flow of funds provision since they are general obligations. (8-13)
Knowing a client's tax bracket is particularly useful when evaluating the suitability of which type of investment?
a. Variable annuities
b. Municipal bonds
c. Preferred stocks
d. Common stocks
B
Knowing a client's tax bracket is particularly useful when evaluating the suitability of municipal bonds . The interest on municipal bonds is typically tax-exempt, which is less of an advantage if the client is in a low tax bracket. (8-25)
Given the following choices, in which security would a pension fund manager least likely invest?
a. Treasury Notes
b. AA rated corporate bonds
c. Blue chip stocks
d. Municipal bonds
D
Since a pension fund pays no taxes, it would not purchase municipal bonds . The most typical investment would be in high grade fixed income securities such as corporate bonds and U.S. government securities. The pension fund can also buy equities, typically blue chip stocks. (8-25)
When analyzing a general obligation bond, all of the following would be positive indicators of the bond's quality EXCEPT:
a. Voter registrations have increased over the last 18 months
b. The department of motor vehicles reports that out-of-state drivers have been registering their cars in your state at an increasing rate
c. The state increased the toll for the use of the turnpike
d. A multiplex cinema, do-it-yourself store, and book-selling chain have all announced new franchises in your community
C
An increasing population trend and a mixture of diverse businesses (both new and established) are positive demographic indicators that reinforce the quality of general obligation issues. User fees are generally associated with revenue issues. (8-2)
An investor in general obligation bonds should be aware of:
I. Call features
II. Purchasing power risk
III. Market risk
IV. Legislative action
a. I and III only
b. II and IV only
c. I, II, and III only
d. I, II, III, and IV
D
Every municipal bond, whether a general obligation (GO) or revenue, is subject to market fluctuations. The call feature on any bond is important since it determines if the investor will be required to redeem his bond prior to its original maturity. Legislative action can affect the tax levying capability of a municipality and would therefore be a factor for a GO bond. (8-20)
An official statement for a general obligation bond states that property taxes may not be raised above a certain level. This is known as a:
a. Level debt service bond
b. Double-barreled bond
c. Limited tax bond
d. Moral obligation bond
C
A GO bond is backed by taxes. The issuer promises to raise taxes, if necessary, to pay principal and interest on the bonds. A limited tax GO bond will have a ceiling on how high the tax rate can be raised. (8-2)
The City of Fremont, Nebraska is issuing revenue bonds to increase its electric power generating facilities and to replace outstanding bonds. Interest on the bonds will be:
a. Subject to federal income tax and exempt from state taxes
b. Subject to federal and state income tax
c. Subject to state income tax and exempt from federal income tax
d. Exempt from federal income tax
D
For individual investors, the interest derived from state and municipal bonds is exempt from federal income tax. The investor may have to pay state taxes, depending upon the tax status of the investor's home state. (8-1)
Which of the following is required before a municipality can begin making payments on a moral obligation bond?
a. Approval of a majority of legal age voters
b. Approval of the state legislature
c. Approval of the bond trustee
d. Approval of the appropriate state agency
B
State legislative approval is required before a municipality can begin making payments on a moral obligation bond. (8-11)
MORAL OBLIGATION BOND (S7) : A bond secured by revenues that is additionally secured by a moral, but not legal pledge from the state to make up any deficiencies. The state legislature would need to approve any makeup funds.
The highest quality rating for a municipal note is:
a. MIG 1
b. AAA
c. Aaa
d. MIG 4
A
Municipal notes are rated by Moody's. These are denoted as Moody Investment Grade (MIG) 1 through 4. MIG 1 is the highest rating and MIG 4 is the lowest rating. (8-18)
The interest from bonds issued by U.S. territories, possessions, and the Common-wealth of Puerto Rico is exempt from:
I. Local tax
II. State tax
III. Federal tax
a. I and II only
b. I and III only
c. II and III only
d. I, II, and III
A
The interest income received from bonds issued by U.S. territories, possessions, and the Commonwealth of Puerto Rico is exempt from all levels of taxation. These bonds are termed "triple tax-exempt ." (8-1)
TRIPLE-TAX EXEMPT (S7) : Municipal bonds on which the bondholder pays no federal, state, or local taxes on the interest. In general, bonds issued by possessions and territories of the U.S. (e.g., Puerto Rico) are triple-tax exempt.
What type of bond would most likely be secured by an excise tax, cigarette tax, or gasoline tax?
a. GO Bond
b. Special Tax Bond
c. Special Assessment Bond
d. Water and Sewer Bond
B
A special tax bond is financed by a tax on certain items such as cigarettes, liquor, or gasoline. (8-10)
A bond with an 11% coupon is purchased at 103. The maturity of the bond is 20 years. The bond is callable in 10 years at par. Which is correct?
a. The yield will be higher if called.
b. The yield will be higher if held to maturity.
c. The yield will be the same if called or if held to maturity.
d. The yield will be determined by the issuer.
B
If the bond is held to maturity, the investor will be able to amortize the premium over a longer period of time, thereby realizing a higher yield. If the bond is called in ten years, the premium is amortized over half the time, resulting in a lower yield. A bond purchased at a premium and callable at par will always have a lower yield to the call than to maturity. (8-24)
Roundville Bank is considering an investment in Roundville County bonds. The bonds contain a provision which permits banks to deduct 80% of the interest cost being paid to depositors on the funds used to purchase the bonds. These securities are known as:
a. Alternative minimum tax bonds
b. Bank qualified bonds
c. Private activity bonds
d. Moral obligation bonds
B
Bank qualified municipal bonds allow banks to deduct 80% of the interest cost paid to depositors on the funds used to purchase the bonds. This is done to encourage banks to invest in municipal securities. To qualify, a municipality may only issue up to $10,000,000 annually. (8-5)
A state agency revenue bond does not have sufficient revenue to meet debt service. A provision of the indenture allows the agency to request funds from the state legislature. The legislature has the option of providing or not providing the additional funds. What type of bond is it?
a. General obligation
b. Double-Barreled
c. Special tax
d. Moral obligation
D
The legislature does not have a legal obligation to provide funds but is considered to have a moral obligation. Funds would become available after legislative approval. (8-11)
All of the following would indicate credit conditions are deteriorating for a municipality EXCEPT an increase in:
a. Bankruptcies
b. Consumer debt
c. Bond defaults
d. Assessed valuations
D
All of the items mentioned would indicate credit conditions are deteriorating for a municipality except an increase in assessed valuations. This is the value placed on property by the municipality for purposes of taxation. An increase in assessed valuations would indicate that homes within the municipality are increasing in value which would improve the municipality's credit. (8-3)
An investor in the 28% tax bracket is trying to determine if it is better to buy a corporate bond yielding 12% or a municipal bond with a tax-free yield of 10%. To find the taxable equivalent yield for the municipal bond, the investor should divide the 10% tax-free yield by:
a. The 12% corporate yield
b. The 28% tax bracket
c. 100% minus the 12% corporate yield
d. 100% minus the 28% tax bracket
D
To determine the taxable equivalent yield of a municipal bond, divide the municipal yield (10%) by the complement of the tax bracket (100% - 28% tax bracket). The taxable equivalent yield for the municipal bond is 13.9% (10% divided by 72%). This is greater than the 12% return on the corporate bond, thus making the municipal bond the better investment. (8-26)
TAXABLE EQUIVALENT YIELD (S7) : An adjustment made to a tax-free yield for comparison to taxable yields.
An individual's home has a resale value of $500,000 and an assessed value of $200,000. If the tax rate is 10 mills, the property tax would be:
a. $2,000
b. $5,000
c. $20,000
d. $50,000
A
Property tax is computed by multiplying the assessed value by the millage rate. A mill equals 0.001 or $1 per $1,000 assessed value. The tax would be $2,000 ($10 times 200 thousands or $200,000 x .001 x 10 mills). (8-2)
Which of the following orders would you place for a customer who wants to hold her auction rate security if the interest rate is set at 3.4% or higher:
a. Hold order
b. Limit order
c. Bid order
d. Sell order
C
A current holder of an auction rate security may indicate the desire to continue to hold the security only if the rate is set at or above a specified rate. If the clearing rate sets below the interest or dividend rate that the holder or prospective holder specifies in her bid, the holder will be required to sell the securities subject to her bid, and the prospective buyer will not acquire the securities. Auction dealers refer to bids by prospective holders as "buy" orders and bids by holders as "roll-at-rate" orders. (8-19)
The official statement for a revenue bond issue states that the bonds are backed by a pledge of the project's net revenues. This means that the:
a. Debt service is the first item paid after operating and maintenance expenses
b. Debt service is paid after the replacement and renewal fund
c. Operating and maintenance expenses are paid after debt service
d. Debt service is the last item paid in the flow of funds
A
Most municipal revenue bonds are net revenue pledge bonds. This means that bond (debt) service is paid from net revenue (revenue after operating and maintenance expenses). (8-12)
Which of the following would have the least amount of credit risk?
a. Preferred stock issued by a blue chip company
b. Mortgage bonds
c. Treasury notes
d. Revenue bonds
C
Credit risk relates to the ability of an issuer to pay interest and principal when it is due and therefore relates to debt instruments. Since a Treasury note is secured by the full faith and credit of the U.S. government, it is considered free of credit risk. A revenue bond would default on its debt service if the project does not generate enough revenues. (8-10, 7-1)
Mr. Jones is a small business owner who has purchased Treasury Bills and other short-term securities during times when he has excess funds available in the business. He likes the aspects of liquidity and safety. A friend has told him he can get higher rates from Auction Rate Securities. He wants to know why you have not recommended this investment to him. Which TWO of the following would you cite as your reasons?
I. Auction Rate Securities are long-term investments.
II. Interest or dividend rates are reset at established intervals based on a "Dutch" auction.
III. If the auction fails, the client may not have immediate access to their funds.
IV. The interest or dividend rate is set as the lowest rate to match supply and demand at the auction.
a. I and III
b. I and IV
c. II and III
d. II and IV
A
Although auction rate securities are usually sold as an alternative to other short- term securities, they are long-term securities. An RR must disclose to a client that, if the auction fails, the client may not have immediate access to her funds. The RR also has a duty to disclose to clients any material fact relating to the specific features of the auction rate securities and the customer's need for a liquid investment when recommending this type of product. The fact that the interest or dividend rate is reset at specified intervals is a material fact, but would not be a reason to avoid recommending the investment. The same reasoning applies to the fact that the rate is set at the lowest rate that matches supply and demand. These investments may not be suitable for investors who have a need for liquidity. (8-19)
An investor must pay accrued interest for a secondary market purchase of:
a. Zero-coupon bonds
b. Series EE savings bonds
c. Tax anticipation notes
d. Treasury bills
C
Zero-coupon bonds and Treasury bills are original issue discount securities and trade without accrued interest. While Series EE bonds are also OID securities, they do not trade in the secondary market. Tax anticipation notes (TANs) are typically interest bearing securities and trade with accrued interest. (8-18, 5-4, 7-3, 7-8)
TAX ANTICIPATION NOTE (TAN) (S7) : A short-term municipal security used by a municipality to help its cash flow. It has a maximum maturity of one year and repayment based on specific future tax collections of the municipality
When pricing a bond, which of the following would be required?
I. Coupon
II. Maturity
III. Settlement date
IV. Bond years
a. II and IV only
b. I and III only
c. I, II, and III only
d. I, II, III, and IV
C
When pricing a bond (determining the yield when price is known or determining the price when yield is known), the coupon, settlement date, and maturity are required. (8-24)
All of the following services rate securities EXCEPT:
a. Moody's
b. Standard & Poor's
c. Fitch
d. AMBAC
D
AMBAC insures new municipal issues. Moody's, Standard & Poor's, and Fitch are rating services. (8-20, 5-16)
Salem County has issued industrial development revenue bonds for the benefit of the Mohawk Carpeting Company. In evaluating the credit quality of these bonds, an investor should look at:
a. The bank balances of the Salem County Industrial Revenue Authority
b. The tax collection ratio of Salem County
c. The revenue stream of Mohawk Carpeting that will be committed to meet the lease payment obligation to Salem County
d. The yield differential between Salem County GOs and Mohawk Carpeting debentures
C
The security backing the industrial development revenue bond is the lease payment made by the corporation. An investor must assess whether Mohawk Carpeting can meet this obligation by generating sufficient revenues from its primary business. (8-10)
All of the following are TRUE concerning both Auction Rate Securities and Variable Rate Demand Obligations EXCEPT:
a. Interest rates are set at specified intervals
b. They are often issued by municipalities
c. They are long-term securities with short-term trading features
d. They have a put feature allowing the holder to redeem the security at par
D
Although they are both long-term securities with short-term trading features, only VRDOs have a put feature that permits the holder to sell the securities back to the issuer or third party. Auction rate securities (ARSs) do not have this feature, and if the auction fails the investor may not have immediate access to their funds. In addition, ARSs use an auction process to reset the interest rate on the securities, whereas the reset interest rate on a VRDO is set by the dealer at a rate that allows the securities to be sold at par value. (8-19)
In January an investor receives a bonus from her employer. She will need to have access to the funds in April. An RR should NOT recommend which of the following municipal securities?
a. A variable rate demand obligation
b. An auction rate security
c. A tax anticipation note
d. A bond anticipation note
B
VRDOs and ARS are both are long-term securities with short-term trading features. VRDOs have a put feature that permits the holder to sell the securities back to the issuer or third party. Auction rate securities (ARS) do not have this feature and if the auction fails the investor may not have immediate access to their funds. TANs and BANs are short-term municipal notes and if their maturities extend beyond April, these securities could be easily sold in the secondary market. (8-18)
Which of the following would have a negative impact on a municipality's creditworthiness?
a. An increase in per capita income
b. An increase in property values
c. An increase in unfunded pension liabilities
d. A decrease in per capita debt
C
Many municipalities have pension funds for their employees. If there is less money in the fund than the amount needed to pay future benefits, it is referred to as an unfunded pension liability. This is a negative factor since the municipality would have to contribute that amount in the future. This drain on monies could affect the municipality's ability to meet its bonded debt (total outstanding debt). (8-3)
Auction Rate Security is a type of investment that has the interest or dividend rate reset periodically. The term "net clearing rate" refers to which of the following?
a. The average rate of all submitted bid
b. The highest rate to match supply and demand
c. The lowest rate to match supply and demand
d. The lowest rate of all submitted bids
C
Based on submitted bids from holders and prospective buyers, the net clearing rate set by the auction agent will be the lowest rate that matches supply and demand. After the deadline for submission of orders, the auction agent assembles all the orders from lowest to highest bid and determines the net clearing rate. The net clearing rate is the lowest rate bid sufficient to cover all the securities exposed for sale. (8-19)
Which of the following are important factors in determining the suitability of a municipal bond recommendation to a customer?
I. State of residence
II. Tax bracket
III. Financial condition
a. II only
b. I and II only
c. II and III only
d. I, II, and III
D
An investor's tax bracket and financial condition are important factors. The state in which the investor resides is important since the interest earned on a municipal bond may be subject to that state's income tax. (8-1, 8-25)
Which of the following municipal entities would not issue overlapping debt?
a. Park district
b. Library district
c. School district
d. Turnpike authority
D
Overlapping debt involves only general obligation borrowing. A turnpike authority would typically issue only revenue bonds. (8-4)
An investor purchasing a variable rate demand obligation seeks:
a. Guaranteed payments of principal and interest
b. A fixed rate of return for the life of the investment
c. Capital appreciation if interest rates decline
d. Capital preservation if interest rates rise
D
The issuer of a variable rate demand obligation will adjust (reset) the interest rate at specified intervals. The demand feature permits owners of the notes to demand that the issuer purchase the obligations, at par, on the date that the interest rate is reset. (8-20)
A grant anticipation note is normally paid from:
a. Proceeds from the issuance of long-term bonds
b. Funds received from the federal government
c. Revenues received at a future date
d. Receipts of future property taxes
B
A grant anticipation note (GAN) is normally paid from funding provided by the federal government. A bond anticipation note (BAN) is paid from proceeds from the issuance of long-term bonds. A revenue anticipation note (RAN) is paid from revenues to be received at a future date. A tax anticipation note (TAN) is normally paid from future tax receipts, such as property (ad valorem) taxes. (8-18)
Prior to the maturity of a variable rate demand obligation, an investor has the right to receive the:
a. Current market value
b. Par value
c. Par value plus accrued interest
d. Par value less accrued interest
C
A variable rate demand obligation (VRDO) can be redeemed prior to maturity on any date the interest rate on the obligation is reset. Rates can be reset on a monthly, weekly, or daily basis. The obligation will be redeemed at its par value plus accrued interest. (8-20)
A client owns a municipal bond that has been escrowed to maturity. Which of the following statements is TRUE?
a. The issuer has deposited money in an escrow account that will contain U.S. government securities used to pay off the municipal bonds at maturity.
b. The issuer has deposited money in an escrow account that will contain U.S. government securities used to pay off the municipal bonds prior to maturity.
c. The issuer has deposited money in an escrow account that will contain other municipal bonds used to pay off the municipal bonds at maturity.
d. The issuer has deposited money in an escrow account containing U.S. government securities that will create a tax liability for the municipal bondholder at maturity.
A
When interest rates fall, a municipality may want to engage in advance refunding. In this case, the municipality will sell a new issue with the proceeds of the sale going into an escrow account containing U.S. government securities. Since the municipal bond has been escrowed to maturity, the U.S. government securities would be purchased with a maturity date that coincides with maturity date of the municipal bonds. (8-11)
Short-term municipal obligations payable from funds that usually will be received from the federal government are:
a. Bond anticipation notes
b. Revenue bonds
c. Grant anticipation notes
d. Tax anticipation notes
C
Grant anticipation notes are short-term municipal notes issued on the expectation of receiving grant money usually from the federal government. (8-18)
Which of the following securities is NOT suitable for an investor with $80,000 who needs the funds in three months to purchase a house?
a. A 13-week Treasury bill
b. An auction rate preferred stock that resets its rate every three months
c. A three-month CD that is yielding 20 basis points above the prime rate
d. A money-market fund
B
An auction rate security is a long-term security that resets its interest rate periodically through an auction process. Since the client needs the funds in three months, any investment should be free from potential loss of principal. There is no guarantee he will be able to sell this security at the price it was purchased. The other three investments will offer this client very little or no principal risk. (8-19)
Which of the following types of debt best defines a municipal issuer's total bonded debt?
a. Long-term debt only
b. Both short-term and long-term debt
c. Both long-term and short-term debt plus overlapping debt
d. Long-term debt plus overlapping debt
C
Total bonded debt is the sum of both long-term and short-term debt of a municipality plus its applicable share of overlapping debt. Overlapping debt is that portion of the debt of other government units for which residents of a particular municipality are responsible, such as services or facilities shared by several municipalities. (8-4)
A municipality issues a bond backed by revenue from a project. If the municipality also has bonds outstanding which are backed by the same revenue, which of the following statements is TRUE?
a. This is a double barreled bond.
b. This is a parity bond.
c. This type of bond would require voter approval.
d. This type of bond may only be issued if the municipality creates an escrow fund.
B
This is an example of a parity bond, one where two or more issues of revenue bonds are backed by the same pledged revenues. A double barreled bond is backed by a source of revenue and the full faith and credit of an issuer that has taxing power, a general obligation (GO) bond issuer. General obligation bonds, not revenue bonds, require voter approval. (8-11)
If an auction for auction-rate securities were to fail, the holder would:
a. Receive the par value of the securities
b. Continue to hold the securities and the interest rate would be set to the maximum rate
c. Continue to hold the securities and the interest rate would be set to the minimum rate
d. Continue to hold the securities and the interest rate would be set to a rate that would have cleared the auction
B
A failed auction occurs when there are not enough bids to cover the amount of auction-rate securities being sold. In this situation, the holders would continue to hold the securities and the interest rate would be set to the maximum rate allowed in the program documents. This rate is normally higher than the rate that would have cleared a successful auction. (8-19)
An airport would deduct all of the following expenditures before arriving at its net revenues EXCEPT:
a. Runway maintenance expenses
b. Debt service expenses
c. Hanger expenses
d. Air traffic control salaries
B
Debt service expenses would be paid first only in gross revenue pledges. It would be assumed that the airport was using a net revenue pledge that results in all maintenance and operation expenses being deducted before arriving at net revenues. (8-13)