Equity funds VAS Bond funds


The primary focus of equity funds is to invest in common stock. Within equity funds, we find different objectives. Growth funds invest in companies likely to grow their profits faster than competitors and/or the overall stock market. These stocks usually trade at high P/E and price-to-book ratios.

Value funds, on the other hand, seek companies trading for less than the portfolio managers determine they're truly worth. These funds buy stock in established companies currently out of favor with investors. Since the share price is depressed, value stocks tend to have high dividend yields. Value funds are considered more conservative than growth funds.

What if he can't make up his mind between a growth fund and a value fund? There are funds that blend both styles of investing, and the industry calls these blend funds. In other words, no matter how creative the portfolio managers might get, they end up being either a growth fund, a value fund, or a blend of both styles.

If an investor's objective is to receive income from equities, an equity income fund may be suitable. These funds buy stocks that provide dependable dividend income. Receiving dividends tends to reduce the volatility of an investment, so equity income funds are lower risk than growth funds. They may also invest in debt securities to keep the yield consistent.

What if the investor can't decide between a mutual fund family's growth funds and its income funds? Chances are, he will choose their "growth and income fund." A growth and income fund buys stocks in companies expected to grow their profits and in companies that pay dependable, respectable dividends. Since we've added the income component, growth and income funds have lower volatility than growth funds. Many allocate a percentage to fixed-income to assure a regular source of dividend distributions to the shareholders.

So, from highest to lowest volatility, we have growth, then growth & income, and then equity income funds.

Bond funds (Fixed-Income funds)
Stock is not for everyone. Even if an investor owns equity mutual funds, chances are he will put a percentage of his money into bond funds, as well. If the investor is not in a high tax bracket, we'll recommend taxable bond funds corporate and U.S. Government bonds.

The investor's time horizon determines if she should purchase short-term, intermediate-term, or long-term bond funds. Her risk tolerance determines if she needs the safety of U.S. Treasury funds or is willing to reach for higher returns with high-yield funds. If the investor is in a taxable account and wants to earn interest exempt from federal income tax, her agent might put her into a tax-exempt bond fund, which purchases municipal bonds. If the investor is in a high-tax state such as Maryland, Virginia, or California, she might want the "Tax-Exempt Fund of Maryland," Virginia, or California. Now, the dividends she receives will be exempt from both federal and state income taxes.

Whichever tax-exempt fund she chooses, the next question is, "How much of a yield does she want, and how much risk can she withstand?" Her answers determine how long the average maturity of the fund, and whether to focus on high-yield or investment-grade bond funds.

Advantages of Mutual Funds

Advantages of investing through mutual funds vs. buying stocks and bonds directly include:
  • Investment decisions made by a professional portfolio manager
  • Ease of diversification
  • Ability to liquidate a portion of the investment without losing diversification
  • Simplified tax information
  • Simplified record keeping
  • Automatic reinvestment of capital gains and income distributions at net asset value
  • Safekeeping of portfolio securities
  • Ease of account inquiry
 
The first point is probably the main reason people buy mutual funds they have no knowledge of stocks, bonds, taxation, etc., and they have even less interest in learning. Let a professional portfolio manager often an entire team of portfolio managers decide what to buy and when to buy or sell it. As we mentioned, it's tough to have your own diversified portfolio in individual stocks and bonds because a few hundred or thousand dollars will only buy a few shares of stock or a few bonds issued by just a few companies.

On the other hand, a mutual fund would usually hold stock in, say, 100 or more companies, and their bond portfolios are also diversified. Therefore, even with the smallest amount of money accepted by the fund, the investor is diversified. This is called the "undivided interest concept," which means that $50 from a small investor owns a piece of all the securities in the portfolio, just as $1 million from a larger investor does.

Another bullet said, "Ability to liquidate a portion of the investment without losing diversification." That means if an investor owns 100 shares of IBM, MSFT, and GM, what is he going to do when he needs $5,000 to cover an emergency? If he sells a few shares of each, he'll pay three separate commissions. If he sells 100 shares of any one stock, his diversification is reduced. With a mutual fund, investors redeem a certain number of shares and remain just as diversified as they were before the sale. And, they can usually redeem shares without paying fees. Mutual funds can diversify their holdings by:

•    Industries
•    Types of investment instruments
•    Variety of securities issuers
•    Geographic areas

If it's a stock fund, it is typically a growth fund, a value fund, an income fund, or some combination thereof. No matter what the objective, the fund usually buys stocks from issuers across many different industries. In a mutual fund prospectus, there is typically a pie chart that shows what percentage of assets is devoted to an industry group. Maybe it's 3% in telecommunications, 10% retail, and 1.7% healthcare, etc. That way if it's a bad year for telecommunications or retail, the fund won't get hurt like a small investor who owns shares of only one telecom company and one retail company.

A bond fund can be diversified among investment interests. That means they buy debentures, secured bonds, convertible bonds, zero coupons, mortgage-backed securities, and even a few money market instruments to be on the safe side.

Even if the fund did not spread their investments across many different industries, they would purchase securities from a variety of issuers. If they focus on the retail sector, they can buy stock in a variety of companies Walmart, Target, Sears, Nordstrom, Home Depot, etc. And, since any geographic area could be hit by an economic slump, a tropical storm, or both, most funds spread their holdings among different geographic areas.

The Investment Company Act of 1940 defines a diversified company as:
"Diversified company" means a management company which meets the following requirements: At least 75 per centum of the value of its total assets is represented by cash and cash items (including receivables), Government securities, securities of other investment companies, and other securities for the purposes of this calcula-tion limited in respect of any one issuer to an amount not greater in value than 5 per centum of the value of the total assets of such management company and to not more than 10 per centum of the outstanding voting securities of such issuer.

So, how does the "Act of 1940" then define a non-diversified company?
"Non-diversified company" means any management company other than a diversified company.
If the fund wants to promote itself as being diversified, it must meet the definition above. For 75% of the fund's assets, no more than 5% of its assets are in any one company, and it doesn't own more than 10% of any company's outstanding shares.

If it doesn't want to abide by the definition, it must refer to itself as a "non-diversified fund." The term "management company" includes both open-end and closed-end funds. From there, each could be either diversified or non-diversified, leaving us with the following four types of Management Company:
•    Diversified Open-End Fund
•    Non-Diversified Open-End Fund
•    Diversified Closed-End Fund
•    Non-Diversified Closed-End Fund
Because closed-end funds use leverage, the most aggressive type above is the non-diversified closed-end fund.

Pooled Investments

Types and Characteristics of Pooled Investments

In the securities industry, there are many ways to refer to the same thing. What some call a "pooled investment vehicle" others refer to as a "packaged product" or a "mutual fund."

Whatever we call these investments, a pooled investment vehicle pools the capital of many investors together, with that capital then managed by a professional. Rather than investing directly in a company, investors buy investment products that come with various features.

The best-known pooled investment vehicle is the mutual fund. While some investors buy shares of SBUX, many prefer to own shares of a mutual fund that devotes a percent of the portfolio to SBUX and other large-cap stocks. Similarly, rather than putting $100,000 into one issuer's bonds, many investors prefer the diversification and professional management offered by a bond fund.

 

A mutual fund is an investment portfolio managed by an investment adviser. Investors buy shares of the portfolio. The adviser uses the money from investors to invest in stocks and bonds. When an investor sends in money, the portfolio gets bigger, but it also gets cut into more slices to accommodate the investment into the fund. The only way for the slices to get bigger is for the portfolio to become more valuable. The portfolio value rises when securities in the fund increase in market value and when they pay income to the portfolio.

That is the same way it happens in any securities account. When the market values of the securities in the account drop, the account value is down for the day unless income is received that outweighs the drop. For example, if an account was worth $100,000 when the markets opened and then just $98,817 when the markets closed, the investor is down for the day. . Unless he happened to receive dividends and interest of more than that decline of $1,183.

There are two main advantages of owning stocks and bonds through mutual funds as opposed to owning them directly. The first is the professional portfolio management. The second is diversification. If an investor has $400 to invest, he can't take a meaningful position in any company's stock, and even if he tried, he would end up owning just one company's stock. Common stock can drop in a hurry, so we never put all our money in just one or two issues. Diversification protects against this risk, and mutual funds own stocks and bonds from many different issuers, usually in different market sectors. So, even a small investment is diversified, while a common stock investor with a small amount would risk everything on just one issuer.

ADRs

Americans who own shares of Toyota or Nissan own American Depository Receipts (ADRs). ADRs allow American investors to diversify their portfolio with foreign investments that trade in the U.S. financial system and U.S. currency while giving foreign companies easier access to U.S. capital markets. The ADR investor buys an American Depository Receipt that represents a certain number of American Depository
Shares of a foreign corporation's stock. The shares are held in a U.S. bank in the foreign country, which issues a receipt to the investor in America.

 The custodian bank provides services including registration, compliance, dividend payments, communications, and record keeping. These fees are typically deducted from the gross dividends received by the ADR holders.


Or, if the issuer does not pay dividends, broker-dealers and banks cover the custody fees charged by depository banks and then pass the charges on to their customers. ADRs file a registration statement called an F-6 which discloses information on the structure of the ADR including fees that may be charged to the ADR holders. Some ADRs grant voting rights to the investor; some do not.
If dividends are declared, they are declared in the foreign currency and must be converted to dollars. That is why ADR owners are subject to currency risk. Also, if the stock is worth a certain number of yen on the Japanese markets, that won't work out to as many U.S. dollars when our dollar is strong, although it works out to more American dollars when our dollar is weak.
As the SEC explains in an investor bulletin, "Today, there are more than 2,000 ADRs available representing shares of companies located in more than 70 countries."
custody fees custody fees

There are currently three levels of ADR trading, ranging from the more speculative issues trading over-the-counter to those, like Toyota, trading on the NYSE or NASDAQ Level 1 ADRs trade over-the-counter. Level 2 ADRs trade on exchanges. Level 3 ADRs are part of a public offering that then trades on the NYSE or NASDAQ In other words, some ADRs merely establish a trading presence in the U.S. while Level 3 ADRs also raise capital for the foreign issuer.

Dividends

Not all shareholders are looking for dividends. An investment in Berkshire Hathaway today, for example, would be made without the issuer stating any plans to pay dividends, ever. The only type of investor interested in this stock, then, is a growth investor.

But, there are growth & income investors and equity-income investors for whom dividends are important.

Dividends are a share of profits paid out to shareholders if the Board of Directors for the corporation votes to declare them. The day the Board declares the dividend is known as the declaration date. The board decides when they'll pay the dividend, too, and we call that the payable date. The board also sets the deadline for being an owner of stock if you want this dividend, and we call that the record date because an investor must be the owner of record as of that date to receive the dividend.
 
Now, since an investor must be the owner of record as of the record date to receive the dividend, there will come a day when it's too late for investors to buy the stock and get the dividend.

Why? Because stock transactions don't "settle" until the second business day following the trade date, which means you might put in your purchase order to buy 1,000 shares of ABC on a Monday, but you aren't the official owner until that transaction settles on Wednesday. Your broker-dealer must send payment to their clearing agency, and the seller must deliver the 1,000 shares before the transaction has settled. This process takes two business days for common stock and is known as regular way settlement, or "T + 2," where the "T" stands for Trade Date. Assuming there are no holidays, a trade taking place on Monday settles on Wednesday, while a trade on Thursday settles on Monday.
So, if an investor must be the owner of record on the record date, and it takes two business days for the buyer to become the new owner, wouldn't she have to buy the stock at least two business days prior to the record date? Yes.

On the other hand, if she buys it just one business day before the record date, her trade won't settle in time. We call that day the ex-date or ex-dividend date.

Starting on that day investors who buy the stock will not receive the dividend. On the ex-date, it's too late. Why? Because the trades won't settle in time, and the purchasers won't be the owners of record with the transfer agent as of the record date. If the trade takes place on or after the ex-date, the seller is entitled to the dividend. If the trade takes place before the ex-date, the buyer is entitled to the dividend.

The regulators set the ex-date, as a function of regular way or T + 2 settlement. The ex-date is one business day before the record date.

Investors don't qualify for the dividend starting with the ex-dividend date; therefore, the amount of the dividend is taken out of the stock price when trading opens. If the dividend to be paid is 70 cents, and the stock is set to open at $20, it would open at $19.30 on the ex-date.

Let's look at how the process looks from a press release: Equity Office declares first quarter common dividend
Mar 16, 2005-- Equity Office Properties Trust (EOP), a publicly held office building owner and manager, has announced that its Board of Trustees has declared a first quarter cash dividend in the amount of $.50 per common share. The dividend will be paid on Friday 15 April 2005, to common shareholders of record at the close of business on Thursday 31 March 2005.
March 16th is the Declaration Date. The Payable Date is April 15th. The Record Date is Thursday, March 31st. The article doesn't mention the Ex-Date (because that's established by the exchange regulators), but we can figure it must be Wednesday, March 30th. If you bought the stock on Wednesday, your trade wouldn't settle until Friday, April 1st, which means the seller's name would be on the list of share¬holders at the close of business on Thursday, March 31st.
A dividend can be paid in the following ways:
•    Cash
•    Stock
•    Shares of a subsidiary
•    Product

Common Stock

Common stock, on the other hand, is all about the profits a company makes. Unlike with bonds, common stock does not give the investor a stated rate of return. If shareholders receive 64 cents per share of common stock as a dividend this year, they might or might not receive that much next year. A famous toy maker just cut its dividend in half as it tries to turn itself around. And, many companies never pay dividends.

Both the income produced by common stock and the market value of the stock itself are unpredictable. Therefore, common stock investors should only invest the money they could afford to lose.

Bond interest is a fixed expense to the issuer paid to the bondholder. Profits at most companies are unpredictable and, therefore, so are the dividends and the market price of the issuer's common stock.

Rights and Privileges
Common stockholders are owners of the corporation and vote at all annual and special meetings. The owner of common stock has the right to vote for any major issue that could affect his status as a proportional owner of the corporation. Things like stock splits, board of director elections, mergers, and changes of business objectives all require shareholder approval.

Owners of common stock typically have the right to vote on:
•    Members of the board of directors.
•    Proposals affecting material aspects of the business
•    Ratifying the auditors.
•    Mergers & Acquisitions.
•    Stock Splits.
•    Liquidation of the company

One thing shareholders never vote on is whether a dividend is paid and, if so, how much. The board of directors decides if a dividend is to be declared from profits and, if so, how much the payment per-share will be. Dividends benefit the shareholder now, while the profits that are reinvested back into the business should eventually help to increase the value of the stock, benefiting the shareholder in the long run.
 

At the annual shareholder meeting votes are cast per-share, not per-shareholder. Therefore, a mutual fund holding 45 million shares of Wells Fargo (WFC) has a lot more votes than a retail investor holding 300 shares at the Wells Fargo annual meeting. In fact, the retail investor's vote is almost meaningless compared to what the mutual fund decides to do with their 45 million votes.

Either way, all shares get to be voted. If a shareholder owns 100 shares of common stock, he has 100 votes to cast in corporate elections. Let's say there are three seats up for election on the Board of Directors. There are two ways the votes could be cast.

 Under statutory voting, he can only cast the number of shares he owns for any one seat. So, he could cast up to 100 votes for any one seat, representing a total of 300 votes for three seats. Under statutory voting abstaining on any of the seats up for election provides no benefit to the shareholder.

Under cumulative voting, however, he could take those 300 votes and split them any way he wanted among the three candidates. He could even abstain on the other seats up for election and cast all 300 votes for one candidate. That's why cumulative voting gives a benefit to the small/minority shareholders. If they can get a candidate on the slate who will look out for the small shareholders, the minority shareholders can cast all their votes for that one candidate and shake things up.

Beyond voting, common stockholders have the right to inspect the corporation's financials through quarterly (10-Q) and annual (10-K) reports. Public companies must file these reports with the SEC, but even a shareholder in a private company has this same right. Shareholders may also see the list of stockholders and the minutes of shareholder meetings.

Common stockholders have a preemptive right to maintain their percentage of ownership. This means if the company wants to raise money in the future by selling more common stock, existing shareholders must get a chance to buy their percentage of the upcoming issue. If not, their ownership would be diluted. Investors buying the stock on the secondary market up to a certain date also receive rights to buy more shares from the additional offering.

Rights offerings avoid dilution of equity by giving owners a chance to maintain their percentage of ownership, if they choose to.

Should a corporation claim bankruptcy protection and have to be liquidated, com¬mon stockholders get in line for their piece of the proceeds. Unfortunately, they are last in line. They are behind all the creditors, including bondholders, and behind preferred stockholders.

But, at least they are in line, and if there are any residuals left, they get to make their claim on those assets, known as a residual claim on assets or "residual rights." Common stock is the most 'junior" security, since all other securities represent senior claims on the company's assets.

Shareholders have limited liability, which means they are shielded from the debts of the company and lawsuits filed against it. Unlike a sole proprietor whose business is going sour, shareholders of a corporation would not be sued by creditors. This is true whether the company is public or private.

Common stock owners have a claim on earnings and dividends. As owners, they have a share of the profits or net income of the company. Some of the profits are reinvested into the business, which tends to make the share price rise. Some of the profits might be paid to shareholders as dividends.

As we mentioned, one of the rights common stockholders enjoy is the right to maintain their proportionate ownership in the corporation. We call this a preemptive right because the existing shareholders get to say yes or no to their proportion of the new shares before the new shareholders get to buy them. Otherwise, if you owned 5% of the company, you'd end up owning less than 5% of it after they sold the new shares to everyone but you, called dilution of equity.

For each share owned, an investor receives what's known as a subscription right. It works like a coupon, allowing the current shareholders to purchase the stock below the market price. If a stock is trading at $20, maybe the existing shareholders can take two rights plus $18 to buy a new share. Those rights act as coupons that give the current shareholders two dollars off the market price. So, the investors can use the rights, sell them, or let them expire.

Premium Bonds

What happens when interest rates fall? Bond prices rise. If you owned this 8% bond and saw that interest rates had just fallen to 6%, how would you feel about your bond?
Pretty good. After all, it pays 2% more than new debt is paying. Do you want to sell
it? Not really. But you might sell it if investors were willing to pay you a premium.
Current Yield
Bond investors push the price of the bond up as interest rates go down. Maybe your bond is worth $1,200 on the secondary market now dividing our $80 of annual interest by the $1,200 another investor would have to pay for the bond gives us a cur¬rent yield of just 6.7%. That's lower than the coupon rate.

So, wait, did the price of this bond just rise, or did its current yield drop?
Exactly right! When you see a coupon of 8% and current yield of 6.7% (or anything lower than that 8% printed on the bond), you're looking at a premium bond. A discount bond trades below the par value, while a premium bond trades above the par value.

The nominal yield of the bond doesn't change Therefore, the only way to push a yield lower than the nominal yield stated on the bond is to have an investor pay more than par for the bond. Similarly, the only way to push the yield higher than the nominal yield stated on the bond is to have an investor pay less than par for the bond.

Yield to Maturity
If you sell your bond, you obviously don't care about the next investor's yield. But, when this investor's bond matures, how much does she get back from the issuer? Only $1,000. So, she put down $1,200 and will only get back $1,000 at maturity. Her Yield to Maturity (YTM) goes down below both the nominal and current yields.

Yield to Call
Remember when we decided a person who buys a bond at a discount wants the bond to return the principal amount sooner rather than later? Well, if you pay more than the par value for a bond, you're going to lose money when the bond returns your principal, no matter when that happens. So, if you're going to lose money, you want to lose it slowly to increase your yield. That's why a person who purchases a bond at a premium will have a lower yield to call than yield to maturity. He's going to lose money in either case, so he'd prefer to lose it over 10 or 20 years (maturity) rather than just 5 years (call).
So, yield to call is the lowest yield for a bond purchased at a premium. And, if there are successive call dates, the earliest call date will produce the worst or lowest yield to the investor.

Disclosing Yield on Customer Confirmations
When a customer purchases a bond, the broker-dealer sends her a trade confirmation no later than the settlement date. And, on this trade confirmation the firm must disclose either the YTM or the YTC. Should they disclose the best possible yield or the worst possible yield?
Always prepare the customer for the worst or most conservative yield, so there are no bad surprises, right? Okay, for a discount bond, which yield is lower, YTM or YTC? YTM. That's what the firm would disclose to a customer who purchases a bond at a discount.

For a premium bond, which yield is lower? Yield to Call. So, that's what the firm would disclose to a customer who purchases a bond at a premium. The exam might call this calculation "yield to worst," by the way or even "YTW." The worst yield the investor can receive is the one based on the earli¬est call date.

As important as it is to inform customers that even a safe investment in U.S. Treasuries could lead to a large loss of principal, we also don't want to overstate this relationship of interest rates to bond prices. When rates rise, bond prices drop. However, bondholders will reinvest their semiannual interest payments at higher rates, too. So, it's not all bad.

And, even though bond prices rise when rates drop, bondholders reinvest their fixed interest payments at lower rates/yields.

The price swings we just looked at have nothing to do with credit quality. Rather, they are related to the term to maturity. The longer the term to maturity, the more volatile the bond's market price.

Within the world of bonds, the longer the term, the riskier the investment.

Discount Bonds

Par value is what is returned to the bondholder at maturity and what the coupon rate is multiplied against. But, bonds are not bank deposits. Rather, they are securities trading on a secondary market. Among other factors, a bond's market price fluctuates in response to changes in interest rates. If a bondholder has a bond that pays a nominal yield of 8%, what is the bond worth when interest rates in general climb to 10%?

Not as much. If you had something that paid you 8%, when you knew you could be receiving more like 10%, how would you feel about the bond?

Not too good. But, when interest rates fall to 6%, suddenly that 8% bond looks good, right? It's all relative.
 
Current Yield
When we take a bond's market price into consideration, we're looking at current yield. Current yield (CY) takes the annual interest paid by the bond and divides it by what an investor would have to pay for the bond.
Current Yield = Annual Interest / Market Price

So, let's say after an investor buys an 8% bond, interest rates rise, knocking down the market price to just $800. What is the current yield if that happens?
$80/$800 gives us a current yield of 10%.

Did the bond's market price just drop, or did its current yield rise? Those are two ways of saying the same thing.

Yield answers the question, "How much do I get every year compared to what I pay to get it?" If interest rates rise to 10%, suddenly this bond that pays only 8% isn't worth as much.

The only motivation for buying this 8% bond is if an investor could get it at a discount. And, if she can get the $80 that the bond pays in annual interest for just $800, isn't she getting 10% on her money? That's why we say her current yield is 10%, higher than the nominal yield that never, ever changes.

Rates and yields up, price down. Rates are what new bonds pay. Yields are what existing bonds offer, after we factor in their market price.

A discount bond is a bond trading below par value. When you see a current yield higher than the coupon rate of the bond, you're looking at a discount bond. An 8% bond with a 10% current yield, for example, must be a discount bond. An 8% bond with a 6% current yield would not be a discount bond. As we'll see in a minute, it would, in fact, be a "premium bond."

Yield to Maturity
Yield to maturity (YTM) is the return an investor gets if she holds the bond to maturity. It is sometimes called basis and represents the only yield that really matters to an investor.

It factors in all the coupon payments and the difference between the market price paid for the bond and the par value received at maturity.

At maturity, an investor receives the par value, which is $1,000. If the investor puts down only $800 to buy the bond and receives $1,000 when the bond matures, doesn't she receive more at maturity than she paid?

She does, and that's why her yield to maturity is even higher than her current yield. She gets all the coupon payments, plus an extra $200 when the bond matures. If you see a yield-to-maturity higher than the coupon rate or the current yield, you're looking at a discount bond. For example, a bond with a 4% nominal yield trading at a 5.50 basis or yield to maturity is a discount bond.

Yield to Call
Like homeowners, sometimes issuers get tired of making interest payments that seem too high. That's why many bonds are issued as callable, meaning after a certain period the issuer can buy the bonds back from investors at a stated price.

A bond that matures in 10 or 20 years is often callable in just 5 years. If a bond is trading at a discount, rates have risen. Therefore, it is unlikely such a bond would be called. But, if it were called, the investor would make his gain faster than if he had to wait until maturity. That's why yield to call (YTC) is the highest of all for a discount bond.

Callable Bonds

A bond has a maturity date that represents the date the issuer will pay the last interest check and the principal. At that point, it's all over—the debt has been paid in full, just like when you pay off your car, student loan, house, etc. This can be referred to as "maturity" or redemption. As we saw earlier, many bonds are repurchased by the issuer at a set price if interest rates drop. So, a bond might not make it to the maturity date due to an early redemption or "call." Either way, the debt would have been retired by the issuer.

Municipal bonds are frequently callable by the issuer. Refunding a current issue of bonds allows municipalities to finance their debt at lower rates going forward. Or, there could be a covenant in the bond indenture for the current issue that is burdensome, motivating the issuer to start over. An optional redemption gives the issuer the option to refinance/refund their debt as of a certain date at a stated price, or over a series of prices and associated call dates. Some bonds are issued with mandatory call provisions requiring the issuer to call a certain amount of the issue based on a schedule or on having enough money to do so in the sinking fund.



When issuers redeem callable bonds before the stated maturity date, they may call the entire issue or just part of it. For obvious reasons, the call provisions can, therefore, be referred to as in-whole redemptions or partial redemptions. The refunding is sometimes done through a direct exchange by bondholders of the existing bonds for the new issue. Usually, though, the issuer sells new bonds to pay off the existing issue.

When refunding an issue of bonds, issuers either perform a current refunding or an advance refunding. If the issuer uses the proceeds of the "refunding bonds" to promptly call (within 90 days) the "prior issue," we refer to this as a current refunding. On the other hand, when the issuer places some of the proceeds of the refunding issue in an escrow account to cover the debt service on the outstanding issue, we refer to this as an advance refunding. Because an escrow account is, literally, money in the bank, the prior issue whose debt service is now covered by the escrow deposit is not required to be included on the issuer's debt statement.

Do we just take the issuer's word the US. Treasury securities held in the escrow account are sufficient to cover the debt service on the prior issue?
No. Rather, an independent CPA issues a "verification report" verifying the yield on the escrow deposit will be sufficient to pay off the outstanding or refunded issue of bonds. Because of the certainty surrounding a refunded issue of bonds, these bonds are typically rated AAA and are among the safest of all municipal bonds on the market. Because of their inherent safety, refunded bonds are also liquid.

The typical advance refunding is performed by placing proceeds from the sale of the refunding issue in an escrow account holding Treasury securities, with only the escrow account used to cover the debt service on the prior issue of bonds. In a "cross¬over refunding" the promised revenue stream backing the prior issue continues to be used to meet debt service until the bonds are called with proceeds from the escrow account.
Paying off a debt is sometimes referred to as a debt being "defeased."

Refunding bonds are not tax-exempt. Municipalities, in other words, can borrow money on the cheap for infrastructure, but if they could issue tax-exempt refunding issues, some governmental entities would do nothing but issue refunding bonds in a never-ending attempt to maximize their budgets.

Municipal Securities

If there is an old brick industrial building that was supposed to be turned into a major condominium and townhouse development back before the bottom fell out of the real estate market. Unfortunately, the developers borrowed $15 million but pre-sold only one condominium, sending the property into foreclosure.

So, the park district, whose land sits next to the foreclosed property, wanted to tear down the outdated structure for their operations. The park district needed $6 million to acquire and develop the property and, therefore, raised that amount by issuing municipal bonds. In a recent election, a majority of Forest Parkers voted to allow the park district to raise property taxes slightly to create the funds needed to pay off a $6 million bond issue to be used to better the community.

The bonds pay investors tax-exempt interest at the federal level. Illinois residents also escape state income tax on the bond interest.

For us, all it took to see the connection between this municipal securities section and the so-called "real world" was to walk 15 steps to the front window and see that the building pictured below has now been torn down and carted away brick-by-brick, all because a municipal taxing authority borrowed money by issuing bonds.

There are two main types of municipal bonds: general obligation and revenue. General obligation bonds are safer than revenue bonds because they are backed by the municipality's ability to collect and raise taxes from various sources. However, some states are considered safer issuers than others, and the same goes for counties, school districts, port authorities, etc. Revenue bonds are only as safe as the revenue source tied to the bonds.

To make the bonds more marketable and keep interest payments as low as possible, many municipal bonds come with a credit enhancement from an insurance company who insures against default. If interest rates rise, bond prices drop. That is not what is covered here. The insurance policies cover interest and principal payments, not market or interest rate risk. Examples of municipal bond insurance (or assurance) companies include AMBAC and MBIA.
Because some municipal bonds are insured and some are not, bond ratings agencies including Moody's and S&P typically indicate whether a rating is "pure" or "insured." A "pure" rating is based on the credit quality of the issuer only, while an "insured" rating implies the credit quality is based on the insurance policy backing the bonds against default.

General Obligation Bonds
The phrase general obligation means the municipality is legally obligated to pay the debt service on the bonds issued. GOs are backed by the full faith and credit of the municipality.

Where does a municipality get the money they'll need to pay off the bonds?
 If necessary, they'll dip into all the sources of general revenue available to a city or state or park district, like sales taxes, income taxes, parking fees, property taxes, fishing licenses, marriage licenses, whatever. And, if they must, they'll even raise taxes to pay the debt service on a general obligation bond.
General obligation bonds are backed by the full taxing power of the issuer, and that's why GOs require voter approval. As we said, Forest Parkers first had to approve a $6 million bond issue before the park district could do the borrowing and back up the loan with their increased property taxes.
States get most of their revenue from sales and income taxes, while local governments rely on property taxes. Since local governments (cities, park districts, and school districts) get much of their revenue from property taxes, a GO bond is associated with property taxes, called add value . That phrase means the property tax rises or falls "as to value" of the property.

A municipality might assess property at 50% of its market value. So, a home with a market value of $400,000 would have an assessed value of only half that, or $200,000. A homeowner takes the assessed value of his home and multiplies it by a rate known as the millage rate to find his tax bill.

If the millage rate is "9 mills," we multiply the assessed value of $200,000 by .009 to get a tax bill of $1,800. That $1,800 goes to support many different overlapping municipalities, for example: water district, park district, school district, library & museum district, village government, and county government.

Some municipalities limit the number of mills that can be levied against property. If so, they might end up issuing limited tax bonds, which means there are limits on the taxes that can be used to pay the debt service.

Maybe property tax rates can only go so high to pay the debt service on a GO, or maybe only certain taxes can be used but not others. School districts are often limited as to how high property taxes can go to support their bonds, while other governmental units have no such limits. So, if you see limited tax bonds, associate the term with GOs.

Whenever the issuer's full faith and credit backs the bonds, we refer to the bonds as "general obligations." There is a peculiar type of municipal bond backed by that full faith and credit but also by the revenues generated at the facility being built with the bond proceeds. These bonds are called double-barreled bonds.

For example, a hospital is something all residents of a municipality benefit from, which is why the county or state might put its full faith and credit behind the bond issue. However, hospitals also generate revenues, which can be used to pay debt service. In this case, the issuer has two sources of revenue to pay debt service, which is why we call it a double-barreled bond. Anything backed by the issuer's full faith and credit as well as revenues is called a double-barreled bond. Since the full faith and credit of the issuer backs the issue, we consider this a GO.


Revenue Bonds
Rather than putting the full faith and credit of the issuer behind it, a revenue bond identifies a specific source of revenue, and only that revenue can be used to pay the interest and principal on the bonds. Have you ever driven on a toll way or paid a toll to cross a bridge? What did you drop in the basket? A user fee. That money you put in the toll basket helped to pay the debt service on the revenue bond issued to build the toll way or toll bridge. If money problems arise, the issuer won't raise property taxes. They'll raise the user fees.

You don't like the higher tolls? Use the freeway. But, home¬owners aren't affected one way or another since their property taxes cannot be used to pay off revenue bonds. Facilities that could generate enough revenue to pay off the bonds include airports, convention centers, golf courses, and sports stadiums. The stadium where the New York Mets play their home games was built with the proceeds of a revenue bond. As an article in Bloomberg explains, "The Mets sold $613 million municipal bonds in 2006 backed by payments in lieu of property taxes, lease revenue and installment payments to finance the construction of Citi Field. The team also issued $82.3 million of insured debt in 2009, the year the 42,000-seat ballpark opened in Queens."

Unfortunately, the revenues a few years ago were significantly lower than what the consultants predicted. That caused the bonds' rating to drop. The next year, however, with attendance up 20%, the revenues improved just enough to boost the credit rating to one notch above junk. What about future seasons? Turns out, predicting the credit rating for the bonds is about as reliable as predicting where the Mets will place in their division each year.

General obligation bond ratings are based on the credit score of the issuer. On the other hand, revenue bonds are only as strong as the revenues generated by the project being built. When the revenues are tied to the success and popularity of a baseball team, it is not surprising the credit rating could be upgraded and downgraded many times before maturity.

Since we don't have property tax on the table, the municipal government doesn't need voter approval to issue a revenue bond. So, we don't associate "voter approval" with a revenue bond. That is for general obligation bonds only.

There are other ways a municipality could identify specific sources of revenue for a bond issue. For example, if the residents of a county wanted their roads paved, the county could add a special tax on gasoline throughout the county and let motorists pay for the new roads each time they fill up their tanks. This special tax is used to pay the debt service on the revenue bonds, which are issued to raise the money required to pave the roads. That's an example of a special tax bond, a type of revenue bond.

Any tax not a property or sales tax is considered a special tax, including special taxes on business licenses, excise taxes, and taxes on gasoline, tobacco, hotel/ motel, bottled water, and alcohol. this kind called "sin taxes."

There are also special assessment bonds. Say a wealthy subdivision in your community experiences problems with their sidewalks. The concrete is chipped, threatening the property values of the homes in the exclusive subdivision. The residents want the municipality to fix the sidewalks. The municipality says, okay, if you pay a special assessment on your property, since you're the only ones who'll benefit from this improvement. That special assessment will be the revenue used to pay the debt service on a special assessment bond, which is issued to raise the money to fix the sidewalks.

See how it works? They identify a future source of revenue, like tolls, ticket sales, or special taxes on gasoline. Then, since they need all that money right now, they issue debt securities against this new source of revenue they're creating. They take the proceeds from selling the debt securities and get the project built. Then those revenues they identified come in, and they use them to pay the interest and, eventually, the principal due to investors who bought the bonds.

Cities like Chicago and New York have public housing projects, which are under HUD, a unit of the federal government. Municipalities issue PHA (Public Housing Authority) or NHA (New Housing Authority) bonds to raise money for housing projects. The debt service is backed by the rental payments, which are in turn backed by contributions from Uncle Sam. PHAs and NHAs are considered the safest revenue bond because of this guaranteed contribution from the federal government. Sometimes they are referred to as "Section 8" bonds because something needs at least three names in this business.

Industrial Development Revenue bonds are used to build or acquire facilities that a municipal government will then lease to a corporation. These IDRs carry the same credit rating as the corporation occupying the facility. The issuing municipality does not back the debt service in any way. Again, the debt service will be paid only from lease payments made by a corporation, so it's the corporation that backs the debt service. As you know, corporations have been known to go belly-up occasionally. If they're the ones backing up the debt service, you can imagine what happens when they themselves no longer have any assets behind them.
And if it happens, the issuer won't be there to bail out the bondholders. While revenue bonds are only serviced by specific sources of revenue, a moral obligation bond provides for the possibility of the issuer going to the legislature and convincing them to honor the "moral obligation" to pay off the debt service. This is a moral obligation, not a legal one, and it would take legislative action to get the money authorized.