How to Analyze General Obligation Bonds on the Series 7 Exam
The Series 7 exam tests your ability to analyze different types of municipal securities and help a customer make a decision that best suits her needs. Because they’re backed by taxes rather than sales of goods and services, GO bonds have different components to look at when analyzing marketability and safety.
They fund nonrevenue producing facilities. GO bonds are not self-supporting because municipalities issue them to build or support projects that don’t bring in enough (or any) money to help pay off the bonds.
They’re backed by the full faith and credit of the municipality. The taxes of the people living in the municipality back general obligation bonds.
They require voter approval. Because the generous taxes of the people living in the municipality back the bonds, those same people have the right to vote on the project.
The following question tests your knowledge of GO bonds.
Which of the following projects are MORE likely to be financed by general obligation bonds than revenue bonds?
I. New municipal hospital
II. Public sports arena
III. New junior high school
IV. New library
(A) I and II only
(B) III and IV only
(C) I and III only
(D) I, III, and IV only
The correct answer is Choice (B). Remember that GO bonds are issued to fund nonrevenue producing projects. A new municipal hospital and a public sports arena will produce income that can back revenue bonds. However, a new junior high school and a new library need the support of taxes to pay off the bonds and, therefore, are more likely to be financed by GO bonds.
How to ascertain marketability
Many different items can affect the marketability of municipal bonds, including the characteristics of the issuer, factors affecting the issuer’s ability to pay, and municipal debt ratios. Here’s a list of some of the other items that can affect the bonds’ marketability:
Quality: The higher the credit rating, the safer the bond, and therefore the more marketable it is.
Maturity: The shorter the maturity, the more marketable the bond issue.
Call features: Callable bonds are less marketable than noncallable bonds.
Interest (coupon) rate: Everything else being somewhat equal, bonds with higher coupon (interest) rates are more marketable.
Block size: The larger the block size, the more marketable the bond usually is.
Dollar price: All else being equal, the lower the dollar price, the more marketable the bond is.
Issuer’s name: Bonds are more marketable when the issuer has a good reputation for paying off its bonds on time.
Sinking fund: If the issuer has put money aside to pay the bonds off at maturity, the bonds are more marketable because the default risk is lower.
Insurance: If the bonds are insured against default, they’re considered very safe and are much more marketable. Bond insurance is considered a credit enhancement.
How to deal with debt
One factor that influences the safety of a GO bond is the municipality’s ability to deal with debt. Look at previous issues that the municipality had and find out whether it was able to pay off the debt in a timely manner.
In addition to the municipality’s name, you want to look at its current debt. Net overall debt includes the debt that the municipality owes directly plus the portion of the overlapping debt that the municipality is responsible for:
Net direct debt: The debt that the municipality obtained on its own. Net direct debt comes from both GO bonds and short-term municipal notes. Revenue bonds are not included in the net direct debt because they’re self-supporting (see Dealing with Revenue Bonds: Raising Money for Utilities and Such).
Overlapping debt: Overlapping debt occurs when several authorities in a geographic area have the ability to tax the same residents.
To determine the debt per capita (per person), take the debt and divide it by the number of people in the municipality.
Taxes, fees, and fines
Taxes are another factor that influence the safety of GO bonds. Property taxes and sales taxes are the driving force behind paying back investors. Aided and abetted by traffic fines and licensing fees, taxes put money in the municipal coffers and eventually in investors’ hands. The following factors come into play:
Property values: Ad valorem taxes are the largest source of backing for GO bonds. Even though people living in a municipality want their property values to be low, people investing in municipal bonds want the property values to be high. The higher the assessed value, the more taxes collected and the easier it is for the municipality to pay off its debt.
Population: Obviously, the more people who live in a municipality and pay taxes to back the bond issue, the better. Also, the population trend is important. Investors prefer to see more people moving into a municipality than moving out.
Tax base: The tax base is comprised of the number of people living in the municipality, the assessed property values, and how much the average person makes. Larger tax bases are ideal.
Sales per capita: Because sales taxes also support GO bonds, the amount of sales per capita is also important.
Traffic fines and licensing fees: You know that $100 speeding ticket that you got last month? The money that you paid in fines helped pay off some of the municipality’s debt.
Try your hand at a question involving property taxes, an issue that affects the safety of GO bonds.
An individual has a house with a market value of $350,000 and an assessed value of $300,000. What is the ad valorem tax if the tax rate is 24 mills?
The answer you want is Choice (C). First make sure that you start with the assessed value; multiply it by the tax rate and then by 0.001 to get the answer:
$300,000 × 24 × 0.001 = $7,200