Module 5 Part 2
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Investors have many ways to protect their investments. The following list describes some of these protective services.
The INDENTURE is a large document outlining all of the requirements of the issuing municipality. Part of the indenture can be found in the official statement, but it is usually a separate document held by the trustee. The indenture outlines all the important features of the bond — maturity dates, interest rates, name of the trustee and trustee bank, and all protective covenants. It does not have the RE-OFFERING YIELDS. RE-OFFERING YIELDS are yields at which the bond is selling in the market, so re-offering cannot be guaranteed.
- PROTECTIVE COVENANTS are agreements made between the issuer and the purchaser of a revenue bond. Protective covenants are set forth in the indenture. Protective covenants are basically promises made by the issuer to perform certain duties in connection with the bond. The most important protective covenants are:
- •Rate covenants
- •Insurance covenants
- •Maintenance covenants
- •Revenues pledge covenants
A RATE COVENANT
Ensures that the issuer will keep rates high enough to meet operation and maintenance expenses as well as debt service and any other costs that the issuer may incur.
Is a promise by the issuer to carry sufficient insurance on the facility to protect the bondholders against destruction or damage to the facility
Is a promise by the issuer to maintain the facility in good working order and to keep it in good repair so as to maintain revenues.
REVENUES PLEDGE COVENANT
- Is a promise by the issuer on how the money received in revenues is to be paid. The items paid first and second are outlined in the flow of funds, and depend on the type of pledge. The types of pledges are:
- -Gross revenues pledges
- -Net revenues pledges
Most revenue bond indentures allow for PERIODIC REVIEWS or audits of the project books by a consulting engineer or other qualified party.
FLOW OF FUNDS
Is a term that describes how (and for what purpose) the funds generated by a facility will be spent. The flow of funds is one of the most important bond provisions set forth in the indenture.
Is the fund into which all revenues must first be deposited at the time they are received by the issuer.
Depending on the type of pledge in the revenues pledge covenant found in the indenture, money from the revenue fund would go either to the operation and maintenance fund or the debt service fund. (Both funds are defined below.)
If the fund contains a NET REVENUES PLEDGE, payments made from the revenue fund must first be used to meet the ongoing expenses of the project. (These payments are made to the operation and maintenance fund.) Remaining funds will be used to pay debt service on the bond.
If the fund contains a GROSS REVENUES PLEDGE, payments made from the revenue fund must first be used to pay the principal and interest (debt service) on the bond. (These payments are made to the debt service fund.) Remaining funds will be used to pay operation and maintenance costs on the facility.
OPERATION AND MAINTENANCE FUND
Is a fund that contains money to be spent only on the operation and maintenance of the facility
A SINKING FUND is a fund that must be set up for term bonds only, and is money the issuer must regularly set aside for eventually redeeming its bonds, as specified in the indenture. This fund assures the bondholders that there will be sufficient dollars available at maturity.
A sinking fund is set up by the issuer to deposit part of the income, either from taxes or revenues, in an ESCROW ACCOUNT. This money may not be used for anything except to pay for the principal of the issue when it comes due.
The money from the sinking fund must be invested in U.S. government securities for safety (not put into a bank).
Money must be set aside and deposited into this account every year. The money from the sinking fund must be invested in U.S. government securities for safety (not put into a bank). It is used as an investment to earn a return until the payment is due — whether through a partial call of the bonds, waiting until the bonds mature, or repurchasing the bonds in the open market.
SINKING FUND CALL
The money in the sinking fund is used by the municipality to buy its own bonds in the open market if they are at a discount, or to pay off bonds that are called. If part of the bond issue is called AND PAID by this sinking fund, it is known as a SINKING FUND CALL.
Term bonds usually have a sinking fund since the whole bond comes due at one time and provides money for the issuer at that time.
Serial bonds do not need a sinking fund since part of the issue comes due every year.
However, a sinking fund is usually provided with a serial bond to put excess money in for possible calls as well as for the part of the issue that comes due each year.
DEBT SERVICE FUND
Is a fund that contains additional money to be spent only on the bond’s principal and interest payment (debt service) if, at a certain point, the revenues are temporarily not enough to make these payments.
If any money remains in the revenue fund after debt service and operation and maintenance costs have been paid, it is allocated to the funds listed below, in the following order:
•DEBT SERVICE RESERVE FUND: Serves as a reserve to pay debt service in future years.
•RESERVE MAINTENANCE FUND: Serves as a reserve to pay for unanticipated maintenance costs on the facility.
•RENEWAL AND REPLACEMENT FUND: Serves as a reserve to pay for the replacement of worn-out equipment and to make repairs over the life of the project.
•SURPLUS FUND: Can be used for any lawful purpose, including the redemption of bonds or the reduction of fee payments by users.
Which of the following provides for the debt service and maintenance of a municipal revenue bond?
(A) Maintenance covenant
(B) Record covenant
(C) Rate covenant
(D) Insurance covenant
(C) Rate covenant. A rate covenant keeps rates high enough to pay for all of the necessary operation and maintenance costs to make the facility run. The other covenants are technically just promises, like keeping records, having insurance, and maintaining the facility.
FEASIBILITY STUDIES AND ENGINEERING REPORTS
Before a revenue bond may be issued, a research analyst is hired to perform a FEASIBILITY STUDY and engineers are hired to draw plans and produce ENGINEERING REPORTS for the project. The feasibility study and the engineering reports are usually requested to determine whether the project is actually needed and/or whether the needed revenue will be available. The engineering report is also issued to show that the facility will stand up to the elements of nature and is a structurally sound facility. A feasibility study and an engineering report are always required on a proposed facility that is being financed by a revenue bond.
Prior to a municipal bond being issued, a municipality must obtain a LEGAL OPINION from a BOND COUNSEL
. A BOND COUNSEL is a lawyer who is knowledgeable in the laws of municipal bonds. The legal opinion by the bond counsel, in effect, states that the bond is a municipal bond as determined by existing local and tax laws and that the interest is exempt from federal and state (if applicable) taxes.
- In making its opinion, the bond counsel:
- •Researches the state and local laws to check into the requirements for a bond to have tax-exempt status
- •May assist in getting favorable legislation passed in the locality, if necessary
- •Supplies information to the underwriters for the official statement
BOND RATINGS AND RATING ORGANIZATIONS
Just as each consumer has a credit score measuring their creditworthiness, the creditworthiness of municipalities and the bonds they issue is also measured to provide investors with an indication of the issuer’s financial strength and ability to make principal and interest payments. BOND RATINGS are a measure of the chance of default of interest and principal by the issuer. The three major bond-rating organizations are:
- -Standard and Poor (S&P)
- -Fitch Investor’s Service
- These agencies rate:
- •General obligation bonds and some revenue bonds that are backed by property taxes
This means that the lower the chance of a municipality either missing an interest payment or not making a principal payment, the higher the rating. When a municipality misses interest payments on a bond, the ratings go down, usually to the DEFAULT RATING, which is D for S&P and C for Moody’s.
REFUNDED or PRE-REFUNDED
If a bond is REFUNDED or PRE-REFUNDED (or ADVANCE-REFUNDED, explained more fully in Section 8.7), the ratings by both S&P and Moody’s go up to AAA and Aaa, respectively.
The ratings for each rating service are shown in the chart below.
The more added to the letter, the higher the rating; for example, AA is better than A, and A1 is better than an A rating.
MAKE SURE TO COME BACK TO THIS SECTION AND MEMORIZE THE RATINGS
Both Moody’s and Standard & Poor only rate large offerings.
These rating organizations use a number of factors when rating each issue, including any or all of the following:
- •The amount of bonds the issuer has outstanding at the time of rating
- •The amount of overlapping debt, if any
- •The amount of debt of each taxpayer (per capita debt)
- •The amount of population, its growth and character
- •The method of generating income for payment
- •The amount of property and its assessed valuation
- •How well the municipality has collected taxes in the past
White’s Tax-Exempt Bond Rating Service or White’s Ratings
Is a rating agency that classifies municipal securities based on the market factors of the trading of the bonds. It does not use the credit conditions of the municipality itself, but rather how the public sees the municipality as an investment and how they receive new issues of that municipality in the market. Example: A Baa- or BBB-rated bond by Moody’s or S & P’s for instance, might have an AA rating by White’s because the municipal issuer might be highly respected even if there is a lot of outstanding debt per capita.
BANK QUALIFIED BONDS.
In addition to ratings on municipal bonds that give investors an idea of how strong the bonds are, some municipal bonds are also classified as BANK QUALIFIED BONDS. Most of the time these bonds are rated BBB/Baa or higher, but the ability of the bonds to pay is not what makes the bonds BANK QUALIFIED.
A bank-qualified bond is a municipal bond purchased by a bank that allows the bank to deduct 80% of the carrying costs it paid to purchase and hold the bonds.
Carrying costs are the interest expenses incurred to purchase or carry an inventory of securities, including costs for purchasing municipal bonds. The tax code does not allow banks to deduct the interest costs for purchasing and holding municipal bonds, EXCEPT for bank qualified bonds. It is a special benefit so banks can have bonds available for their customers.
Which of the following is an S&P rating?
(D) AA. S&P’s ratings are all capital letters. Moody’s ratings are capital letters with lower case letters.
(this multiple choice question has been scrambled)
MUNICIPAL SECURITIES RULEMAKING BOARD (MSRB)
Regulates the actions of underwriters, broker/dealers, and the people who sell municipal bonds. MSRB rules do not apply to issuers, they only apply to the people who sell the municipal securities. The voters have the say in the issuance of new municipal issues.
The two markets for municipal bonds are the market for new issues and the secondary market.
THE PRIMARY MARKET — NEW ISSUES
Before a municipal issue can come to market, it must be advertised. With general obligation bonds, two advertisements are placed: A NOTICE OF SALE and a TOMBSTONE. With a revenue bond, only one advertisement, the tombstone, is used.
A NOTICE OF SALE
Is an advertisement by a municipality to prospective underwriters wherein the municipality requests that bids be submitted on the cost of underwriting a new issue. This type of advertisement is only used in connection with a competitive underwriting.
Is an advertisement by the underwriters to prospective buyers. Tombstone advertisements may only include very basic information regarding the new issue
, including the following:
- •The offering price
- •The name of the issuer
- •The dated date (i.e., the date that interest starts to accrue)
- •The dates on which interest payments are made
- •The offering scale, which shows the yield to maturity
- •How to obtain an official statement
- •The name of the underwriter
- •The names of the members of the selling syndicate (and occasionally the selling group)Tombstone advertisements may not include any inducements to the new issue. They are for informational purposes only. The names of the members of the selling syndicate (and selling group) appear either in order of participation amount or in an order that is otherwise determined by agreement.
UNDERWRITING MUNICIPAL BONDS
The two methods of underwriting municipal securities and bringing them to market are:
The issuer advertises for underwriters to submit bids on the cost of underwriting the issue. The issuer chooses the underwriter that has offered the bid that allows the municipality to generate the highest possible amount of proceeds from the underwriting at the lowest possible interest cost. The various broker/dealer firms who wish to compete in the bid to underwrite submit their bids to the issuer after seeing the advertisement called the NOTICE OF SALE.
In a NEGOTIATED UNDERWRITING, the issuer asks a broker/dealer with which the issuer has an established working relationship to submit a cost estimate for underwriting the issue. If the cost estimate is too high, the issuer tries to negotiate a lower cost with that broker/dealer. If a lower cost cannot be negotiated, the issuer calls another underwriter. Both negotiated and competitive underwritings are covered in the Underwriting Module.
All municipal bonds, when newly issued, come with an OFFICIAL STATEMENT. The OFFICIAL STATEMENT discloses all the important aspects of the bond, the issuer, and the protections for the buyer. This also includes any call features.
Which of the following is not a method or component of a municipal underwriting?
(D) The bid
(C) Standby. A standby underwriting is not a form of municipal underwriting. As shown in the Underwriting Module, a standby underwriting is a form of corporate underwriting. Competitive and negotiated are both methods of municipal underwritings, as mentioned above. The bid is part of the competitive underwriting in which different underwriters submit competing bids to the issuer.
THE SECONDARY MARKET
All trading of municipal securities in the SECONDARY MARKET
(the market consisting of trading between two investors) is done in the over-the-counter market. Bonds that are sold by an investor are considered sold in the secondary market.
Any issue being sold for the second time or more is considered a SECONDARY ISSUE, so the market where it is sold is called the secondary market
. Remember, bonds that are sold directly from the issuer are primary issues sold in the primary market.
are broker/dealers who buy
the bonds from investors wanting to sell
and then resell
them to investors wanting to buy
- The three major secondary market-trading venues are:
- •Interdealer trading
- •The retail business, which is trading between individuals
- •The institutional investor business (generally consisting of entities investing millions of dollars)
SOURCES OF INFORMATION FOR MUNICIPAL BONDS
For information about new or secondary municipal bond issues, a broker/dealer or a municipal bond dealer can consult any one of several publications.
- -The BOND BUYER
- -The MUNIFACT WIRE
- -The KENNY WIRE and the C-WIRE
The BOND BUYER
Is a publication that is now produced online for underwriters only
. Underwriters must know all the information in this daily newspaper. Although the Bond Buyer is shown online daily, it only produces various indexes once a week. The Bond Buyer Revenue Index is composed of 25 revenue bonds with 30 years or more to maturity
. There are three general obligation indexes: the GO 11 and the GO 20, and the GO 40 all with bonds maturing in 20
- -The GO 11 index has an average rating of AA.
- -The GO 20 index has an average rating of A+ (A1).
- -The GO 40 index has an average rating of BBB.
The type of information that underwriters must know, including important features and lists, is covered in detail in the Underwriting Module.
The MUNIFACT WIRE is a wire service for secondary trading, with some underwriters watching it.
•The Munifact Wire is run by the Bond Buyer and provides a great deal of information regarding new issues of municipal bonds in both the primary and the secondary markets. It gives information about the issuer, the indenture, and any information for analyzing the ratings and quality of the issues. There are no prices or yields.
The KENNY WIRE and the C-WIRE
Are wire services for secondary trading.
•The Kenny Wire and the C-Wire provide information about municipal securities. More importantly, these services are known for finding and listing bonds for which dealers are seeking bids in the secondary market.
The Wall Street Journal and local newspapers carry some tombstone advertisements and notices of sale.
However, these resources are generally considered secondary to the above-mentioned publications.
The GO 40 index is composed of which of the following?
(A) Revenue bonds of 25 years to maturity
(B) General obligation bonds of 20 years to maturity
(C) General obligation bonds of 30 years to maturity
(D) General obligation bonds of 40 years to maturity
Answer (B) General obligation bonds of 20 years to maturity. All of the GO indexes are composed of 20-year bonds. The Revenue Index is composed of 30-year bonds. The GO Index has three indexes that calculate the yields for general obligation bonds, all with different amounts of bonds; one has 11 bonds, the second has 20 bonds, and the third has 40 bonds. The Revenue Index has 25 bonds that are used to calculate the yields for the index.
SECONDARY MARKET FOR MUNICIPAL BONDS
The secondary market for municipal bonds is thriving, especially when investors sell off their bonds because they need money. The following is information on the secondary market.
INTERDEALER TRADING is a term that describes trading between BOND TRADERS. Bond traders are firms that have a municipal department trading in the secondary market. These bond traders make a market in the different municipal bonds that are available, meaning that they buy bonds from investors or other dealers who want to sell the bonds, or they sell bonds to investors or other dealers who want to buy bonds.
- When dealers want to purchase certain bonds, they contact other bond traders and request prices on those bonds (if they are available for purchase). If those dealers cannot find any of the bonds they want, they then contact one of the many BROKERS’ BROKERS, and ask this broker to find the bonds they want.
A firm that is a broker’s broker only acts in an assistant role called an AGENCY BASIS. A broker’s broker:
- •Never acts as a market maker
- •Helps dealers find a particular bond they are looking for
- •Helps institutional firms buy and sell bonds
- •Helps large buyers and/or sellers remain anonymous
- •In general, acts in a broker capacity
- •Never acts in a principal transaction even when buying bonds to help municipal firms fill an institution’s order
Bond dealers sometimes wish to remain anonymous when trying to sell certain bonds because they may not want the whole dealer community to know that they are selling a particular bond at a particular price. In these cases, dealers also use a brokers’ broker to help them sell the bonds since the brokers’ broker does not reveal the identity of the selling dealer.
INDIVIDUAL INVESTORS are called HOUSEHOLD INVESTORS
These investors are usually in the higher tax brackets and are looking for an investment that gives a yield exempt from taxes. These investors contact municipal dealer departments of broker firms to buy or sell the municipal securities for their portfolio. These firms, or dealers, then fill the individual investor’s requests or contact the broker’s broker to find the bonds the investors desire.
Are LARGE investors who purchase large amounts of bonds (or other securities) at one time. Institutional investors consist of commercial banks, insurance companies, and bond mutual funds. These investors buy large quantities of each issue. On occasion, some of them purchase an entire issue.
A broker’s broker is used to doing which of the following?
(A) Buy bonds for his own account
(B) Find bonds for another broker/dealer and act as an agent in purchasing them
(C) Find bonds for a client and act as an agent in purchasing them
(D) Help a broker/dealer that is going broke
Answer (B) Find bonds for another broker/dealer and act as an agent in purchasing them. A broker’s broker is a go-between, helping other brokers find and buy bonds.
QUOTES: DEALER-TO-DEALER AND DEALER-TO-CUSTOMERS
Municipal bonds are quoted in basis points, also known as BiPs.
A quote in basis points is in yield to maturity basis. When making a quote for a municipal bond, each basis point is equal to 1/100 of 1%, or .0001.
- •Thus, a bond quoted at a 7.85 basis is actually selling on a 7.85% yield to maturity.
- •Arise of three basis points (3 BiPs) raises this quote to 7.88%.
- •Arise of 12 BiPs raises the original quote to 7.97%.
- •Arise of 113 BiPs raises the original quote to 8.98%.
When a bond is quoted in basis points, the only way to find the dollar amount is to use a BASIS BOOK or calculate it on a bond calculator. Since basis is a “yield,” there is no dollar equivalent because a 7% six-year bond quoted at 7.25 basis would be priced differently than a 7% 20-year bond also quoted on a 7.25 basis.
•Therefore, the only way to change a basis to dollars for the bond, or to change the value in dollars for a bond to basis is to use a BASIS BOOK.
Bonds at Par, Premium, or Discount
- Bonds are sold to investors at:
- •FACE VALUE
- •ABOVE FACE VALUE
- •BELOW FACE VALUE
When a bond sells at its FACE VALUE, it is SELLING AT PAR or selling at 100. The basis quote is equal to the nominal yield.
When a bond is priced ABOVE FACE VALUE, it is being priced at a PREMIUM or selling above 100. The basis quote is less than the nominal yield. It will be quoted at the “yield to call.”
When a bond is priced BELOW FACE VALUE, it is being priced at a DISCOUNT or selling below 100. The basis quote is greater than the nominal yield. It will be quoted at the “yield to maturity.”
If a bond is selling at a premium, the quote from the broker to a client must take into consideration the fact that the bond could all be called. Therefore, the price of all premium bonds must take into account the possibility of in-whole calls, and if the bond is callable at par, the broker must quote the yield to call.
A FIRM QUOTE
Is a quote given by dealers when they are ready or able to do business at a specified price. Dealers can place a restriction of time on the quote (e.g., 10 minutes, or firm for one hour with five-minute recall). This recall allows dealers to recall the bid during the hour. When dealers call the traders back, the traders must make an immediate decision. The five minutes is an antiquated notion that five minutes notice must be given. A firm quote is a forcing bid to make potential investors make up their minds. It is also an out for dealers if they have a better offer. Although dealers can give firm quotes to multiple potential investors at the same time, they must do business in the order in which they have spoken to them.
Are given for informational purposes only. They can be given at any time on any type of bond — general obligation or revenue. A subject quote is given when the dealer is not committed to doing business at that price, but rather is simply informing the potential investor of the general price range of the bond. If the potential investor is really interested in purchasing, the dealer may offer a firm quote which may differ from the subject quote provided.
Your firm’s trading department is called by another broker/dealer that is interested in purchasing bonds from your firm. The trading department gives a quote of, "7.80% yield, good for an hour with a five-minute recall." Which of the following is true about this quote?
(A) The other firm has control of the bonds for one hour, and after the hour it has five minutes to respond.
(B) The other firm has control of the bonds for one hour, but during the hour your firm can call the other firm back with a five-minute "fill or kill."
(C) The other firm has control of the bonds for one hour, but during the five-minute period your firm can show the bonds to other broker/dealers.
(D) The other firm has control of the bonds for one hour, and your firm cannot show the bonds to any other broker/dealers in that hour until it gives the other firm a five-minute warning.
Answer (B) The other firm has control of the bonds for one hour, but during the hour your firm can call the other firm back with a five-minute "fill or kill." During the hour, your firm can show the bonds, but cannot sell them until it gives the other firm the five-minute call.
FEATURES & CHARACTERISTICS OF MUNICIPAL BONDS
If the bond has a call provision, it must also list the yield to call if the yield to call is lower than the yield to maturity.
- All bonds have three yields:
- •NOMINAL YIELD (also known as the COUPON RATE)
- •CURRENT YIELD
- •YIELD TO MATURITY
- •A YIELD is defined as the amount of money returned to the investors from their investment.
The NOMINAL YIELD is also known as the COUPON or the RATE. This is the fixed amount of interest that is paid every year. Remember that sometimes there can be more than six months from the dated date to the first interest payment date. After the first payment, all interest payments are six months apart.
The CURRENT YIELD is the yield based on the amount of income the investor is receiving in relationship to the current market price. To refresh your memory, the formula is:
- CURRENT YIELD = ANNUAL INTEREST AMOUNT (NOMINAL YIELD)/
- CURRENT MARKET PRICE
Write this formula out three times everytime you see this flash card
YIELD TO MATURITY — ALSO KNOWN AS BASIS
The YIELD TO MATURITY of a bond takes into account the price discount from (or premium over) the face amount of the bond. Simplified, the yield to maturity is a yield that also takes into account the discount or premium spread out over the years to maturity. Yield to maturity is also called BASIS.
- For the TEST, be aware that:
- •The yield to maturity and the current yield are more than the nominal yield for discount bonds.
- •The yield to maturity and the current yield are less than the nominal yield for premium bonds.
When a bond is selling at a premium, which of the following would be highest relative to the others?
(A) Current yield
(B) Yield to maturity
(C) Nominal yield
Answer (C) Nominal yield is always the highest in a premium bond. The yield to maturity or basis and the current yield are lower than the nominal yield, because at maturity investors receive less than what they paid for the bond. Depending on the length to maturity, either the current yield or the basis could be the lowest. Remember, when a bond is at a premium, the nominal yield is always the highest. When a bond is at a discount, the nominal yield is always the lowest.
Three types of YIELD CURVES are used to describe the relationships between yields on fixed rate investments and the maturity dates for these investments. These curves are graphically represented as:
- •A normal yield curve
- •An inverted yield curve
- •A flat yield curve
The NORMAL yield curve has lower interest rates in the early maturities and higher interest rates in the later years. The reason for this is that the holders of long-term bonds should get more interest for holding the bonds for a longer time.
The INVERTED yield curve has higher interest rates in the early maturities and lower interest rates in the later years. This is uncommon, but occurs when interest rates are high and are expected to become lower in the coming years.
FLAT YIELD CURVE
The flat yield curve has all of the maturities equal, or with very little increase of not more than .2% (20 basis points) or .3% (30 basis points).
In reality, the curves change all the time due to interest rate changes and changes in supply and demand of bonds or other fixed rate investments. If interest rates change, the bond prices change. Longer-term bonds usually change the most in price when interest rates change.
Remember, when presented with a sample of bonds with different maturities and asked which will change the most in price, always pick the longest bond.
Regarding the changing yields, remember when a bond sells at par, the nominal yield, current yield, and the yield to maturity are equal. If you are asked to rank bonds in their order of yield when the bonds are not selling at par, always begin with the nominal yield. Then, when the price changes — either down to a discount or up to a premium — the current yield, YTM, and YTC will change inversely; the current yield will move the least amount, the YTC will move the most, and the YTM will be between current and YTC. Thus:
•The order of all four yields will be: N, C, B, M, C — Nominal, Current, Basis, YTM, YTC.
INVERSE RELATIONSHIP OF BOND PRICES AND YIELDS
As interest rates go up, bond prices go down. As interest rates go down, bond prices go up. This is known as the inverse relationship of bond price and bond yields.
A quote for a 7% municipal serial bond might be priced at a 7.20% basis, meaning the 7% coupon bond is selling at a yield to maturity basis of 7.20%. (Basis is just a shortened term for yield to maturity basis).
Bonds that sell at par value have the yield to maturity, current yield, and nominal yield equal to each other.
This is because there is not any appreciation or loss on the bond to affect the yield to maturity
When an issuer fails to make an interest payment, the bonds are considered to be in DEFAULT and trade without accrued interest.
- Bonds trading without accrued interest are said to be trading FLAT. With general obligation bonds and corporate bonds, this can give investors a sense that the issuer is near bankruptcy and, therefore, the issue is not a very good investment. All back interest must be paid to the present bondholder. Bearer bonds require that
- past, present, and future interest rate coupons still be attached for good delivery.
When interest rates are rising, which of the following occurs with bond prices and bond yields?
(A) Both bond prices and bond yields rise.
(B) Both bond prices and bond yields fall.
(C) Bond prices rise and bond yields fall.
(D) Bond prices fall and bond yields rise.
Answer (D) Bond prices fall and bond yields rise. Prices and yields go in opposite directions. They have an inverse relationship. Since interest rates are rising, the bond is not in demand, so it falls in price, and, therefore, the yield increases.
When buying municipal bonds in the secondary market, the buyer must pay the seller the amount of ACCRUED INTEREST that is due on a bond since the last interest payment was made. The method of calculating the number of days is exactly the same as with corporate bonds. This amount is added to the price. Therefore, the buyer of a bond pays the market price plus accrued interest for a bond. This is to compensate the seller for the amount of interest that the seller earned by holding the bond past the date of the last interest payment. This is not really costing the buyer any money because on the next interest date the buyer will be sent a check for the whole interest payment, only a part of which was paid to the previous owner.
Municipal bonds pay interest based on a 30-day month and a 360-day year. The buyer pays the accrued interest from the previous interest payment date to, but not including, the settlement date. You must remember, however, that municipal bonds settle three business days after the trade date. If you encounter such questions on your exam, make sure that a weekend or holiday isn’t between the trade date and the settlement date. If so, add one day for a holiday and add two days for weekends.
SETTLEMENT DATE - LAST INTEREST PAYMENT DATE = NUMBER OF MONTHS AND DAYS
ACCRUED INTEREST Example:
- A San Francisco high school bond has interest payments every February 1 and August 1. An investor buys the bond on Monday, June 20. How many days of accrued interest does the buyer pay the seller of the bond?
- Trade date 6/20
- +3 days for settlement (no weekend)
- Settlement date 6/23
- Last interest date - 2/1
- = 4/22, or 4 months (4 × 30 days = 120 days) and 22 days = 142 days
- If the bond were a 6% bond per year, and the investor bought 10 bonds, the amount of accrued interest would be:
- 10 bonds × $1,000 per bond × 6% × 142 days ÷ a 360-day year = $236.67 in accrued interest
CALLING MUNICIPAL BONDS
Municipalities almost always issue bonds that are callable. If the bonds are over 10 years to maturity, such as 15, 20, or 30 years, the bonds are usually callable in the 10th year. There are many types of bond calls, depending on the event. In some cases, the bonds are callable at a premium that reduces down to par after a period of time (usually five years), while in other cases, the bonds are only callable at par. The types of calls are:
- •IN-WHOLE CALL
- •PARTIAL CALL
- •DEFEASED CALL
- •SINKING FUND CALL
- •EXTRA-ORDINARY CALL
- •CATASTROPHE CALL
Usually callable in the first years at a premium that reduces to par after three to five years — initiated when refunding or advance refunding has occurred
Usually callable in the first years at a premium that reduces to par after three to five years — initiated when the issuer has extra money due to more revenues than expected
Usually callable in the first years at a premium that reduces to par after three to five years — initiated when advance refunding has occurred, but the issuer prefers to keep the money in U.S. government bonds that are paying the issuer more interest than the municipality is paying the bond holders
SINKING FUND CALL
Usually callable in the first years at a premium that reduces to par after three to five years — initiated in term bonds when the issuer has extra money due to more revenues than expected or in serial bonds that have a term-maturity as well
Always callable at par — initiated when there is leftover money from the bond issue and the project is completed
Always callable at par — initiated when the project blows up, collapses, or is destroyed by an earthquake or other natural disaster
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