Municipal and corporate debt: what stands behind the bond

Follow the backing

States, cities and local authorities borrow through municipal bonds, whose interest is generally exempt from federal income tax and often from the issuing state’s tax for its residents. Two kinds of municipal backing matter. A general obligation bond is backed by the issuer’s power to tax; the analyst looks at the tax base and debt burden. A revenue bond is backed only by the income of the project it finances — tolls, water charges, airport fees. If the project falls short, the issuer is not obliged to raise taxes to cover it.

Municipal issuers are not registered with the SEC the way a corporate issuer is, so the disclosure reaches investors by a different route. Most municipal securities issued after July 3, 1995 are required to file annual financial information, operating data and notices of certain events with the Municipal Securities Rulemaking Board, and that material is published free of charge on the MSRB’s EMMA system. A municipal issue with nothing filed on EMMA is a warning sign rather than a quirk.

Corporations borrow on the strength of their own credit, and a bond’s terms set its place in line. A secured bond is backed by specific collateral the company pledges, such as property or equipment; bonds with no collateral are unsecured and may be called debentures, with a general claim on the company’s assets and cash flows; and senior debentures rank ahead of junior, or subordinated, ones. Rating agencies grade default risk: BBB or Baa and above is investment grade; below that is high-yield. A rating says nothing about interest-rate risk. The agencies whose scales you meet are Moody’s Investors Service, S&P Global Ratings and Fitch Ratings, and the reason you meet those three rather than any others is not that the law names them: they are three of the credit rating agencies registered with the SEC as nationally recognized statistical rating organizations, or NRSROs. Registration is what the SEC does here. It does not approve the ratings themselves, and a candidate who reads a rating as carrying a regulator’s endorsement has the relationship backwards.

Read a credit rating for what it is. A rating is an agency’s assessment of credit risk at a particular point in time. It is not investment advice, not a guarantee of credit quality or of future credit risk, and not an indication that an investment is suitable. Ratings can change, so the rating printed in an offering document may not be the rating on the day someone buys, and rating agencies are generally paid by the issuers whose bonds they rate. A high rating makes default less likely in the agency’s view; it does not promise that every payment will be made.

A downgrade is a rating agency lowering its rating because credit quality has weakened. The cut that draws attention is the one out of investment grade; triple-B is the lowest investment-grade category. An issuer rated investment grade and then cut below it is called a fallen angel. Its coupon and maturity stay as written, and a downgrade is not a default, which is a missed interest or principal payment. The price usually falls: high-yield bonds trade at higher yields, and downgrades can bring selling.

Municipal new issues reach investors in one of two ways. In a competitive sale the issuer asks underwriters to submit firm bids, and it awards the bonds to the underwriter or syndicate whose bid meets the terms of the notice of sale and gives the lowest interest cost. In a negotiated sale the issuer chooses an underwriter or syndicate directly and negotiates the terms, such as the interest rate, call features and purchase price. Either way, a municipal syndicate is a group of underwriters formed to buy the new issue from the issuer and resell it to the public, sharing the underwriting risk, the capital needed and the work of distribution.

Exam terms

Municipal bond

A bond issued by a state, city or other local government or authority. Its interest is generally exempt from federal income tax.

General obligation bond

A municipal bond repaid from the issuer’s general taxing power.

Revenue bond

A municipal bond repaid only from the income of a specific project.

EMMA

The MSRB system carrying municipal continuing disclosure, free to the public.

Debenture

An unsecured corporate bond backed by the issuer’s general credit.

Investment grade

A credit rating of BBB or Baa or higher; below that is high-yield.

Downgrade

A rating agency lowers its rating because credit quality has weakened.

Fallen angel

An issuer or bond cut from investment grade to below investment grade.

Competitive sale

A municipal new issue awarded to the underwriter or syndicate bidding the lowest interest cost.

Negotiated sale

A municipal new issue sold to an underwriter or syndicate the issuer chose and negotiated terms with.

Worked example

Quentin is comparing two bonds issued by the same city. One financed a new high school and is repaid from property taxes. The other financed a toll bridge and is repaid from the tolls.

1. The school bond is a general obligation bond: the city’s taxing power stands behind it.
2. The bridge bond is a revenue bond: only the tolls stand behind it. An analyst asks whether projected tolls comfortably cover the debt service.
3. If traffic disappoints, bridge bondholders bear the shortfall; the city has no duty to divert taxes to them.
4. If tax receipts fall, the city must still levy what it takes to pay the school bond, which is why GO bonds are generally the safer of the two.
5. Interest on both is generally exempt from federal income tax, and from the state’s tax if Quentin lives there — the backing differs, the tax treatment does not.

Check yourself

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Related practice

• Issuer type and repayment sourcePractice this
• Credit ratings and bond credit riskPractice this