Chapter 6

Chapter 6

Government Securities

Government Securities

• Treasury Securities

• Federal Agency Securities

• Municipal Securities

Treasury Securities

• U.S. Treasury is responsible for the financing of the federal government’s debt (financing and refunding) and financing fiscal policy. The Treasury finances its debt by issuing T-bills, T-notes, T-bonds, inflation-index bonds, and non-marketable Treasury securities.

• The federal government’s debt in 2003 was approximately $6.4 trillion.

• The federal government’s deficit in 2002 was approximately $158 billion.

Federal Government Revenues and Expenditures, 2001 and 2002

Item 2001Amount

($ billions)

2002Amount

($ billions)

Revenue:Individual Income TaxCorporate Income TaxSocial Insurance Taxes and ContributionsOther revenue Sources Total RevenueExpenditures:National DefenseInternational AffairsHealth CareIncome Security ProgramsSocial Security and MedicareNet Interest on Federal DebtOther Expenditures Total ExpendituresBalance

$994.3151.1694.0151.8___ $1,991.2

$305.516.5172.3269.6432.9206.2460.9___$1,863.9- 127.3

$858.3148.0700.8146.1___ $1,853.2

$384.622.4196.5312.6456.4170.9467.8___$2,011.0-157.8

Source: The President's Council of Economic Advisors, Economic Report of the President. www.gpo.gov/usbudget

http://www.gpo.gov/usbudget

Historical Government Revenues, Expenditures,and Budgets: Select Years from 1969-2002

Year Total Revenue

Total Expenditures

Net BudgetSurplus Or

Deficit

1969198019901993199719981999200020012002

$ 186.9B 517.1 1,031.3 1,164.8 1,579.31,657.91,827.52,025.21,991.21,853.2

$ 183.6B 590.9 1,251.8 1,497.5 1,601.21,667.81,702.91,789.01,863.92,011.0

$ 3.3B - 73.8 -220.5 -332.7

-21.9-9.9

+124.6+236.2+127.3-157.8

Source: The President's Council of Economic Advisors, Economic Report of the President. www.gpo.gov/usbudget


Federal Debt: 2003

Type Amount ($ billions)

Marketable DebtBillsNotesBondsInflation-Indexed NotesInflation-Indexed Bonds Total Marketable

Nonmarketable DebtDomestic SeriesForeign SeriesState and Local Government SeriesUS Savings SecuritiesGovernment Account SeriesOther Total Nonmarketable

Total Public Debt Outstanding

918.81,616.6585.8107.2 45.3___ 3,273.7

30.011.6149.6196.42,780.53.9____ 3,172.0

6,445.7

Source: Board of Governors of the Federal Reserve System, to www.publicdebt.ustreas.gov/opd/opd.htm

http://www.publicdebt.ustreas.gov/opd/opd.htm

Websites

• For information on the U.S. Treasury’s debt go to www.publicdebt.ustreas.gov/opd/opd.htm

• For information on government expenditures and revenues go to www.gpo.gov/usbudget or go to www.economagic.com and click on Federal Reserve – St. Louis.

http://www.publicdebt.ustreas.gov/opd/opd.htm


http://www.economagic.com/

Types of Treasury Securities

– Market Series: • Treasury Bills • Treasury Bonds • Treasury Notes• Treasury-Inflation Index Bonds

– Non-Market Series: Securities that cannot be traded. • Government Agency Series• Foreign Series• U.S. Savings Bonds

Treasury Bills

Treasury Bills

• Short-term Treasury securities.

• Features:– Original Maturities: 91 days, 182, and 1 year– Zero-Coupon Bonds– States exempt the interest from state taxes– Smallest denomination = $1,000– Rates quoted as annual discount yield (banker’s

discount yield)

Treasury Bills

maturitytodays

360

F

PFYieldDiscount

TB0

0637.197/100YTM

1]P/F[YTM

06.180

360

100

97100YieldDiscount

06.YieldDiscount

180ndays,97P:Example

180/365

n/365TB0

TB0

Treasury Notes and Bonds• Treasury Notes and Bonds are intermediate and

long-term Treasury securities.• Features:

1. Original Maturities: • Notes: maturity up to 10 years• Bonds: maturity ranges from 10-yrs to 30yrs

2. Semi-annual coupons3. Denomination in multiples of $1,000; often

$100,0004. Treasury has not issued callable bonds or notes

since 19855. Rates quoted as annual discount yield

Treasury Inflation-Index Bonds -- TIPS

• The Treasury began offering Treasury inflation-indexed bonds in 1997.

• The securities are called TIPS: Treasury Inflation

Protection Securities.


• TIPS are structured so that: – Each period’s coupon payment is equal to a

specified fixed rate times an inflation-adjusted principal, and

– at maturity, the bond pays the larger of the inflation-adjusted principal or the original par value.


Example• Suppose the Treasury issues a 5-year TIP with a

nominal principal of $1,000 and annual coupon rate of 4%.

• If there is no inflation in the ensuing five years, then the TIP will pay bondholders $40 each year and $1,000 at maturity.

• If there is inflation, as measured by the consumer price index, CPI, then the Treasury will adjusted the nominal principal.


Example

• Suppose the U.S. experiences an annual inflation rate of 3% the first year of the bonds.

• In this case, the inflation-adjusted principal would be $1,030 and a bondholder would receive an annual coupon of $41.20 (= ($1,030)(.04)).

• If the 3% inflation continues for each year, then the bondholder would receive coupon interests in each of the next four years of $41.20, $42.44, $43.71, $45.02, and $46.37, and a principal at maturity of $1,159.27.


Year Inflation Inflation-Adjusted Principal

TIP CashFlow

12345

3%3%3%3%3%

$1,030.00$1,060.90$1,092.73$1,125.51$1,159.27

$41.20$42.44$43.71$45.02

$46.37 + $1,159.27

Treasury Strips

• Stripped Treasury Securities: Short-term PDBs derived from T-notes or T-bonds.

• Merrill Lynch and Salomon Brothers started them in 1980.– Dealers would buy a T-bond or note, place them

in a custodial account, then strip them into interest-only (IO) or principal-only PDBs to sell to investors.

Treasury Strips

• The U.S. Treasury facilitated the market for generic stripped securities when in 1985 it initiated the Separate Trading of Registered Interest and Principal of Securities (STRIPS) program to aid dealers in stripping Treasury securities.

Treasury Strips

• The securities created under the STRIPS program were deemed direct obligations of the government.

• For clearing and payment purposes, the names of the buyers of STRIPS were included in the book entries of the Treasury, thus eliminating the need to set up custodial accounts.

Treasury Strips

• For dealers, the creation of strip securities represents an arbitrage.

• As we examined in Chapter 2, the equilibrium price of a bond is that price obtained by discounting its cash flows by spot rates – the rate on zero-coupon bonds.

– If the market prices a bond below its equilibrium value, then dealers can earn a risk-free profit by buying the bond and stripping it into IO and PO bonds to sell.

– If the market prices a bond above its equilibrium value, then dealers can realize a risk-free profit by buying stripped securities and then forming an identical coupon bond to sell. This process is known as rebundling or reconstruction.

Theoretical Spot Yield Curve

• A theoretical spot yield curve is a plot of spot rates against their maturities, with the spot rates estimated using the bootstrapping technique.

• In practice, the process of stripping and rebundling

causes the actual yield curve for Treasury securities to approach this theoretical spot yield curve.

• As a result, the theoretical spot yield curve estimated by using bootstrapping is often used by practitioners to price financial instruments and by dealers to identify arbitrage opportunities.


• A theoretical spot yield curve can be constructed from observed yields on T-bills and Treasury coupon-paying bonds defining the Treasury yield curve by using a bootstrapping technique.

• As described in Chapter 2, the bootstrapping technique requires taking at least one pure discount bond and then sequentially generating other spot rates from coupon bonds. To illustrate, consider the Treasury securities shown in the table.


Security Type Maturity Semi-Annual Coupon

Annualized YTM

Face Value

Current Price

Spot Rate

1 T-Bill .5 years - 5% 100 97.561 5.00%

2 T-Bill 1 year - 5.25% 100 94.9497 5.25%

3 T-Note 1.5 years 2.75 5.5% 100 100 5.551%

4 T-Note 2 years 2.875 5.75% 100 100 5.577%

5 T-Note 2.5 years 3 6.00% 100 100 6.03%

6 T-Note 3 years 3.125 6.25% 100 100 6.30%


• There are two T-bills with maturities of six months (.5 years) and one year, trading at bond-equivalent yields of 5% and 5.25%.

• Since T-bills are pure discount bonds, these rates can be used as spot rates (St) for maturities of .5

years (S.5) and one year (S1).


• To obtain the spot rates for 1.5 years (18 months):

1. Take the T-note with a maturity of 1.5 years, annual coupon rate of 5.5% (semi-annual coupons of 2.75), and currently priced at par and value that bond by discounting its cash flows at spot rates.

2. Solve for the spot rate for 1.5 years. Doing this yields a spot rate of S1.5 = 5.51%.


0551.1705956.94

75.1022S

)2/S(1(

75.102705956.94

))2/S(1(

75.102

))2/0525(.1(

75.2

))2/05(.1(

75.2100

))2/S(1(

CF

))2/S(1(

CF

))2/S(1(

CFP

3/1

5.1

35.1

35.1

21

35.1

5.12

1

0.11

5.

5.5.1


• To obtain the spot rate for a two-year bond (S2) we repeat the process using the two-year bond paying semi-annual coupons of 2.875 and selling at par.

• This yields a spot rate of S2 = 5.577%.

• Continuing the process with the other securities in the table, we obtain spot rates for bonds with maturities of 2.5 years and 3 years: S2.5 = 6.03% and S3 = 6.30% (last column of the preceding table).


• Consider the arbitrage from buying and stripping the 3-year 6.25% coupon bond.

– A dealer could buy the issue at par and strip the issue with the expectation of selling the strips at the yields corresponding to their maturities.

– The proceeds from selling the strips would be 100.1217, yielding the dealer a profit of $.1217 per $100 face value.

– In contrast, if the dealer sells at the spot rates defining the theoretical yield curve, the profit is zero and the arbitrage disappears.


Maturity Semi Annual SpotYears Cash Flow YTM PV Rates PV0.5 3.125 0.0500 3.0488 0.0500 3.04881.0 3.125 0.0525 2.9672 0.0525 2.96721.5 3.125 0.0550 2.8807 0.0551 2.88042.0 3.125 0.0575 2.7900 0.0577 2.78902.5 3.125 0.0600 2.6957 0.0603 2.69363.0 103.125 0.0625 85.7394 0.0630 85.6210

100.1217 100.0000

Note: Allow for small rounding differences


Thus, the process of stripping will change the supply and demand for bonds causing their yields to move to their theoretical spot yield curve levels.


• It should be noted that because the liquidity of the stripped market is less than that of Treasury securities, the spot yield curve generated from observed stripped securities is not considered as good an estimate of the Treasury yield curve as the theoretical spot yield curve generating from bootstrapping.

Treasury Auction

• Auction: New T-Bills, T-Notes, and T-Bonds are sold on an auction basis through the Federal Reserve Bank of NY. Three-month T-bills (13 weeks or 91-day bills) and 6-month T-bills (26 week or 182-day bills) are auctioned every Monday.

Issue Frequency

13-week T-bill26-week T-bill52-week T-bill2-year T-note5-year T-note10 –year T-note20-year T-bond

WeeklyWeeklyEvery 4 weeksMonthlyQuarterlyQuarterlySemi-annual

Treasury Auction

• Treasury yield auction Process: – Each dealer submits either a competitive bid (price

and quantity) or noncompetitive bid (quantity only)

– Bids are ranked from lowest yield (highest price) to highest yield (lowest price) that exhaust the issue (includes both competitive and noncompetitive bids)

– The last price is known as the stop-out price

– Noncompetitive bids get the average price

Treasury Auction: Example

Example of T-bill Auction Process

1. Announcements of a T-bill auction are made on the Thursday preceding the Monday offering. In the announcement, the Treasury will indicate the size of the auction, the proportions of the offering that will be used to replace maturing debt and for new funding, and their estimate of cash needs for the remainder of the quarter.

2. Bidders must file tender forms by Monday. Competitive tenders submit a quantity bid and a yield bid based on a discount yield basis; noncompetitive tenders submit only a quantity bid up to $1M face value.


• Discount yield:

• Price given discount yield and face value of 100 is:

toMaturityDays

360

F

PFR 0

D

P0 = 100 [1- RD (Days to Maturity/360)]


3. The distribution is determined by first subtracting the noncompetitive bids from the total bids; the remainder represents the amount that is awarded to competitive bidders.


Volume of bills requestedVolume of bills accepted by the Treasury

Volume of noncompetitive offers acceptedVolume of competitive offers

$12.5 billion$11.0 billion$1.5 billion$9.5 billion

Example: If the volume of bills requested is $12.5 billion and the amount accepted by the Treasury is $11 billion with $1.5 billion being noncompetitive, then the issue would be oversubscribed, with $1.5 billion going to noncompetitive bidders and $9.5 billion going to competitive bidders.


4. The distribution to competitive bidders is determined by arraying the bids from lowest yield (highest price) to highest yield (lowest price). The discount yield is carried out to three decimal points.


Suppose we have the following competitive bids:

Bid Discount Yield % Bid Price Quantity Bid in billions Cumulative bids in billions

3.7503.7553.7603.7653.7703.7753.8003.825

*3.830 3.8353.840

99.05299.05199.05099.04899.04799.04699.03999.03399.03299.03199.029

.20

.57

.781.251.301.501.701.85.75.75

_.35_11

.20

.771.552.804.105.607.309.159.90

10.6511.00


5. The Treasury allocates to competitive bidders until $9.5 billion is distributed. The lowest price at which at least some bills are awarded is the stop price. In this case, the stop price is 3.83% or 99.032.

6. Those bidding above the stop price of 3.83% are awarded the quantity they requested, while those with bids below the stop price do not receive any bills – shut out.


• The bids at the stop price are awarded a proportion of the remaining bids.

• At 3.83%, there are $0.35 billion left in bids ($9.5 billion-$9.15 billion) and $0.75 billion requested at the stop price. Each of the bidders at 3.83% would therefore receive 46.667% (= .35/.75) of his bid.


6. The weighted average bid that the noncompetitive bidders receive is 3.786%:

7. The difference between the stop bid yield and average yield is called the tail; in this case the tail is .044% (= 3.83% - 3.786%).

Average Bid = ($.2/$9.5)(3.75%) + ($.57/9.5)(3.755%) + + (.35/9.5)(3.83%) Average Bid = 3.786%

Treasury Secondary Market

• The secondary market for Treasuries is part of the OTC market.

• In the secondary market, recently issued Treasury securities, called on-the-run issues, are the most liquid securities with a very narrow bid-ask spread; approximately 70% of the total secondary market trading involves on-the-run issues.

• In contrast, Treasury securities issued earlier, referred to as off-the-run issues, are not quite as liquid and can have slightly wider spreads.

Government Security Dealers

• Both the primary and secondary markets are controlled by primary Treasury security dealers.

• Primary implies you are on the Federal Reserve’s list. To be on the list, a dealer must agree to trade (act like a specialist) and have sufficient capital.

• As of 2002, there were 22 primary security dealers.

Primary Government Security Dealers, 2002

ABN AMRO Inc.BNP Paribas Securities Corp.Bank of America Securities, LLCBanc One Capital Markets, Inc.Barclays Capital, Inc.Bear, Stearns & Co. Inc.CIBC World Markets CorpCredit Suisse First Boston Corp Daiwa Securities America, Inc.Deutsche Bank Securities In.Dresdner Kleinwort Wasserstein Securities LLC

Goldman, Sachs, & Co.Greenwich Capital Markets, Inc.HSBC SecuritiesJ.P. Morgan Securities, Inc.Lehman Brother Inc.Merrill Lynch Government Securities Inc.Mizuho Securities USA Inc.Morgan Stanley & Co. IncorporatedNormura Securities International, IncSalomon Smith Barney Inc.UBS Warburg LLC

Federal Reserve Bank of New York: www.newyorkfed.org/markets/pridealers_listing.html

http://www.newyorkfed.org/markets/pridealers_listing.html

Treasury Dealers: Profit

• By taking temporary positions, dealers hope to profit from two sources:

1. Carry income 2. Position profit


• Carry income is the difference between the interest dealers earn from holding the securities and the interest they pay on the funds they borrow to purchase the securities.


Carry income • When dealers acquire securities, they often finance the

purchase by borrowing from banks, other dealers, and other institutions. – One major source of funds for them is demand loans from banks.

Demand loans are short-term loans to dealers (one or two days), secured by the dealer's securities. These loans are usually renewable and often can be called at any time by the bank.

– Another important source of dealer funding is repurchase agreements.

• When dealers sell their securities, the invoice price is equal to the agreed-upon price plus the accrued interest. Generally, dealers profit with a positive carry income by earning higher accrued interest than the interest they pay on their loans.


Position Profit

• The position profit of dealers comes from long positions and short positions.

• In a long position, a dealer purchases the securities and then holds them until a customer comes along. The dealer will realize a position profit if rates decrease and prices increase during the time she holds the securities.

• In a short position, the dealer borrows securities and sells them hoping that rates will subsequently increase and prices will fall by the time he purchases the securities.

Government Security Dealers:Interdealer Market

• There is also an interdealer market in which primary and nonpriamry dealers trade billions of dollars each day amongst themselves.

• This interdealer market functions through government security brokers that for a commission match dealers and other investors who want to sell with those wanting to buy.

• The government brokers include such firm as Cantor Fitzgerald Securities, Garban LLC, Hilliard Farber and company, Intercapital Government Securities, Liberty Brokerage, and Tullett and Tokyo Securities.

Web Information on Treasuries

• Information on the Treasury’s upcoming and past auctions can be found at www.publicdebt.ustreas.gov/of/ofaucrt.htm

• Information on primary security dealers is at www.newyorkfed.org/markets/pridealers_listing.html

• Information on requirements to be primary security dealers is at www.newyorkfed.org/markets/pridealers_policies.html

• Information on how to buy Treasury securities on line is at

www.publicdebt.ustreas.gov/ols/olshome.htm

• Information on rates can be found at www.federalreserve.gov/releases/h15/data.htm and www.economagic.com

http://www.publicdebt.ustreas.gov/of/ofaucrt.htm

http://www.newyorkfed.org/markets/pridealers_listing.html

http://www.newyorkfed.org/markets/pridealers_policies.html

http://www.publicdebt.ustreas.gov/ols/olshome.htm

http://www.federalreserve.gov/releases/h15/data.htm

http://www.economagic.com/

Repurchase Agreements

• Repurchase Agreements (RA or RP): Agreement in which the holder of a security sells the security with an agreement to buy it back.

• RPs represent a secured loan.

• RP are often formed with Treasury and Federal Agency securities. The RP seller may agree to buy back the next day (overnight) or it may be as long as 90 days (term RP).


• RPs are often used by dealers to finance their purchases of Treasury securities.

• Example: A dealer buying $20M of T-bills could sell the T-bills to a bank (using the bank funds as the source of financing for the T-Bills), then agrees to buy the bills back over the next week when he needs them in order to sell to his customers.


• To the borrower (dealer), the RP represents a collateralized loan, with the Treasury securities serving as the collateral.

• Government security dealers often use overnight repos to finance their positions, agreeing to buy back the securities the next day or two.


• To the lender, the RP position, defined as a reverse repo, represents a secured short-term investment.

• Banks, investment banking firm, dealers, corporations, state and local governments, and other institutions find RPs attractive for investing their excess cash.


• Collateral Seller: Some practitioners refer to the party with the repo position (sale/repurchase) as the collateral seller.

• Collateral Buyer: Some refer to the party with the reverse repo (purchase/resale) as the collateral buyer.

Repurchase Agreements: Example

• Suppose a Treasury dealer plans to buy $20 million of T-notes on the Treasury auction day and anticipates holding them for one day before selling the securities to her customers for $20M plus a premium.

• To finance the purchase, the dealer could buy the

notes and simultaneously enter a repurchase agreement with an investor. Per the agreement, the dealer would sell the notes for $20M minus the interest paid to the lender.


• In this market, dealers and lenders state the interest in terms of an annualized repo rate based on a 360-day year.

• If this rate were 6%, then the interest would be $3,333 and the price the dealer would sell the notes for on the repo agreement would be for $19,996,667.


Interest = (Principal) (Repo Rate) (Length of Loan/360)Interest = ($20,000,000) (0.06) (1/360)Interest = $3,333

Price Sold = $20,000,000 - $3,333 = $19,996,667

Repurchase Price = $20,000,000 • One day later, the dealer would buy back the T-notes on the

repurchase agreement for $20M and then sell them to her customers for hopefully $20M or more plus one day’s accrued interest.

Types of Repurchase Agreements

• Term Repo is a RP that is not overnight.

• Open Repo is a RP that has no maturity. It is typically an overnight repo that is automatically rolled over into another overnight repo until one of the parties closes.

• Dollar repos is a RP that permits the borrower to repurchase with securities similar, but not identical to the securities initially sold.

Market for Repurchase Agreements

• Many financial and non-financial corporations take both repo and reverse repo positions.

• A bank, for example, might loan funds to a dealer with an open reverse repo (collateral buyer), while financing part of its short-term loan portfolio with a term repos (collateral seller).


Security Dealers

• Security dealers use repos to set up long positions and reverse repos to form short positions.

• In the case of a long position, a Treasury security dealer might finance her security acquisition with a repurchase agreement. If interest rates decrease and prices increase, the dealer would then profit from the long position.


Security Dealers

• For short positions, a dealer might sell Treasury securities as part of her normal business with the securities coming from the collateral obtained from taking a reverse repo position. – From the combination of a security sale and a reverse

repurchase agreement, the dealer would have a cash or liquid position from the security sale and an obligation to deliver the securities on the reverse repo.

– To profit, the dealer is hoping that rates would increase causing the price of the underlying Treasury securities to fall.


Security Dealers

• Note: A dealer might hedge a long position financed with a repurchase agreement with a futures contract, earning just the carry income equal to the difference between the accrued interest earned on the securities held and the rate paid on the repurchase agreement -- the repo rate.


Banks • Another important use of repurchase agreements is by

banks as a way to finance their federal funds positions.

• Federal funds are deposits of banks and deposit institutions with the Federal Reserve (Fed) that are used to maintain the bank’s reserve position required to support their deposits.

• Banks maintain federal funds desks where they manage their federal funds positions: borrowing funds when they are deficient and lending funds when they have an excess amount of reserves.


Banks

Two common ways depository institutions finance a deficient reserve positions are through the federal funds market and the repo market. – The federal funds market is a market in which

depository institutions with excess reserves lend to institutions that are deficient. Federal funds loans are typically overnight to one week, unsecured, and traded directly between lending bank (usually a small regional bank) and borrowing bank (often a money center bank).

– This contrast with the repo loan that is secured and often offered by dealers making a market.


Banks

Because of the security backing the repurchase agreement, their rates tend to be less than federal fund’s rate; the spread on overnight federal funds and repurchase agreements is about 25 basis points.

Repurchase Agreements: Risk

• If the borrower (collateral seller) cannot buy back the underlying securities, the lender is left with securities whose price could or may already have decreased.

• To minimize such risk, a repo agreement may require that the borrower set up an initial margin in the form cash, pledge additional collateral, or sell some securities in excess of the amount of the principal of the trade.


• Another risk facing the lender (collateral buyer) is that the borrower may use the collateral fraudulently as security for other repurchase agreements.

• This could occur when the repurchase agreement allows for the borrower/collateral seller to hold the securities in a separate customers account maintained by the seller (known as a hold-in-custody repo or letter repo), instead of actually delivering the securities to the lender/collateral buyer or delivering them to a custodial account set up with a third party.


• The extent of this type of risk was brought to light in 1985 when it was learned that several government security dealers who had declared bankruptcy (ESM Government Securities and Bevil, Bresler, and Schulman) had used the same securities as collateral on different repurchase agreements.

• Investors who had purchased these repos included a number of municipalities and state-insured thrifts (many in Ohio); their losses were over $500 million.


• Since that scandal, lenders have tried to avoid such risk by requiring notification of ownership transfer of the securities if possible (recall, Treasury securities are in book-entry form), and by requiring more detailed accounting.

• In addition, the scandal led to the passage of the Government Security Act of 1986 that required greater disclosure of repurchase agreements and gave the Treasury the authority to oversee dealers in the repo market.

Websites

• Information on the size of the repo market as a source of dealer financing go to www.bondmarkets.com and click on “Research Statistics” and “Funding/Repo.”

http://www.bondmarkets.com/

Federal Credit Agency

• Federal Credit Agencies were created to solve financial problems not being met in the private sector: loans to farmers, loans to small businesses, promotion of exports, and creation of secondary mortgage markets.

• Two Classifications:

1. Federally Sponsored Agencies

2. Federal Agencies


• Federally Sponsored Agencies also referred to as government-sponsored agencies, and government-sponsored enterprises, are privately owned companies with a federal charter.

• Among these agencies are– Federal National Mortgage Association (FNMA or Fannie Mae), – Farm Credit Banks (FCB), – Federal Agriculture Mortgage Corporation (FAMC or Farmer

Mac), – Student Loan Marketing Association (SLMA or Sallie Mae)

• These government-sponsored companies sell securities and use the proceeds to provide loans and liquidity to support the housing industry, agriculture sector, and college loan programs.


• Federal Agencies are true federal agencies created by the U.S. government.

• Included in this group are – Export-Import Bank– Tennessee Valley Authority (TVA)– Federal Housing Administration (FHA)– Small Business Administration (SBA) – Government National Mortgage Association (GNMA or

Ginnie Mae)

• These agencies obtain financing by borrowing from the Federal Financing Bank, which in turn, borrows from the Treasury.


FEDERALLY SPONSORED AGENCIES

Farm Credit Banks (FCB) Federal Home Loan Bank (FHLB) Federal Home Loan Mortgage Corporation (FHLMC) Federal National Mortgage Association (FNMA) Federal Agriculture Mortgage Corporation (FAMC) Student Loan Marketing Association (SLMA) Financing Corporation (FICO) Farm Credit Financing Assistance Corporation (FACO) Resolution Funding Corporation (REFCO)

FEDERAL AGENCIES

Export-Import Bank Farmers Home Administration (FMHA) Federal Housing Administration (FHA) Government National Mortgage Association (GNMA) Postal Service Tennessee Valley Authority (TVA) Federal Deposit Insurance Corporation (FDIC)

Federal Agency Securities

• Federal agencies obtain financing by borrowing from the Federal Financing Bank, which in turn, borrows from the Treasury.

• Some agencies sell their own securities.

– TVA, for example, issued over $30 billion in 1998 ($25 billion in short-term securities and $6 billion in long-term) to finance its utility operations and construction projects in the Tennessee River area.

Federal Agency Securities

• Collectively, the claims sold by federal agencies and government-sponsored companies are referred to as federal agency securities.

• For investors, these claims are considered virtually default free because of the agency's or company's affiliation with the federal government.

• Some federal agency issues are backed by

Treasury bonds and many agencies have lines of credit with the Treasury.

Features of Federal Agency Securities

1. Risk: Federal agency claims are considered virtually default free because of the agency's or company's affiliation with the federal government.

– In the 1980s and early 1990, the General Accounting Office and the Treasury began requiring that all federally sponsored agencies maintain a triple-A credit rating or lose their government support.


2. Yields: Yields on federal agency securities are highly correlated with the yields on Treasuries, with the yield spread of federal over Treasury being positive.

– On occasions some federal agency securities have traded at significantly higher yields than Treasuries (e.g., 200 basis points).


3. Maturity: Federal agency issues vary from short to long term in maturity, ranging from overnight issues to bonds with 30-year maturities.

4. Rates: Agency money-market securities are sold as zero-discount bonds, while intermediate and long-term notes and bonds are sold as coupon bonds; agencies also sell floating-rate bonds.


5. Denominations: The denominations on the bonds vary from $1,000 to $50,000 and up.

• FNMA, FHLMC, the Federal Home Loan Bank system, and several other agencies also offer agency benchmark programs similar to corporate medium term note issues. These programs provide for the regular issuance of coupon securities covering a range of maturities.


6. Taxability: Unlike Treasury securities, which are exempt from state and local taxes, and municipal bonds, which are exempt from federal taxes, most federal agency securities are fully taxable.

– Because of their tax status, as well as their

maturities and relatively low risk, federal agency claims are attractive investments for pension and trust funds, state and local governments, banks, and corporations. The Federal Reserve System also trades in some federal agency securities.

Market for Federal Agency Securities

• Over the last three decades, the debt of federal agencies has grown from $50 billion (1970) to over $2.3 trillion in 2002.


Federal Home Federal Home Federal National Farm Credit Student Loan Tennessee Other(2) TotalYear Loan Bank Loan Mortgage Mortgage System(1) Marketing Valley

Corporation Association Association Authority

1985 74.4 11.9 93.9 68.9 8.4 16.3 20 293.9

1986 88.8 13.6 93.6 62.5 12.2 17.2 19.6 307.4

1987 115.7 17.6 97.1 55.3 16.5 18.1 21.1 341.4

1988 135.8 22.8 105.5 53.8 22.1 18.3 23.2 381.5

1989 136.1 26.1 116.1 55.7 28.7 17.9 31.2 411.8

1990 117.9 30.9 123.4 54.9 34.2 23.4 49.9 434.7

1991 107.5 30.3 133.9 53.5 38.3 22.4 56.9 442.8

1992 114.7 29.6 166.3 53.2 39.7 23.6 56.9 484

1993 139.5 50 201.1 54.4 39.8 29.9 56 570.7

1994 205.8 93.3 257.2 54.4 50.3 27.5 50.3 738.9

1995 243.2 120 299.2 58.6 47.5 29.4 46.7 844.6

1996 263.4 157 331.3 61.3 44.8 27.9 40.2 925.8

1997 313.9 169.2 369.8 64.8 37.7 27.8 39.4 1,022.60

1998 382.1 287.4 460.3 64.7 35.4 26.5 44.2 1,300.60

1999 529 360.7 547.6 70.1 42 26.4 44.2 1,620.00

2000 594.4 426.9 642.7 75.4 45.4 25.7 44.2 1,854.00

2001 623.7 565.1 763.5 77.9 48.4 26.8 44.2 2,149.60

2002 643.1 601 789 82.2 49.6 26.8 44.2 2,235.90Source: Federal Reserve System: www.federalreserve.gov. Also in www.bondmarkets.com(1)Includes Farm Credit Banks and Farm Credit Financial Assistance Corporation. (2)Includes Defense Department, Export-Import Bank, Federal Housing Administration, GNMA certificates of participation,Postal Services, U.S. Railway Associaiton, Financing Corporation, and the Resolution Funding Corporation.


• The primary market for many federal agency securities is handled through a network of federal security fiscal agents, brokers, and dealers. – New issue can be sold through dealers, by auction, or

by direct sales. – Short-term securities are sold on a continuous basis,

while intermediate issues are sold on a monthly basis, and long-term bonds are offered several times a year.

• There is also an interdealer market that helps to improve the efficiency of the market.


• Intermediate- and long-term issues are usually sold through a solicitation method. – Under this method, a fiscal agent puts the selling group

together. The selling group then provides potential investors with information on the issues. Given that information, the potential investor indicates the amount of the issue they plan to buy and the price they believe the issue should be. The fiscal agent then sets the price based on the inputs of the potential investors.

• The secondary market for agency securities is handled through dealers on the over-the-counter market.

Federal Agency’s Role in the Capital Formation Process

• While different federal agency securities have many similar characteristics, the purpose for which each agency and government sponsored company uses its funds varies considerably.

• The major areas of financing for federal agencies

are – Housing– Agriculture – Savings and loans and bank funding and reorganizing – Student loans – International business


1. Housing and Real Estate: FNMA, GNMA, FHLMC and FAMC are the agencies involved in providing funding and liquidity for the mortgage industry.

• Function: – Creation of Secondary Mortgage Market: They

issue securities and use proceeds to buy existing mortgages.

– Mortgage Backed Securities: Create, insure, and buy MBS: Claims on a portfolio of mortgages.


2. Agriculture Credit Financing: • The Federal Farm Credit Bank System (FFCBS) originally

consisted of 12 Federal Land Banks (FLB), 12 Federal Intermediate Credit Banks (FICB), and 12 Banks for Cooperatives.

– The Federal Land Banks (created by an act of Congress in 1916) made mortgage loans and provided financial funds to farmers and ranchers for purchasing or improving their farms and ranches.

– The Federal Intermediate Credit Banks (created in 1923) provided short-term loans for farmers.

– the Banks for Cooperatives (created in 1933) provided seasonal loans to farm cooperatives.


2. Agriculture Credit Financing:• In 1987, the FFCBS was reorganized under the

Agriculture Credit Act.

• This reorganization led to the merger of the regional FLBs, FICBs, and Banks for Cooperatives into six regional Farm Credit Banks (FCBs) and the Agriculture Credit Bank that now makes agriculture loans through 32 Federal Credit bank Associations.


2. Agriculture Credit Financing:

• The FFCBS issue three types of securities: – Short-term money markets securities with

maturities ranging from 5 days to 270 days – Short-term bonds with maturities from three to

nine months– Intermediate bonds with maturities ranging

from one year to 10 years


2. Agriculture Credit Financing: • All of the FFCBS obligations are handled by the Federal

Farm Credit Bank Funding Corporation, which sells new issues through a selling group of 150 brokers and dealers and sells short-term notes through four dealers.

• In addition to FFCBS, Congress in 1987 created the Farm Credit Finance Assistance Corporation (FACO). This government-sponsored corporation provided capital to the FFCBS when it was facing financing difficulties from loan defaults by farmers during the early 1980s.


3. S&L and Bank Financing:• Federal Home Loan Bank System provides a source of loans to

S&Ls; the agency raises funds by issuing debt securities.

• Federal Deposit Insurance Corporation provides deposit insurance for bank and S&Ls. FDIC also acts as a receiver for failed banks

• Resolution Trust Corporation was responsible for bailing out bankrupt S&L and banks. RTC was funded through bonds issued by the Resolution Funding Corporation. Stopped operations in 1995.


4. College Student Loans:• Student Loan Marketing Association (Sallie Mae)

provides funds and guarantees for lenders who provide student loans through the Federal Guaranteed Student Loan Program and PLUS loan program.


5. International Financing:• World Bank provides public and private sector

loans to finance public and quasi-public projects such as education, power plants, dams, roads, etc.

• Regional Development Banks: Asian Development Bank, African Development Bank, U.S. Export-Import Bank. The banks finance projects and provide insurance and loan guarantees.

Summary of Federal Agencies

AGENCY FUNCTION MAJOR SECURITIES ISSUED

Federal National Mortgage Association(FNMA or Fannie Mae)

Buys mortgages and issues mortgage-backed securities

Sells pass-through securities or participation certificates, which entitle the holder to a cash flow from a pool of mortgage securities

Government National Mortgage Association(GNMA or Ginnie Mae)



Federal Home Loan Mortgage Corporation(FHLMC or Freddie Mac)



Federal Home Loan Bank System (FHLBS)

FHLBS consists of 12 district Federal Home Loan Banks; provides loans to qualified S&Ls

Sell bonds separately and jointly for Federal Home Loan Banks

Summary of Federal AgenciesAGENCY FUNCTION MAJOR SECURITIES

ISSUED

Student Loan Marketing Association(SLMA or Sallie Mae)

Provides funds for lenders participating in the Federally Guaranteed Student Loan Program and PLUS loan programs (loans to parents of undergraduate students)

Issues discount notes, long-term bonds, and pure discount bonds

Farm Credit Financial Assistance Corporation (FACO)

Provides funds primarily to refinance loans to farmers who defaulted on FCBS loans

Issues FACO bonds that are backed by the Treasury

Financing Corporation (FICO) Federally sponsored agency established in 1987 to finance defaults of deposits by savings and loans institutions. The 12 Regional Federal Home Loan Banks purchased its stock. By law, FICO is to be dismantled in 2026.

Authorized to issue up to $10.805 billion in bonds

Resolution Trust Corporation (RTC) Federally sponsored agency responsible for liquidating or restructuring insolvent savings and loans. Stopped operations on December 31, 1995.

Authorized to issue up to $40 billion in long-term bonds

Federal Farm Credit Bank System (FFCBS)

Provides credit to the agriculture sector distributed through 11 Farm Credit Banks

Issues bills, notes, and bonds

Websites

• Information on the seize of the Federal Agency debt can be found by going to www.bondmarkets.com and clicking on “Research Statistics” and “Federal Agency Debt.”

http://www.bondmarkets.com/

Municipal Bonds

• In the U.S., there are over 83,000 state, county, municipal, and other local governments.

• Like corporations, they sell bills, notes, and bonds (referred to as munis) to finance their long-term projects and short-term deficits resulting from current operations.

Municipal Bonds

• There has been a substantial increase in the expenditures of these municipal government units over the last 30 years resulting from population growth, shifts from central cities to the subdivisions, and other demographic changes.

• In 2002, the total expenditure for all state and local governments was approximately $1.38 trillion, three times the level of expenditures for 1980.

• The total revenue generated in 2002 by all state and local governments to support these expenditures was approximately $1.28 trillion.

Tax-Exempt Status

• The common feature of municipal securities is their tax-exempt status: – Interest (but not the capital gain) is exempt from

federal income taxes (personal and corporate). – States also exempt their own securities from state

income taxes.

Tax-Exempt Status

• The tax-exempt feature of municipals makes them very attractive to individuals and corporations in the higher income tax brackets and investment funds whose clients are in the higher brackets.

• An investor in the 35% tax bracket would be

indifferent, with all other factors equal, to a fully taxed bond yielding 10% and a tax-exempt bond yielding 6.5%.

Tax-Exempt Status• If the tax rate increases and the rates on fully

taxable bonds and tax-exempt bonds stay constant, then more investors will find tax-exempt bonds relatively attractive.

• If tax rates decrease, tax-exempt bonds become less attractive with other factors constant.

• The demand for municipals decreased notably after the Tax Reform Act of 1986 lowered rates, reducing the tax-exempt benefits of municipals; the demand, though, increased in 1993 when marginal tax rates were increased.

Tax-Exempt Status

• Until the Tax Reform Act of 1986, commercial banks were one of the larger purchasers of municipals.

• The lowering of the top corporate tax rate from 46% to 35%, though, led to a sizable reduction in their investment in municipal bonds.

• Today, the leading municipal bonds investors are individual investors and mutual funds, followed by commercial banks and property and casualty insurance companies.

Tax-Exempt Status

• The tax code governing tax-exempt securities is quite complex.

• Example: – An investor, who buys an original-issue discount

bond (OID) and holds it to maturity, can treat the difference between the issued price and the par value as tax-exempt interest.

– If the bondholder subsequently sells the OIB before maturity, any increase in its price up to its par value is generally considered interest income and is tax exempt, while any increase above the par value is considered a capital gain and is taxable.

Tax-Exempt Status

• Example: – For an investor who buys an OIB in the secondary

market, though, the tax treatment depends on the purchase price relative to what the IRS defines as the market discount cutoff price (the price defining the allowable discount) and the revised issue price (price reflecting the price change over time that must be accreting).

Types of Municipal Bonds

• Three types of municipal securities:

1. Municipal Anticipation Notes

2. General Obligation Bonds

3. Revenue Bonds

Municipal Anticipation Notes

• Municipal Anticipation Notes are short-term and intermediate term notes issued to finance operations or projects in which future revenue is anticipated.

• Types:– Tax-Anticipation Notes (TANs)– Revenue Anticipation Notes (RANs) – Bond Anticipation Notes (BANs) – Grant-Anticipation Notes (GANs)

Municipal Anticipation Notes

• Municipal-anticipation notes are sold primarily to banks and money-market funds.

• They are usually secured by the issuer's taxing

power and sell at yield spreads over short-term Treasuries that reflect their tax-exempt status and credit ratings.

• Most are sold on a pure discount basis, with face values ranging from $5,000 to $1 million and maturities ranging from one month to three years.

General Obligation Bonds

• General Obligation Bonds (GOs) are long-term and intermediate-term bonds that are secured by the issuing government’s general taxing power. The interest and principal on the bonds can be paid from any revenue source.

• Full faith and credit obligations are GOs issued by states and large municipal governments that have a number of tax revenue sources.

• Limited-tax GO bonds are GOs issued by smaller municipalities or authorities whose revenues are limited to only one or two sources.


• The bond indenture is usually accompanied with an – Official Statement: Document detailing the

features of the issue– Legal Opinion: Document that interprets issues

related to the bond’s collateral, priority of claims, etc.

General Obligation BondsOfficial Statement:

• The official statement is a document, similar to the prospectus for a stock or corporate bond. It provides details of the return, risk, and other characteristics of the issue and provides information on the issuer.

• Information in official statement:

Amount of the Issue Credit Rating Information on Issuer The Names of the Underwriters Selling Group Sources of Payments Sources and Uses of Fund Statement Financial Statements Debt Service Required Notice of any Pending Legislation Bond Insurance (if any)

General Obligation BondsLegal Opinion:

• The legal opinion is a document that interprets legal issues related to the bond's collateral, priority of claims, and the like.

• Municipal bond attorneys with Wall Street-based law firms, as well as local firms, prepare legal opinions.

• Many bank and investment banking firms have their own counsel to review and prepare such documents.


Legal Opinion:• The municipal defaults that have occurred over the

last 20 years have made the legal opinion an important information source for assessing a municipal bond’s credit risk.

General Obligation BondsLegal Opinion:

• In evaluating the creditworthiness of a GO bond, investors need to review the legal opinion to determine:

1. The extent of the state or local government’s unlimited taxing authority

2. Possible statutory or constitutional limitations on the jurisdiction’s taxing power

3. The priority of claims on general funds

4. Bondholders’ redress in the case of a default

5. Any statutory or constitutional questions that could be problematic

Revenue Bonds

• Revenue bonds are municipal securities paid by the revenues generated from public or quasi-public projects, proceeds from a specific tax, or by special assessment on an existing tax.

• Some revenue bonds are backed by a specific revenue source, as well as general revenues – double-barreled bond.

• Dedicated tax-backed revenue bonds are bonds that are paid from dedicated revenues such as a tobacco settlement, lottery, or special fee.

Revenue Bonds

• Revenue bonds have an indenture, legal opinion, and an official statement. Some of the important provisions delineated in the indenture and legal opinion include:

1. Whether the issuer can increase the tax or users’ fee underlying the revenue source.

2. Whether the issuer can incur additional debt secured by the revenue of the project (minimum revenue clauses) or under what conditions new debt can be incurred.

3. How the revenues of the project are to be directed: Net revenue structured revenue bond in which bondholders are paid after operating expenses but before other expenses; Gross revenue structured bond in which the bondholders are paid first.

4. Whether there is any additional collateral or guarantees.

Projects and Programs Financed by Revenue Bonds

• Revenue bonds are an important source of funding for a number of public projects. They are used to finance major capital projects and programs, such as:

• Roads • Bridges • Tunnels • Airports • Hospitals • Power-generating facilities

• Water treatment plants • Municipal Buildings • University buildings• Educational programs • Inner-city housing development• Student loan programs

Sources of Funds for Revenue Bonds

• The revenues used to pay the interest and principal payments on these bonds are usually project specific and include:

• Tolls• Rents • User charges • Earmarked revenues from fees • Specific taxes

Industrial Development Bonds

• Many revenue bonds are used to support not just public projects, but also those projects that benefit both public and private interests.

• In the 1980s, many private sector companies began to use tax-exempt revenue bonds to finance industrial parks, electric-generating plants, and other capital projects.

• One popular revenue bond used to support private-public sector projects is the industrial development bond (IDB), also called an industrial revenue bond (IRB).


• Many state and local governments or authorities sell IDBs to finance the expansion of an area's industrial base or to attract new industries.

• Typically, the government or authority floats a

bond issue and then uses the proceeds to build a plant or an industrial facility; it then leases the facility to a company or provides a low interest loan for the company to acquire the asset.


• Because of the tax-exempt status of IDBs, this type of financial arrangement benefits all parties: – Investors receive a higher after-tax yield

– Corporations received lower interest rates on loans or lower rental rates

– The area benefits from a new or expanding industry

Common Types of Revenue BondsHighway Revenue Bonds: These revenue bonds are used to finance highway systems and their related infrastructures (bridges, tunnels, etc.). There are two general types of highway bonds, classified in terms of how the transportation facility or highway is financed. If the highway, bridge, or tunnel is financed by a toll, then the toll revenue pays the bondholder’s interest and principal payments. The quality of these bonds depends on the ability of the project to be self-supporting. Financial problems that have arisen from these bonds are often based on poor traffic projections. Alternatively, earmarked revenues from gasoline taxes, driver license fees, or auto registration fees may finance the transportation system. Analysts who evaluate the creditworthiness of bonds often look at such coverage ratios as earmarked revenue to debt service.Water and Sewer Revenue Bonds: These bonds are issued to finance the building of water treatment plants, pumping stations, and sewers. Local governments or special bond authorities usually issue them. The bonds, in turn, are usually paid for by user charges. Covenants in the indentures may also specify that user charges be a specified proportion of debt services and reserves. Lease Rental Bonds: These bonds are used to finance the construction of public office buildings, stadiums, university facilities, and the like, and for the purchase of computers and other types of capital equipment. The bonds are paid for by the rents generated from the users: rents, tuitions, earmarked revenues, annual appropriation of a general fund, or stadium receipts. These bonds are sometimes referred to by the facility they are financing: for example, Convention Center Revenue Bond or Sport Stadium Bond.Hospital Revenue Bonds: These bonds are used to build or expand hospitals, to purchase medical equipment, and so on. The revenues used to finance the bonds are usually established by formulas involving a number of different levels of government and the medical facility's major source of revenue (e.g., Medicare and/or Medicaid).

Common Types of Revenue Bonds

Airport Revenue Bonds: Airport revenue bonds are used to finance the construction, expansion, or improvements of municipal airports. The bonds are usually secured by leases with the major airlines for the use of the terminals or by the revenues obtained from landing fees or fueling fees paid by the airlines and by the concession fees paid by terminal store users.Industrial Development Bonds: State and local governments or authorities sell industrial development or revenue bonds (IDB) to finance the expansion of an area's industrial base or to attract new industries. IDBs have been used to financed industrial parks, electric-generating plants, and other projects. Because of their use in financing many inherently private-sector capital projects, the Deficit Reduction Act of 1984 place a limit of $40 million on small IDB issues, prohibited certain capital projects from IDB funding, and restricted the total amount of IDBs that could be issued by a state based on its population.Lottery Bonds: These are secured by expected future lottery revenue. They are often used to finance the construction of new school facilities.Pollution Control Bonds: These bonds are used to help corporations purchase pollution control equipment. Often a municipal government will buy the equipment through the sale of the bonds and then lease the equipment to the corporation.


Resource Recovery Revenue Bonds: These bonds finance resource recovery operations that convert solid waste into commercially recoverable products and landfill residue. Revenue from these operations comes from fees for delivering garbage or sales form the products generated.Public Power Revenue Bonds: These bonds are used to finance construction of electricity-generating power plants and distribution systems. The bonds may be issued to finance the construction of one or several power plants with two or more utility companies. In this case, the issue is referred to as joint-power financing. Sports Complex and Convention Center bonds: These bonds are issued as permanent financing of sports stadiums and arenas and convention centers. The bonds may be lease-rental bonds paid for by rental income from the facility or they be paid from revenue generated from outside revenue sources such as local hotel taxes or city or county taxes.Life-Care Revenue Bonds: These bonds are issued by state and local development agencies to finance the construction of long-term residential care facilities for the elderly managed by nonprofit agencies or religious groups. Revenues supporting the bonds are generated from lease rentals or lump-sum payment made by the residents.Multi-Family Mortgage Revenue Bonds: These bonds are used to finance multi-family structures for low-income families and senior citizens. Some of the facilities are federally secured or provide interest cost subsidies under Section 236 or property tax reductions.


Single-Family Mortgage Revenue Bonds: These bonds are used to secure mortgages on single-family homes insured by FHA, VA, or private mortgage insurance.Section 8 Bonds: These are municipal bonds issued to finance low-and middle-income rental housing. The bonds are issued under terms specified by the Federal Housing Act. Under Section 8 of the act, the U.S. Department of Housing and Urban Development (HUD) maintains a cash reserve for each project to protect against the failure of residents to pay rent. In some cases, eligible low-income tenants pay 15% to 30%, with the government subsidizing the remainder. The risk to bondholders comes from the apartment building not maintaining a sufficiently high occupancy rate.College and University Revenue Bonds: These bonds are used as permanent financing of college buildings (libraries, classroom buildings, dormitories, and the like) and other university capital projects (computers and networks). Bondholders’ interest and principal is paid from tuition, dormitory rental fees, and special fees. They also fall under the category of lease-rental bonds.Student-Loan Revenue Bonds: These are bonds issued by state government agencies with the proceeds used to support loans to college students. The proceeds from these bonds are often used for purchasing federally guaranteed student loans made by local banks. Tax Allocation Bonds: These bonds are issued to finance office and property development in blighted or low-income areas. Bondholders are paid from property taxes that are expected to increase from improved real estate values.

Municipals with Special Features

• Serial Bond Issues: Many municipals issues are serialized: bond issue is broken up into different maturities.

• Insured Municipals: Since many municipals are purchased by banks and other institutional investors who need a high quality ratings, they are often insured by third parties: Capital Guaranty Insurance Company and the Municipal Bond Investor Assurance Company.

• Mello-Roos Bonds: Municipal securities issued by local governments in California that are not backed by the full faith and credit of the government.

• Refunded Bonds: Municipal bonds secured by an escrow fund consisting of Treasury and Federal Agency securities.


• Letter-of-Credit-Backed Municipal Bonds are bonds secured by a letter of credit from a commercial bank. In some case, the government unit must maintain a certain investment quality rating to maintain the guarantee.

• Moral-Obligation Bonds are bonds issued without the legislature approving appropriation. The bonds are therefore considered backed by the permissive authority of the legislature to raise funds, but not the mandatory authority.

• Municipal Put Bonds are bonds that can be cashed in at a specific value before maturity.

• Municipals with Warrants are bonds that allow the holder to buy additional bonds at set prices.


• Municipal Floaters: Municipal bonds with floating rate tied to a reference rates such as T-bill rates, London Interbank Offer Rate, or municipal bond index.

• Minibonds are low denomination issues ($100, $500, and $1000 par) that are sold directly to the public without an investment banker.

• Stripped Municipals: Like Treasury stripped securities, the municipal bond market has developed interest-only and principal only stripped municipals and floating-rate and inverse floating-rate stripped securities. Many of these municipal derivatives are created by investment banking firms, such as Goldman Sachs, Lehman Brothers, and Salomon Smith Barney, who buy municipals, place them in a trust, and then create derivative securities.

Municipal Bond Market

• Primary Market: The sale of GOs and revenue bonds is sometimes handled through a syndicate of commercial banks and dealers who usually underwrite the issue and then resell them on the open market. Municipal bonds are also privately placed.

• Secondary Market: The bonds of large municipal governments are traded on the OTC market. Smaller issues are handled by local banks and regional exchanges.

Municipal Defaults

• In 1975, the Urban Development Corporation of the state of New York defaulted on a $100 million New York City obligation.

• In 1978, Cleveland became the first major U.S.

city since the depression to default on its debt obligations.

• In the 1980s, cities such as Washington, Detroit, and Chicago experienced financial crises.

Municipal Defaults

• Approximately 70 municipalities filed for bankruptcy in 1980 (although none of them defaulted).

• In 1983 the Washington Public Power Supply System (WPPSS) defaulted on a $2 billion municipal government bond issue, with the courts ruling that bondholders did not have claims to certain revenues identified in the indenture.

• In the early 1990s, many states, such as California, and a number of cities experienced budget deficit problems resulting from declines in tax revenues and increases in expenditure on welfare and education, crime prevention, and the like.

• In 1991, 260 municipal governments defaulted.

Municipal Bond Quality Ratings

• Moody's, Standard and Poor's, and Fitch provide quality ratings on municipal securities similar to the ones they use for corporate bonds.

• Moody’s and Standard and Poor’s also rate notes and tax-exempt commercial paper.


• Moody’s has nine different categories from Aaa to C, with investment grades being Aaa to Ba.

• Moody’s also includes a numerical modifier to indicate the degree of quality in each category (e.g., Aa1, Aa2, Aa3, A1, A2, and so on).

• They also use a prefix ‘con’ to indicate when a revenue bond is dependent on the completion of a project or there is some current limiting condition.


• Standard and Poor’s has ten categories from AAA to D, with AAA to BBB being the investment grades.

• They use + and – sign to indicate relative strength.

• They use a ‘p’ to indicate a bond with ‘provisional’ funds.


• In determining ratings, Moody's, Standard and Poor's, and Fitch consider such factors as the amount of outstanding debt, the economic conditions of the area, the revenue source backing the issue, the provisions specified in the indenture, the legal opinion, and other factors noted above in conducting credit analysis.

• If the bond is insured, Moody's and Standard and Poor's also look at the credit quality of the insurer.

• Approximately 50% of municipal bonds have an `A' rating, with 10% having a triple-A rating. Included in this group are many of the insured bonds and refunded issues.


• It should be noted that each company could rate an issue differently. When a bond is rated differently, it can reflect a different emphasis that each places on certain parameters or differences in methodologies.

Moodys Moody’s Standard and Poor’s

Standard and Poor’s

Fitch Fitch

Rating Description Ratings Description Ratings Description

Aaa

Aa1Aa2Aa3

A1A2A3

Baa1Baa2Baa3

Ba1Ba2Ba3

B1B2B3

CaaCaC

Best Quality

High Quality

Upper Medium Grade

Medium Grade

Speculative

Highly Speculative

Poor QualityChance of defaultIn Default

AAA

AA

A

BBB

BB

B

CCCCCCD

Highest Rating

Strong Quality

Strong quality, but susceptible to adverse economic conditions.

Moderate Quality

Low Speculation

Moderately Speculative

SpeculativeVery SpeculativeBankruptcy FiledIn Default

AAA

AA

A

BBB

BB

B

CCCCCCDDDDDD

Highest Credit

Very high Credit

High Credit

Good

Speculative

High Speculative

High DefaultHigh DefaultHigh DefaultIn defaultIn defaultIn default

MUNICIPAL BOND RATINGS

Municipal Bond Regulations

• Following some of the municipal defaults and state and local government budgetary problems of the 1970s, Congress passed the Security Act Amendment of 1975 that expanded federal regulations to the municipal bond market.

• While the act did not require compliance to registration requirement under the 1933 Act, it did put municipal bond dealers, brokers, and bankers under the SEC regulatory system.

Municipal Bond Regulations

• The amendment mandated that the SEC establish the Municipal Securities Rule Board (MSRB), a self-regulatory board responsible for establishing rules for brokers, dealers, and banks operating in the municipal bond market.

• As a result of this board, the Securities and Exchange Commission amended SEC Rule 15c2-12 to prohibit dealers from marketing new municipal issues if issuers did not agree to provide annual financial reports and disclose relevant events such as credit rating changes, property sales, and the like.

• The SEC also approved a rule limiting the campaign contributions that municipal security dealers, brokers, and bankers could make to government officials that they did business with who were running for office.

Websites

• Information on latest events, trades and prices on a number of the municipal bond trades can be found by accessing www.bloomberg.com/markets/rates/munievents.html,

www.investinginbonds.com, and www.bondmarket.com.

• For information on specific municipals go to http://bonds.yahoo.com and click on “Bond Screener.”

• Information on state and local government fiscal conditions is at www.bea.gov .

• For information on municipal ratings go to www.moodys.com (registration required), www.standardandpoors.com (registration required), and www.fitchratings.com .

http://www.bloomberg.com/markets/munibondyield.html

http://www.investinginbonds.com/

http://www.bondmarket.com/

http://bonds.yahoo.com/

http://bonds.yahoo.com/

http://www.bea.gov/

http://www.moodys.com/

http://www.standardandpoors.com/

http://www.fitchratings.com/

Chapter 6

Documents

Transcript of Chapter 6