In this introductory series on the U.S. corporate and municipal bond markets, we will explore the various types of products available for trading, the risks investors may encounter, and strategies to mitigate those risks. Additionally, we’ll demonstrate how to utilize an online trading platform to identify investment opportunities, perform due diligence, and more. By the end of this review, you’ll gain valuable tools to analyze and make informed investment decisions in the corporate and municipal (bond markets).
Exploring Municipal Bonds: Course Overview
Municipal bonds come in various forms, each with unique tax structures, funding sources, and analytical approaches. Types of municipal debt include:
- General Obligation Bonds
- Revenue Bonds (targeted at sectors like housing, healthcare, education, and transportation)
- Bonds subject to the Alternative Minimum Tax (AMT)
- Build America Bonds (BABs)
- Double-Barreled Bonds
- Advanced Refunding Bonds
Understanding Key Differences
What sets these bonds apart? How can investors analyze them effectively in both primary and secondary markets? For example, when assessing revenue bonds, you don’t need to evaluate the issuer’s tax base or collection record. Unlike general obligation bonds, which rely on tax revenue for repayment, revenue bonds are repaid through cash flows generated by specific projects.
What You’ll Learn
This course will cover these distinctions and provide tools to help you navigate the complexities of municipal bonds. You’ll gain insights into:
- The types of municipal notes available for trading.
- Key features of municipal debt, including risks, due diligence, accrued interest calculations, yield disclosures, and tax considerations.
- Updates on state and local tax (SALT) deduction changes.
Additionally, we’ll demonstrate how to use the IBKR Trader Workstation to locate municipal bonds in the secondary market and conduct due diligence to inform your investment decisions.
Course Structure
In the following chapters, we’ll delve deeper into general obligation bonds and revenue bonds. You’re encouraged to revisit earlier lessons as needed to reinforce your understanding of the municipal bond market. Each lesson includes a quiz, and the course concludes with a final exam to ensure comprehension.
Important Disclaimer
This material is intended for educational purposes and does not account for your specific investment needs. Before making decisions, consider whether the information aligns with your financial situation, investment objectives, and other requirements.
Understanding Municipal Bonds: General Obligation Bonds (GO Bonds)
In this lesson, we’ll take a closer look at the two main categories of municipal bonds: general obligation bonds (GO bonds) and revenue bonds. Let’s start with GO bonds.
What Are General Obligation Bonds?
GO bonds are general-purpose bonds issued by municipalities to finance public projects, such as building roads, railways, or other infrastructure. Similar to how corporations may use debt proceeds for general corporate purposes, municipalities use GO bonds to fund large-scale projects that benefit the public.
Only entities with the authority to levy and collect taxes—such as state and local governments—can issue GO bonds, as these bonds are primarily backed by the issuer’s taxing power.
- State GO Bonds: Backed by income taxes, sales taxes, gas taxes, or other state revenue sources.
- Local GO Bonds: Typically funded by property taxes, school taxes, or other local revenue streams.
Requirements and Limitations
Before issuing a GO bond, a municipality usually needs voter approval, as the debt is ultimately serviced using taxpayer funds. Additionally, state laws or constitutional provisions often impose a debt ceiling, which limits how much debt a municipality can accrue.
Key Considerations for GO Bond Investors
When analyzing a GO bond, investors should assess the financial and economic health of the issuer. Key questions to consider include:
- Economic Health: What industries or companies operate within the municipality?
- Employment and Income: What are the employment rates and average income levels of residents?
- Population Trends: Are population levels rising or declining? If declining, will this impact tax revenue?
- Debt Levels: How much debt has the issuer already accumulated, and what is its overall financial condition?
- Fiscal Responsibilities: How well does the issuer manage its budget and handle unfunded liabilities, such as pensions?
Example: New York City GO Bonds (2019)
Consider New York City’s GO bonds issued in 2019:
- Employment Trends: Employment levels had been declining in recent years.
- Revenue Sources: Property taxes accounted for the city’s largest revenue stream, but the real estate market had been sluggish. Additional revenue sources included sales taxes, income taxes, and intergovernmental grants.
- Population Growth: While the city’s population grew over the past eight years, the growth rate was slower than the national average.
Such factors highlight the importance of thorough analysis when evaluating a GO bond, as even large municipalities can face financial difficulties. For example, New York City narrowly avoided bankruptcy in 1975, and understanding historical financial challenges can help investors assess current risks.
Potential Risks: Municipal Defaults
Municipal bond defaults, while rare, are not impossible. Notable examples from the past decade include:
- Puerto Rico
- Detroit, Michigan
- Jefferson County, Alabama
These cases emphasize the importance of identifying potential red flags to mitigate the risk of default.
Exploring Revenue Bonds: A Deeper Dive
In the previous lesson, we discussed general obligation bonds (GO bonds). Now, let’s turn our attention to revenue bonds, another key type of municipal bond issuance.
What Are Revenue Bonds?
Revenue bonds are debt instruments issued to finance revenue-generating projects managed by state or local governments or municipal authorities. These projects often include:
- Airports
- Water and sewer systems
- Hospitals
- Bridges and other public facilities
Unlike GO bonds, which are backed by taxes, revenue bonds are repaid through the cash flows generated by the specific project they fund. This reliance on project revenue makes them riskier than GO bonds, as a shortfall in revenue could jeopardize payments to bondholders.
For example, if a turnpike funded by revenue bonds fails to generate sufficient toll payments, the issuer might default on its debt obligations.
Why Choose Revenue Bonds?
Revenue bonds may be issued as an alternative to GO bonds in certain situations:
- When voter approval for a GO bond issuance is not secured.
- When the municipality has reached its debt ceiling, restricting further GO issuance.
Types of Revenue Bonds
Municipalities have diverse revenue-generating needs, resulting in various types of revenue bonds, including:
- Housing Revenue Bonds: Fund affordable housing projects for low-income households.
- Healthcare Revenue Bonds: Finance the construction of non-profit hospitals and healthcare facilities.
- Transportation Bonds: Support projects like bridges, tunnels, toll roads, airports, and transit systems.
- Industrial Development Revenue Bonds: Build facilities for private companies, often aimed at spurring economic growth.
- Education Bonds: Fund educational institutions.
- Moral Obligation Bonds: Backed by a non-binding pledge of support from the issuer.
- Utility Bonds: Finance water, sewer, and power infrastructure.
- Special Tax Bonds: Repaid through specific taxes like hotel or gasoline taxes.
Key Considerations for Investors
When evaluating revenue bonds, investors should analyze the issuer and project carefully. Since repayment depends on the project’s cash flows, consider the following:
- Revenue Streams: Compare projected revenues to the required debt service payments.
- Operating Expenses: Determine if operating and maintenance costs must be deducted from revenues before debt service.
- Feasibility Studies: Look for potential obstacles to cash flow in the project’s feasibility report.
- Debt Service Coverage Ratio (DSCR): Ensure the ratio of available revenue to required debt service is sufficient.
Example: Turnpike Revenue Bond
Let’s analyze a revenue bond funding a turnpike:
- Gross Annual Revenue: $6 million
- Annual Operating Costs: $1 million
- Net Revenue: $5 million ($6M – $1M)
- Annual Debt Service: $2.5 million
To calculate the Debt Service Coverage Ratio (DSCR):
A DSCR of 2:1 indicates sufficient coverage for debt obligations, providing a cushion for bondholders.
The Role of the Bond Indenture
Investors should also review the bond indenture (or bond resolution/trust agreement). This document outlines:
- The issuer’s responsibilities.
- Bondholder rights.
- Flow of Funds: Details how project revenues are allocated, including:
- Debt service payments.
- Operations and maintenance.
- Renewals and replacements.
- Construction costs.
- Sinking fund allocations.
Exploring Shorter-Term Municipal Securities
Now that we’ve analyzed general obligation (GO) bonds and revenue bonds, let’s shift focus to shorter-term municipal securities. A bond’s maturity—whether it’s a GO bond, revenue bond, or another type—is one of the most important factors for buyers to consider.
Why Maturity Matters
Similar to corporate and government debt, the maturity of a bond impacts its exposure to interest rate risk. The longer the bond’s maturity (e.g., 10, 20, or 30 years), the greater the likelihood that interest rates could rise during its term, reducing its value.
Additionally, longer-term bonds face increased risks, such as:
- Rating Downgrades: A decrease in the issuer’s creditworthiness.
- Default Risk: The possibility that the issuer cannot meet its payment obligations.
For investors seeking shorter-term notes, typically maturing within a year or less, the municipal market offers several options, including TANs, RANs, TRANs, and BANs.
Types of Shorter-Term Municipal Securities
- Tax Anticipation Notes (TANs)
TANs are short-term securities issued in anticipation of future tax receipts, often related to property taxes.- Example: A local government budgets $6 million to build a public park but has only $4 million available. To bridge the gap, officials issue $2 million in TANs, maturing in May 2018, relying on expected tax revenues after the April tax deadline.
- Revenue Anticipation Notes (RANs)
Similar to TANs, RANs are backed by anticipated revenues, but these are typically tied to subsidies or payments from federal or state governments. - Tax and Revenue Anticipation Notes (TRANs)
TRANs combine the features of TANs and RANs, securing repayment from both future tax revenues and other anticipated funding sources. - Bond Anticipation Notes (BANs)
BANs provide interim financing for projects that will eventually be funded through the sale of long-term bonds.- Example: Virginia’s Chesapeake Bay Bridge and Tunnel District issued BANs to help finance its Parallel Thimble Shoal Tunnel project. These notes provided capitalized interest and helped reduce financing costs before the long-term bonds were sold.
- Auction Rate Securities (ARS)
ARS are more complex short-term municipal securities. They are technically long-term investments, but their interest rates reset at short-term intervals through auctions.
Credit Ratings and Insurance in the Municipal Bond Market
When investing in municipal bonds, additional information from key organizations in the bond ecosystem is often essential. Beyond analyzing an issuer’s official statement or attending an investor presentation, institutions like municipal bond guarantors and credit rating agencies—including S&P Global, Moody’s Investors Service, and Fitch Ratings—play a crucial role in assessing and supporting the risks and viability of these instruments.
The Role of Credit Rating Agencies
Credit rating agencies assign ratings to municipal bonds and their issuers, providing investors with a framework to evaluate creditworthiness. These ratings are typically categorized into:
- Investment-Grade: Ratings from ‘AAA’ to ‘BBB’.
- Speculative or Lower Quality: Ratings from ‘BB’ to ‘C’.
Factors Considered by Credit Rating Agencies:
- Issuer’s Official Statement: Includes financial disclosures and project details.
- Bond Documentation: Legal terms and obligations of the issuance.
- Macro Environment: Broader economic conditions affecting the issuer.
Questions agencies may explore:
- Is the issuer attracting profitable industries?
- What is the state of employment or unemployment in the area?
- Are population levels increasing or declining?
The resulting credit rating aligns with the agency’s established scale and helps investors gauge risk.
Bond Guarantors and Their Relationship with Ratings
Municipal bond guarantors ensure that bondholders will receive their principal and interest payments as promised, even if the issuer defaults. However, bond insurers themselves depend on credit ratings, as:
- Bond Insurers are rated by agencies, with ‘AA’ often being the highest rating they achieve.
- Their ratings determine how much capital they need to back guarantees:
- Higher-rated bonds (e.g., ‘A’ or ‘AA’) require less capital to insure.
- Lower-rated bonds (e.g., ‘BB’) demand significantly more capital for guarantees.
Despite their role, bond insurers still have relatively low capital reserves compared to the value of securities they insure, a situation reminiscent of conditions before the 2008-2009 financial crisis.
Political and Governance Risks
Political and governance risks in the municipal bond market have grown over the past 10-20 years, particularly in U.S. state and local credits. These risks are often linked to:
- Unfunded Pension Liabilities: A significant burden on state and local governments.
- Escalating Budgets vs. Population Growth: Expenditure growth often outpaces economic or population growth, signaling potential fiscal strain.
Example: New York State
- 1978-79 Budget: Approximately $16 billion.
- 2018-19 Budget: Surged to $175 billion, representing a compound annual growth rate (CAGR) of over 6%.
- Population Growth: Increased from 17.5 million to 19.5 million during the same period, a CAGR of just 0.25%.
This disparity highlights potential challenges for long-term sustainability, as expenses grow faster than economic activity or population levels.
Key Takeaways from Ed Grebeck’s Insights
In an interview with Interactive Brokers’ Senior Market Analyst Steven Levine, Ed Grebeck, a strategist in global debt markets, provided valuable insights:
Investing in Stocks vs. Bonds
- Stocks are riskier than fixed-income investments.
- Municipal bonds are often viewed as a tool for capital preservation.
Importance of Rating Agencies and Bond Insurers
- Credit rating agencies conduct in-depth research on each bond.
- Bond guarantors rely on agency ratings to set capital requirements and manage risk.
Gaps in Political Risk Assessment
- Rating agencies may capture some governance risks but miss many nuances.
- Investors should supplement research by reading local news and conducting community-level analysis, as political risks are not detailed in official bond statements.
Municipal bond investing requires understanding the broader ecosystem, including credit ratings, guarantors, and potential political and governance risks. Armed with these insights, investors can make more informed decisions and mitigate potential pitfalls.
