How to Decipher the Cover Sheet of an OS

Introduction

In the previous post, we discussed how to obtain an official statement on a municipal bond issue. Now, we will explore various areas of relative importance on the cover sheet of an OS. The particular Official Statement used in this analysis is the Glendale Arizona Industrial Development Authority Hospital Revenue and Refunding Issue dated in 2007 (The file can be downloaded here). On this document, there are numbers next to the highlighted information that can be used as a guide. Throughout this post, we will explain various parts on the cover page of this Official Statement.

Please note: Not all OS’s are created the same. These sections are not necessarily in the same order as other Official Statements. The goal is to showcase the wide array of information on the cover of an OS.

Details

1. The upper right corner of this Official Statement is the rating(s) on the bond. Some issues may be non-rated (NR). The three largest rating agencies are:

a. Moody’s

b. S&P

c. Fitch

2. There is an opinion from bond counsel on the exemption status for several areas of taxes:

a. Federal

b. State

c. Alternative Minimum Tax (AMT)

d. Corporations

3. This section contains:

a. the Size of the Deal

b. the Issuer

c. the Type of Issue (Revenue, General Obligation, Certificate of Participation, etc.)

d. the Particular Series

4. A few key points in this area are:

a. the quantity and increments in which the bonds can be purchased

b. the dates of the year in which interest is paid to the bondholder

5. A subject to redemption prior to maturity is noted in this section. More information about the provision can be found inside the OS.

6. This division consists of descriptions of the obligator, the trustee, and agreement specifications.

7. The Maturity Schedule for the various series of bonds is displayed which includes:

a. Due Date

b. Principal Amount

c. Interest Rate

d. Yield

e. CUSIP

8. This piece includes the specifics of who are not the obligators.

9. Investing in the municipal bonds involves various risks. These risks are disclosed within the Official Statement. The table of contents in the OS allows the reader to efficiently search for a variety of topics such as the risks involved in the municipal bond deal.

10. Appendices are mentioned in this section, which are located towards the conclusion of the OS and can include items such as:

a. General Information

b. Financial Statements

c. Certain Provisions

d. Opinion of Bond Counsel

11. This section notes various counsel involved in the municipal deal such as:

a. Bond Counsel

b. Disclosure Counsel

c. Financial Advisor(s)

12. The manager of the deal and co-managers (if applicable) are located in this segment. If an investor is interested in buying this deal, he/she should give their order to one of the managers.

13. The date the OS was created for distribution is included for recordkeeping purposes.

Conclusion

It is important to navigate through research material in an effective and efficient manner when evaluating potential investment opportunities. The cover page of an Official Statement includes valuable information on the bond issue, but is meant to be a supplement to the entire statement as opposed to a substitution when performing due diligence.

How to Obtain an Official Statement

Introduction

There is a wealth of information available to research municipal bonds. One resource with a plethora of information about a municipal bond issue is the Official Statement (OS). This can be used to become more familiar with the credit of a municipality (issuer). The OS includes such items as the purpose of the deal, the maturity schedule, the status of tax-exemption, sources of payment, debt service requirements, financial statements, and any other pertinent data. The underwriter / senior manager puts together the Official Statement for distribution to dealers, advisors, and investors. The OS is the disclosure notice for a municipal bond issue.

How-To

One might ask, "Where do I find Official Statements?" This brief process will explain the steps needed to retrieve an OS.

1. Go to the website http://www.investinginbonds.com (A picture of the webpage is shown below).

2. Under the Markets in Depth section, there is a subsection titled Municipal Markets. Click on the hyperlink: See Municipal Market At-A-Glance (The section of interest is highlighted in the picture below).

3. Next is a page where you can either select the bonds traded today category, the bonds traded yesterday category, or the bond history category. If you choose bonds traded today or bonds traded yesterday, go to 3A. If you want to enter a CUSIP into bond history, go to 3B.

a. By clicking on bonds traded today or bonds traded yesterday, the page following will show the history of municipal bond trades. In the example below, the State of Arizona was chosen to view bond trade history. You can select a particular bond in the history. On the right side of the page, there is a column labeled More Info. One of the links in this column is Statements (See 4A for further instructions).

b. If you know the CUSIP for the bond you are interested in, you can type it into the bond history box. The following page should show the actual bond and it's description. Click on the hyperlink below the column titled # of Trades.

This will take you to a screen shown below (See 4B for next step).


4. a. By clicking on the Statements link, the site will take you to a page where you can download the Official Statement for this particular issue. The user has an option t0 download the cover page, the entire OS, E-mail the document, or download part of the document. The picture below shows an example of what this page looks like.


b. If you click on the link for Search Munistatements.com, you will come to a page that allows you to download the Official Statement. The user has an option t0 download the cover page, the entire OS, E-mail the document, or download part of the document. The picture below shows an example of what this page looks like.


Conclusion

After the Official Statement is available for viewing, the next step is to research the particular issue. The following post will begin discussion of how to go about performing due diligence on a municipal bond issue beginning with deciphering the cover page of an OS.

What Happened To Bonds?

During the last month, the bond market has weakened dramatically. This is particularly evident in maturities from 10-30 years. The 10 Yr Treasury yield went from 4.63% on May 8 to an intra-day high yield of 5.25% on Friday (6/8) before ending the day at 5.14%. The Treasury market has suddenly become big news, and dominates the talking heads on TV. Investors would do well to ignore the trader talk on TV about bonds, and concentrate on the long-term fundamentals for bonds.


The Fundamentals

The two most important determinants of bond yields are:
1. Inflation expectations
2. Strength/weakness of the economy

The Fed has been concerned about reining in inflation, and raised the Fed Funds rate from a low of 1.0% on 5/4/2004 to the current level of 5.25%. This target was established almost 1 Yr ago on 8/8/2006. Since then, they have been in a holding pattern as inflation has fallen from 2.4% to 2.0% on the core PCE price index. The Fed would like this measure to be within the 1-2% target band. We view the progress on inflation as a positive for bonds. There is no evidence that the recent decline in the bond market is linked to an increase in inflationary expectations. The economy has slowed from about a 2.5% growth rate in August of 2006 to a recent weak 0.6% for the 1st quarter of this year (while the Fed has been on hold). This slowing in the economy is also a positive for the bond markets. So, the economic fundamentals are still positive for bond investors.


The Technicals

Since the long-term fundamentals are still positive for bonds, the most likely explanation for the sharp rise in bond yields last month is to be found in short-term changes or the technicals that pre-occupy the minds of traders. Here are some of the technical developments of the last month:

1. The amount of 10 Yr Treasury securities purchased at the last quarterly refunding on 5/8 by Foreign Central Banks was the highest since November 2005. This appeared to be a positive technical development for the market. These bonds sold at 4.63% at the May auction.
2. Shortly after the auction, the Fed stated it was still concerned about inflation and began to raise doubts that it would ease rates soon. These doubts increased during the month as several hawkish comments were made by different Fed Governors. The chart below from a 6/8 Citigroup report shows the change in expectations for a Fed easing over differing time periods.


As recently as 4/18, the market was pricing in an easing of 75 bp’s this year. This probability has now declined to a 0.0% chance. We believe this change in perception is the primary catalyst for the sell-off this month.
3. There has been Foreign Central Bank tightening by the European Central Bank and the Bank of New Zealand, which has added to the change in psychology of bond traders. Their logic is, "how can the Fed ease when the rest of the world is raising rates?" Were we overly optimistic about the Fed cutting rates 75 bp’s this year?
4. Mortgage durations have been rising in lenders' portfolios as ARMS are replaced with longer fixed rate mortgages by borrowers. This has led to hedging activity by lenders such as FNMA, selling 10 Yr Treasury securities to help shorten the duration of their huge loan portfolios.
5. Traders who look at charts feel that the 20 year bond market rally has ended and are shorting bonds. This has contributed to the weakness in the market.
6. The yield curve has steepened significantly which has been caused by large curve flattening trades being liquidated and replaced by curve steepening trades. This is very plausible because during the time long term yields have risen, short term yields have fallen modestly. Since 3/2/2007, the yield curve has gone from being inverted by (60) bp’s to having a positive slope of 17 bp’s on 6/1/2007. To implement this trade, the trader sells the long bond and buys shorter maturity bonds. This has contributed to the recent rise in rates.


Conclusion

There have been several technical factors that have contributed to the recent rout taking place in the bond market. This has driven yields to attractive levels for investors. This is a good time to ignore the traders on TV. Traders frequently change their opinions and have different time horizons than the investor. These same traders were telling us less than 2 months ago that there was a high probability that we would see a 75 bp's cut in rates this year by the Fed. Now they think there is no chance for a cut in rates. Future actions by the Fed are data dependent. If inflation continues to slow and the economy stays weak, rates will fall. The recent rise in rates should have a dampening effect on the economy which could lead to lower rates in the future. We feel the current sale in the bond market represents an opportunity for investors to add to their fixed income positions.

Muni's vs. CD's

Many investors are investing in CD's because of relatively high short-term interest rates. For some investors, municipal bonds may be a more appropriate and tax-efficient alternative to CD's. The following is a comparison of the two investments.

Liquidity Risk & Quality

Since CD's are meant to be held to maturity, they are less liquid than traditional bond instruments if the investor needs his/her money before maturity. The bid-ask spread on CD's is greater than municipal bonds, so it is more costly to liquidate CD's. Investors should also remember that only the first $100,000 invested in a CD per issuer is insured by the FDIC.

Reinvestment Risk

Most people buy shorter CD's with maturities of 2 years or less. This decision is similar to making a bet that rates will rise by the time the CD matures so the investor can invest at supposed higher rates. The investor is assuming reinvestment risk, because he/she is not protecting their income stream in case rates fall. It is important not to fall into the "rate trap" of purchasing only cash equivalent investments when short term rates are high. A study was completed by Ibbotson Associates in 2005 regarding long-term annual returns from 1926-2004 for fixed income instruments. They came to the conclusion that a portfolio of intermediate bonds has higher expected returns than a portfolio of cash or CD's. The table below showcases the results:

*These are returns on taxable securities and illustrate the higher expected returns for intermediate bond maturities compared to Cash Equivalent investments. On average, intermediate bonds have generated 5.40% annual returns compared to 3.70% returns for cash equivalents (such as CD's).

Tax Ramifications

Many investors are unaware of the tax consequences of an investment in CD's. Taxes have a significant impact when determining the after-tax value of CD's. For example, the table below shows after-tax returns when comparing a CD to a muni for Federal taxpayers in the highest tax brackets:

State taxes can also have a significant impact on returns for muni bonds. In high tax states such as California, the outcome looks like this when both State and Federal tax rates are included for investors in the maximum tax brackets *:

The CD is much less competitive in an after-tax yield comparison in high tax states. Below, a chart is displayed showing the results for a California resident in the upper bracket:


The municipal bond is more attractive compared to the CD in this example, both with and without state taxes included in these calculations.

State Tax-Exempt U.S. Agencies

Another fixed income option with competitive performance is an agency security such as a Federal Home Loan Bank or a Federal Farm Credit Bank. These two agencies are exempt from state taxes, whereas Fannie Maes and Freddie Macs are state taxable. Below is a table stating the various yields over multiple maturities for a state tax-exempt agency and a CD*:

For a chart with the yields from the above table, see below:

We have assumed an even yield for the state tax-exempt agency across the curve. The chart shows the CD yields increasing as the maturity increases. Even at 10 years, the agency has greater after-tax performance than the CD.

*These tables use the maximum tax brackets for the federal level.


Conclusion

Those who are investing in CD's may want to consider investing in other fixed income instruments such as municipal bonds or state-tax exempt agencies based upon the information provided in this post. For some investors, municipal bonds may be a more appropriate and tax-efficient alternative to CD's.

Munis: Kentucky vs Davis

The Supreme Court has finally agreed to hear the Kentucky vs Davis case which challenges the ability of a State to tax out-of-state muni bonds while giving preference to in-state securities which are not taxed. This case will be heard sometime after the next term begins on October 1st. We are still expecting this case to maintain the current tax system where 40 different states give preference to their own in-state securities. For further information please check our post on April 30 regarding the Supreme Court ruling against the trash haulers.

General Provisions for Illinois School Districts

This information is provided by Andrew Cubria from Hutchinson Shockey in Chicago. Huthinson Shockey is an expert on school district financing in the State of Illinois. Andrew works in the Public Finance area of the firm and thought this post would give investors insight into the issuance of public debt from the Public Finance perspective. This summary from Chapman Cutler deals with the Local Government Debt Reform Act for the State of Illinois and shows the complexities of rules and regulations regarding debt issuance. It is important for the Investment Banker to be well aware of these rules and to be able to work with the officials of the issuing municipality to ensure compliance with the law. Occasionally a banker will overlook one of these provisions before pricing, and a deal will not be able to close because of his/her oversight. This is a very rare event.

Courtesy of the law firm Chapman and Cutler L.L.P.

School Finance
General Provisions for Illinois School Districts

The Local Government Debt Reform Act of the State of Illinois, as amended (the “Debt Reform Act”)

Generally, the debt limit for elementary and high school districts is 6.9% of the equalized assessed valuation of the district and for unit school districts is 13.8% of the equalized assessed valuation of the district. Even though these are the standard debt limits, certain exceptions to the debt limit exist.

Tax anticipation warrants, general obligation warrants, state aid anticipation certificates, personal property replacement tax notes, revenue anticipation notes and, generally, alternate bonds do not count against the debt limit of a district, but bonds, installment contracts, leases, debt certificates, judgments, tax anticipation notes and teachers’ orders do count against the debt limit.

As written in the Debt Reform Act, whenever a school district is authorized to issue bonds without referendum, the district may add issuance costs at the expense of the issuer. Typical issuance costs which school districts are required to pay may include underwriter’s discount, bond insurance or other credit enhancement costs.

The Debt Reform Act also allows a school district to use bond proceeds for capitalized interest on its bonds for a period not to exceed the greater of two years or a period ending six months after the estimated date of completion of the project. One reason where it would make sense to capitalize interest is if a revenue bond is issued to fund a project where the stream of cash flows that are generated from that project do not exist for another 18 months. If this were the case, capitalized interest could be used so the issuer is able to meet principal and interest payments.

The Debt Reform Act also permits school districts to sell bonds at a discount. Whenever bonds are sold at a discount, the bonds must be sold at a price and bear interest at rates so that the true interest cost (TIC or yield) or the net interest rate (NIC) received upon the sale of the bonds does not exceed the maximum rate otherwise authorized by applicable law.
The Debt Reform Act extends the time within which a tax levy for general obligation or limited bonds must be filed. Prior to the passage of the Debt Reform Act, a school district was required to file any debt service levy with the county clerk on or before December 31 of a given year in order to have taxes extended for the payment of the bonds in the following year. The Debt Reform Act provides that districts are authorized to levy a tax for the payment of debt service on general obligation or limited bonds at any time prior to March 2 of the calendar year during which the tax will be collected. County clerks are required to accept the filing of such tax levy prior to March 2 notwithstanding that such filings occur after the end of the calendar year next preceding the calendar year during which the tax will be collected.

In extending taxes for general obligation bonds, the county clerk must add to the levy for debt service on such bonds an amount sufficient, in view of all losses and delinquencies in tax collection, to produce tax receipts adequate for the prompt payment of such debt service.

Whenever the authorization of or the issuance of bonds is subject to either a referendum or a backdoor referendum held after August 13, 1999, the approval, once obtained, remains (a) for five years after the date of the referendum or (b) for three years after the end of the petition period for the backdoor referendum.

A school district whose aggregate principal amount of bonds outstanding exceeds $10mm may enter agreements for interest rate swaps and other interest rate risk management tools with respect to any issues of its bonds. The bonds must be identified to the swap. Net payments under swap agreements are treated as interest for the purpose of calculating the interest rate limit applicable to the bonds, provided, that for this purpose only, the bonds are deemed to bear interest at taxable rates. Swap agreements and the payments to be made under swap agreements do not count against a districts debt limit.

Credit ratings for school districts are determined by rating agencies such as Fitch, Inc., Moody’s Investor’s Service or Standard & Poor’s. A credit rating is not legally required, but a favorable rating may reduce the interest rate paid by a district. The rating agencies review the overall management, debt and financial picture of the district, including recent audits and fund balances. Bond insurance may also be used to reduce interest rates paid by a district.

School Districts may also enter into credit agreements to provide additional security or liquidity, or both, for the bonds, including municipal bonds insurance, letters of credit, lines of credit, standby bond purchase agreements and surety bonds. A district may also enter into agreements for the purchase or remarketing of its bonds providing a mechanism for remarketing bonds tendered for purchase. The term of the credit agreements or remarketing agreements may not exceed the term of the bonds, plus any time period necessary to cure any defaults under the agreements

Under Section 265(b)(3) of the Tax Code, banks and certain other financial institutions are not allowed any deduction for interest expense attributable to tax-exempt debt acquired after August 7, 1986, unless the “small issuer exception” applies. The exception is applied if a school district reasonably expects that it will not issue more than $10 million of tax-exempt debt during the calendar year. If a district stays under this $10 million limit, “bank qualified” status is received, and the restriction on the deduction for interest expense does not apply.

Muni Bonds: The Kentucky Case

Waste Haulers and the Dormant Commerce Clause

An important decision was made today in a court case involving municipal government. The case dealt with waste haulers (such as Waste Management, Inc.) suing local governments over directing waste to preferred dumping facilities. The purpose of these facilities is to dispose of the waste in an "environmentally friendly" manner. The Supreme Court ruled against waste haulers who didn't want to be steered to higher cost dumps by local governments. These governments charge the waste haulers "tipping" fees, but don't allow them to dump at less expensive facilities in other areas. The fees collected are then used as security to pay bondholders. The waste haulers argued that this process was "unfair" and violated the Dormant Commerce Clause which prohibits States from discriminating against out-of-state commerce. The Supreme Court ruled that States, indeed, have the right to force haulers to pay higher fees without allowing them to dump in other areas.

Many have argued that the reason the Supreme Court has not heard the Kentucky case is they wanted to rule on this similar case first. The Kentucky case centers on the State of Kentucky giving preference to in-state municipal securities while taxing out-of-state muni bonds. Davis, the plaintiff, and the Kentucky Appellate Court have argued that this discriminates against out-of-state commerce and is in violation of the Dormant Commerce Clause. Most states give preference to in-state muni bonds and tax the interest on out-of-state munis. The tax-exempt mutual fund industry has created a myriad of state preference funds. A negative ruling on the Kentucky case would rewrite the way states are able to tax muni bonds.

We feel these two cases are very similar. They both center around the "public interest" of a local community. In the trash hauler case, local governments force haulers to pay fees that may be higher than other nearby municipalities charge, but the public interest is served by a cleaner regulated environment. The public interest of the citizens of Kentucky is served by lower interest costs for local governments in the State of Kentucky. We agree with the Supreme Court in this case, and expect the court to use the same logic in the Kentucky case. Thus, Waste Haulers and the Dormant Commerce Clause An important decision was made today in a court case involving municipal government. The case dealt with waste haulers (such as Waste Management, Inc.) suing local governments over directing waste to preferred dumping facilities. The purpose of these facilities is to dispose of the waste in an "environmentally friendly" manner. The Supreme Court ruled against waste haulers who didn't want to be steered to higher cost dumps by local governments. These governments charge the waste haulers "tipping" fees, but don't allow them to dump at less expensive facilities in other areas. The fees collected are then used as security to pay bondholders. The waste haulers argued that this process was "unfair" and violated the Dormant Commerce Clause which prohibits States from discriminating against out-of-state commerce. The Supreme Court ruled that States, indeed, have the right to force haulers to pay higher fees without allowing them to dump in other areas. Many have argued that the reason the Supreme Court has not heard the Kentucky case is they wanted to rule on this similar case first. The Kentucky case centers on the State of Kentucky giving preference to in-state municipal securities while taxing out-of-state muni bonds. Davis, the plaintiff, and the Kentucky Appellate Court have argued that this discriminates against out-of-state commerce and is in violation of the Dormant Commerce Clause. Most states give preference to in-state muni bonds and tax the interest on out-of-state munis. The tax-exempt mutual fund industry has created a myriad of state preference funds. A negative ruling on the Kentucky case would rewrite the way states are able to tax muni bonds. We feel these two cases are very similar. They both center around the "public interest" of a local community. In the trash hauler case, local governments force haulers to pay fees that may be higher than other nearby municipalities charge, but the public interest is served by a cleaner regulated environment. The public interest of the citizens of Kentucky is served by lower interest costs for local governments in the State of Kentucky. We agree with the Supreme Court in this case, and expect the court to use the same logic in the Kentucky case. Thus, it seems likely the current system of taxing out-of-state munis and giving preference to in-state bonds will survive this challenge in Kentucky.