LOS g, (Part 2): Distinguish between tax-backed debt and revenue bonds.

Q1. Consider three municipal bonds issued by the Greater Holmen Metropolitan Capital Improvement District, a local authority that carries an issuer rating of single-A from the major debt rating agencies. All three bonds have the same coupon rate and maturity date.

• Series W was issued to finance the rebuilding and expansion of local schools and is backed by the District’s authority to levy property tax.
• Series X was issued to build a water purification plant for the region. The District charges fees to the surrounding municipalities for their use of the plant. These fees are the only source of the interest and principal payments on the bonds.
• Series Y was issued to raise funds for the general use of the District in its ordinary maintenance projects and is backed by the District’s authority to levy property tax. These bonds carry a third party guarantee of principal and interest payments.

What is most likely the order of the market yields on these three bond issues, from highest to lowest?

A)   Series Y, Series W, Series X.

B)   Series X, Series Y, Series W.

C)   Series X, Series W, Series Y.

Q2. The most junior type of municipal bond is the:

A)   income or revenue bond.

B)   indenture bond.

C)   general obligation bond.

Q3. Which statement about the risks of bond investing is least accurate?

A)   Interest on some municipal bonds is not excluded from federal income taxes.

B)   Bankruptcy courts do not always follow the absolute priority rule.

C)   In a competitive Treasury-bill auction, not all bidders pay the same price.

Q4. Support for the revenue bonds comes from:

A)   the gross revenues of the underlying project.

B)   property taxes based on the project.

C)   the net revenues of the underlying project.

LOS g, (Part 2): Distinguish between tax-backed debt and revenue bonds.fficeffice" />

Q1. Consider three municipal bonds issued by the Greater Holmen Metropolitan Capital Improvement District, a local authority that carries an issuer rating of single-A from the major debt rating agencies. All three bonds have the same coupon rate and maturity date.

• Series W was issued to finance the rebuilding and expansion of local schools and is backed by the District’s authority to levy property tax.
• Series X was issued to build a water purification plant for the region. The District charges fees to the surrounding municipalities for their use of the plant. These fees are the only source of the interest and principal payments on the bonds.
• Series Y was issued to raise funds for the general use of the District in its ordinary maintenance projects and is backed by the District’s authority to levy property tax. These bonds carry a third party guarantee of principal and interest payments.

What is most likely the order of the market yields on these three bond issues, from highest to lowest?

A)   Series Y, Series W, Series X.

B)   Series X, Series Y, Series W.

C)   Series X, Series W, Series Y.

Correct answer is C)

Series X is a revenue bond. Because they pay interest and principal only if revenues from the project they finance are sufficient, revenue bonds are typically riskier and therefore have higher market yields than general obligation bonds. Series Y is an insured bond. Municipal bond insurance typically results in a higher rating, and therefore a lower market yield, than an equivalent bond from the same municipal issuer. So of these three bonds, Series X should have the highest market yield and Series Y the lowest.

Q2. The most junior type of municipal bond is the:

A)   income or revenue bond.

B)   indenture bond.

C)   general obligation bond.

Correct answer is A)

General obligation bonds are backed by the full faith, credit, and taxing power of the issuer. Revenue bonds are serviced by the income generated from specific income-producing projects and can not be paid from other proceeds unrelated to the project.

Q3. Which statement about the risks of bond investing is least accurate?

A)   Interest on some municipal bonds is not excluded from federal income taxes.

B)   Bankruptcy courts do not always follow the absolute priority rule.

C)   In a competitive Treasury-bill auction, not all bidders pay the same price.

Correct answer is C)        

All T-bills are auctioned using the single-price method, in which all-successful bidders pay the price implied by the stop yield, which is the yield at which the quality demanded equals the quantity for sale. Bankruptcy courts follow the absolute priority rule when possible, but not always. Most municipal bonds are exempt from federal taxes, but not all of them.

Q4. Support for the revenue bonds comes from:

A)   the gross revenues of the underlying project.

B)   property taxes based on the project.

C)   the net revenues of the underlying project.

Correct answer is C)        

Revenue bonds are serviced by the net income generated from specific income-producing projects (e.g., toll roads).

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