Municipal Notes, Special Structures and Refundings

The anticipation notes

Each note is named for the money that will retire it, which makes the whole family learnable in one pass.

Tax anticipation notes — TANs — are repaid from taxes not yet collected.

Revenue anticipation notes — RANs — are repaid from expected revenue, typically intergovernmental transfers or fees.

Tax and revenue anticipation notes — TRANs — combine the two.

Bond anticipation notes — BANs — are repaid from the proceeds of a future long-term bond issue. This is the one with a distinct risk: repayment depends on the issuer's ability to sell the permanent bonds on acceptable terms, so a BAN carries market access risk that a TAN does not.

Grant anticipation notes — GANs — are repaid from an expected federal or state grant.

Construction loan notes — CLNs — fund construction pending permanent financing, common in housing.

Tax-exempt commercial paper serves the same bridging purpose with maturities up to 270 days and is typically rolled over.

Municipal notes are rated on their own scale — MIG ratings from Moody's, with MIG 1 the highest — rather than on the long-term letter scale, which is a small detail the exam occasionally reaches for.

Variable rate and auction rate structures

A variable rate demand obligation is a long-dated bond whose interest rate resets frequently — daily or weekly — against a benchmark, coupled with a put feature letting the holder tender the bond back at par on short notice. The combination gives an investor a money-market-like instrument with a long-dated bond's tax exemption. The put is typically supported by a bank liquidity facility, so the credit analysis includes the bank as well as the issuer. Because the rate resets, the price stays near par: a VRDO is the low-price-volatility answer in a municipal context.

Auction rate securities set their rate through periodic Dutch auctions rather than against a benchmark, with no put feature. The design assumed the auctions would always clear. In 2008 they did not, and holders who believed they held a cash equivalent found themselves owning a long-dated bond they could not sell. The exam's takeaway is the general one: liquidity that depends on a market mechanism functioning is not the same as contractual liquidity, and an ARS must never be presented to a customer as a cash equivalent.

The special structures

Special tax bonds are payable from the proceeds of a particular tax — on fuel, tobacco, alcohol, or business licences — rather than from general taxes or from project revenue. The credit is only as good as that tax stream, which can be eroded by the very behaviour change the tax was designed to encourage.

Special assessment bonds are payable from assessments levied on the specific properties that benefit from an improvement — a new sewer line, sidewalks, street lighting. Only the benefited property owners pay.

Moral obligation bonds carry a non-binding pledge that the state legislature will consider appropriating money to make up a deficiency in the debt service reserve. It is a promise to consider, not a promise to pay, and it requires legislative action each time. It provides real comfort in practice and no legal claim at all, and the exam wants that distinction stated exactly.

Build America Bonds were taxable municipal bonds issued under a federal programme in 2009 and 2010 in which the issuer received a direct federal subsidy on its interest cost. They are the standing example of a taxable municipal bond: their interest is fully taxable to the holder, so they are bought for yield rather than for tax exemption, and they are attractive to tax-exempt buyers such as pension funds who get nothing from a tax exemption.

Bank qualified bonds are small issues designated by the issuer, which allow a bank buying them to deduct a portion of the carrying cost that it otherwise could not. The designation adds value to bank buyers and therefore lowers the issuer's cost.

Calls

Municipal bonds carry more varied call structures than corporates, and the outline names them.

Optional calls are at the issuer's discretion after any call protection period, at par or at a declining premium.

Mandatory calls are required by the indenture, usually to satisfy a sinking fund.

A partial call redeems part of an issue, with the specific bonds selected by lot or by another method stated in the indenture.

Extraordinary calls are triggered by an event rather than by the issuer's choice: the catastrophe call after destruction of the facility, or a call funded by unexpectedly high prepayments in a housing issue.

A make-whole call requires payment of a price derived from the present value of remaining payments, which largely removes the economic disadvantage to the holder.

A put or tender option runs the other way, letting the holder require repurchase — the feature that makes a VRDO work.

As lesson 3.2 established, and as MSRB Rule G-15 requires on the confirmation, a premium bond is quoted to the call because that is its lowest yield.

Refunding

Refunding is refinancing: issuing new bonds to retire an old issue, generally to reduce interest cost, but sometimes to remove restrictive covenants or to restructure maturities.

Current refunding retires the old issue within ninety days of the new issue's delivery. It is straightforward.

Advance refunding issues new bonds well before the old issue can be retired. The proceeds cannot simply sit idle, so they are invested in an escrow of US government securities structured to produce exactly the cash needed to service the old bonds until they are called or mature. The old bonds are then said to be defeased: still outstanding, but no longer a claim on the issuer's revenue, because a portfolio of Treasuries stands behind them.

That produces the two terms the exam wants. A pre-refunded bond is one whose escrow is structured to the first call date; it will be called then. A bond escrowed to maturity is one whose escrow runs to the final maturity; it will not be called.

Either way, the credit quality of the refunded bond is transformed. It is now secured by an escrow of government securities rather than by the municipality, and rating agencies typically rate such bonds AAA. A pre-refunded bond is the highest-quality municipal security a customer can hold, and its remaining life is short and known. That is the answer whenever a question describes a municipal bond whose rating has been upgraded to the top and whose maturity for pricing purposes is the call date.

Crossover refunding is the variant where the escrow initially services the new bonds, and only later crosses over to service the old ones. Until the crossover, the old bonds remain a claim on the issuer's original revenue source, so they are not defeased and do not get the escrow's credit quality — which is precisely why the exam includes it.

A direct exchange refunding swaps new bonds for old with the existing holders instead of selling new bonds for cash.