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A list of acronyms and terms can be found below the alphabetical entries.
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A

Accretion is essentially the opposite of amortization, and is an accounting process used to adjust the overall amount, or book value, of bonds outstanding on financial statements. Amortization involves writing down the book value of a bond issued at a premium; accretion involves writing up the book value of a bond issued at a discount.

When a bond is issued at a discount — it sells for less than its face value — the issuer will record the bond on its financial statements at par value less the discount. Term bonds with a face value of $100 million, for example, may sell for $95.5 million: $100 million in par value with a $4.5 million discount. The bonds are initially recorded on the financial statements at $95.5 million.

The $4.5 million discount is accreted, or gradually decreased, each year. Because the discount is subtracted from the bonds’ par value, accreting the discount increases the value of the outstanding bonds on the financial statements. When the bonds near maturity, they will be recorded at their par value. For example, the bonds originally reported at $95.5 million will be recorded as $100 million – their face value – immediately before they mature.

See also:

·         amortization

·         bond discount

·         book value

Accrued interest is the amount of interest that has been earned on a security, such as a bond, between interest payments. Most municipal bonds pay interest every six months; in the interim, however, the bond gradually accrues interest until one payment is made at the six-month mark.

When a bond or security is purchased between interest payment dates, the price of the bond includes the accrued interest. The buyer pays the seller the accrued interest as, otherwise, the seller will not receive any of the interest earned while holding the security for a partial period.

For convenience, accrued interest is usually calculated based on a 360-day year, which assumes each month has 30 days.

For example, a 4 percent, $5,000 bond may pay $100 in interest each January 1 and July 1. If a buyer purchases the bond on May 1, four months of interest, or $67, has accrued. In other words, the seller has already earned $67 by holding the bond until May. When the buyer purchases the bond, the money paid to the seller will include the $67 in accrued interest earned by the seller.

The entirety of the $100 interest payment on July 1 will go to the buyer holding the bond as of that date. Thus, by paying the $67 of accrued interest to the seller when purchasing the bond, the buyer effectively earns $37 in interest in that period, or the equivalent of holding the bond for two months from May 1 to July 1.

See also:

·         interest

Bond refundings are typically used to save money by refinancing to take advantage of lower interest rates. Bonds may also be refunded to eliminate certain covenants or obligations imposed on the issuer. In a current refunding, the refunding happens immediately: new bonds are issued within 90 days of the existing bonds being called, and proceeds from the new bonds are used to pay off the old bonds.

In some cases, however, the need for a refunding may occur before the bonds are eligible to be called. In this scenario, there are two outstanding bond issues for the same project. Because the existing bonds cannot yet be called, however, proceeds from the new bonds are not used to immediately pay off the existing bonds. Instead, they are set aside in an escrow account to be used to pay periodic interest on the existing bonds, plus principal when the original bonds eventually reach their call date and are redeemed.

The proceeds from the new bonds in the escrow are usually invested in very low-risk securities, such as State and Local Government Securities (SLGS) offered by the federal government. Although these securities have low yields, they nevertheless earn some income. The timing for receipt and the amount of the investment income is included in the calculation of the amount of refunding bonds that need to be issued to fund the escrow to pay interest and principal on the original bonds. The escrow is structured to have funds timely available to make principal and interest payments on the existing bonds.

In this way, the original, higher-rate debt is functionally replaced with new, lower-rate debt. The issuer now pays interest and principal on the new, lower-rate bonds from the same sources — e.g., taxes — used for debt service on the original bonds. Debt service on the original bonds, however, is paid out of the escrow with money from the new bond proceeds. From the issuer’s point of view, it is no longer responsible for the original bonds, which have been defeased: they are no longer recorded on the financial statements as a liability, and certain bondholder rights may be terminated (looking to the escrow and not the issuer for payment).

From the original bondholders’ points of view, they continue receiving scheduled interest payments on their bonds, with the understanding that the issuer has set in place the process to call the bonds when they reach their call date.

The federal government determined that some issuers abused the advantage of unlimited tax-exempt advance refundings and reduced the number of times an issue could be refunded on a tax-exempt basis. The federal Tax Cuts and Jobs Act of 2017 prohibited further use of tax-exempt advance refundings as of January 1, 2018. Although state and local governments may still advance refund their bonds, the new refunding bonds must now be taxable. As a result, the refunding bonds will likely offer higher interest rates, thereby reducing the money saved on interest payments. Even so, taxable advance refundings may still offer worthwhile savings in some cases.

See also:

·         current refunding

·         escrow account

·         present value (PV) savings

·         refunding trust

·         verification agent

In the context of municipal bonds, amortization is the process of periodically paying off the principal of a bond issue and reducing the amount of debt outstanding. Principal payments may be made to the bondholders themselves or, in the case of term bonds, to a sinking fund that “saves up” in advance for one large principal payment when the bonds mature.

The State of Tennessee structures its amortization schedules, or debt service schedules, for its general obligation bonds with level principal payments. The Tennessee State School Bond Authority (TSSBA) and most local governments use level debt service structures.

Specifically regarding bond premiums, amortization is an accounting process used to decrease the overall amount, or book value, of bonds outstanding on financial statements. When a bond’s coupon rate, or the interest paid to bondholders, is higher than current market rates, the bond will sell at a premium, or for more than its face value. For example, bonds with a face value of $100 million may sell for $104.7 million: $100 million in par value with a $4.7 million premium. The bonds are initially reported on the financial statements at $104.7 million.

Similar to depreciation for capital assets, the $4.7 million premium is amortized each year, or gradually written down. As the premium is amortized, the total book value of the bonds reported on the financial statements decreases. When the bonds approach maturity, they will be recorded at their par value; the bonds originally reported at $104.7 million, for example, will be recorded at $100 million – their face value – immediately before they mature.

See also:

·         accretion

·         book value

·         debt service

·         debt service schedule

In the context of municipal bonds, arbitrage involves a state or local government issuing debt at relatively low interest rates due to its federal tax-exempt status, and then investing the proceeds from that debt in the taxable market to earn a higher return.

To help state and local governments save money on interest costs for public projects, the federal government allows the issuance of tax-exempt bonds. Because they keep more of the interest earned rather than paying a portion in taxes, bondholders may be more willing to invest in a municipal bond with a lower yield than a federal or corporate bond with a higher yield. Consequently, state and local governments can typically issue bonds with lower interest rates than their federal or corporate counterparts.

A government might then take the proceeds from the tax-exempt debt and invest them in the higher-yielding taxable market. For example, a local government might issue tax-exempt debt at 3 percent interest, then invest those proceeds in taxable securities yielding 3.5 percent. The government would keep the difference and essentially “make money” off the additional 0.5 percent.

This practice – arbitrage – disadvantages the federal government and reduces its tax revenues. Accordingly, several federal laws restrict or prohibit arbitrage in two main ways: 

·         Yield restrictions. Generally, governments may not invest bond proceeds above the yield on that bond issue. There are several exceptions; governments may have a short window at the beginning of the project to invest their proceeds without restrictions, for example.

·         Arbitrage rebates. If governments do have arbitrage earnings, they must generally send the excess interest to the IRS.

Unlike fixed-rate loans, which typically have the same interest rate over the entire period – e.g., 3.5 percent for 20 years – different maturities of bonds in a single bond issue may have different coupon rates. Maturities toward the beginning of the overall term of the bond issue may have lower interest rates than maturities toward the end of the term. For example, a bond maturing within a year may have a 2 percent coupon, while the bond maturing in 20 years may have a 5 percent coupon.

See also:

·         bond year

·         coupon or coupon rate

B

Balloon indebtedness refers to a debt structure where all or a substantial portion of the principal is not repaid until the final maturity. Under Tennessee state law, local government balloon indebtedness is defined as debt that:

·         takes more than 30 years to mature;

·         postpones paying principal or interest for more than three years after the debt is issued; or

·         does not have “substantially level” or declining debt service – principal is concentrated in a few large payments at the end of the term, or matures all at once in a bullet maturity.

Local governments must get approval from the state Comptroller’s Office to issue balloon debt.

See also:

·         term bond

Bank bonds are bonds purchased by a provider of a liquidity facility (usually a bank) in the event of a failed remarketing.

When interest rates rise, for example, bondholders may exercise a put option that requires the state or local government issuer to buy back its bonds, generally at their par value. If the bonds cannot be immediately remarketed to new investors, a bank providing a liquidity facility, such as a standby bond purchase agreement, steps in to purchase the bonds. The bonds are termed bank bonds until they are sold to other investors, or other terms of the standby bond purchase agreement are met. During the time the bonds are held by the bank, the interest rate is usually set at a higher rate.

See also:

·         liquidity facility

·         standby bond purchase agreement

Largely defunct today, bearer bonds are considered property of the “bearer,” or person or entity that holds them. As opposed to registered bonds, no record of ownership or sale is kept for bearer bonds – only a physical bond certificate serves as proof of ownership. To receive interest, physical coupons are detached from the certificate and mailed to the bond issuer or the issuer’s paying agent, and the certificate itself is presented at the maturity date for payment of principal.

Historically, the anonymity of bearer bonds made them a popular vehicle for tax evasion and money laundering. As a result, a 1982 federal law prohibited federally tax-exempt and tax-advantaged bonds from being issued in bearer form.

Issuing bonds is a way to borrow money, often for large projects (e.g., office buildings or parking garages) that are too expensive to pay for with current funds in a single payment. A bond is the borrower’s promise to repay a set amount of money, plus periodic interest, on a specific date.

Unlike a car loan or a house mortgage, a government’s borrowing is structured differently. Instead of establishing a repayment schedule based on a single interest rate and single maturity date, when a government issues bonds, the repayment schedule is based on multiple maturity dates with different interest rates. Thus, at any given time, the government may owe money to thousands of different individuals, businesses, or governments holding its bonds and not just to a single lender.

Both private businesses and government entities issue bonds, and bonds share common characteristics:

·         The issuer is the entity borrowing money, such as a state or local government.

·         The bond’s par or face value is the amount of money that will be repaid at the bond’s maturity date. Most municipal bonds are issued in multiples of $5,000, requiring a rounding up or down of the amount borrowed.

·         The bond’s coupon or coupon rate is the interest rate that will be paid to the bondholder, often every six months. For example, a $5,000 bond with a 5 percent coupon will pay $250 in interest each year, or $125 every six months.

A bond may be bought, sold, and held by many investors over its life before it is paid off. When bonds are originally issued or are traded later on the secondary market, they may not sell for their par amount. A bond’s price depends on how its coupon rate compares to current interest rates on the market for similar investments. If a bond’s coupon rate is lower than the market rate, the bond will be less attractive to investors and will sell for less than its par amount, or at a discount.

In Tennessee, the authority for the state and local governments to issue bonds is found in the Tennessee Constitution and statutes. At the state level, the four primary debt issuers are:

·         the State Funding Board, which issues the state’s general obligation debt for capital projects, as authorized by the Tennessee General Assembly. 

·         the Tennessee Housing Development Agency (THDA), which uses bonds to finance low- and moderate-income home loan programs.

·         the Tennessee Local Development Authority (TLDA), which is authorized to issue bonds and notes to make loans to local governments, small businesses, and nonprofits for specific purposes, such as water and sewer recovery facilities.

·         the Tennessee State School Bond Authority (TSSBA), which uses bonds to finance capital projects for the state’s colleges and universities.

State law authorizes many local government entities to issue bonds, including counties, cities, metropolitan governments, utility districts, and Industrial Development Boards (IDBs). County and city school districts, however, do not have the legal authority to issue bonds.

See also:

·         bearer bond

·         Local Government Public Obligations Act of 1986

·         long-term debt

·         registered bond

·         yield curve

A bond anticipation note (BAN) is a type of short-term borrowing used prior to issuing long-term bonds. BANs may be used to generate funding to pay for the construction or acquisition phase of a project. When the project is finished, bonds are issued, and the bond proceeds are used to pay off the bond anticipation notes.

Commercial paper is one example of a bond anticipation note.

See also:

·         commercial paper

·         note

When an issuer sells a new issue of municipal bonds to an underwriter, the transaction is finalized on the closing date: the issuer and its financing team, along with the underwriter and its legal counsel, sign closing documents. At that point, the underwriter pays for the bonds and the issuer delivers the bonds to the underwriter.

See also:

·         delivery date

·         delivery versus payment (DVP)

Along with the financial advisor, the bond counsel is an integral part of the issuer’s financing team. The bond counsel looks at legal issues related to a bond issue and subsequently gives a legal opinion. The opinion generally confirms that the issuer is legally authorized to issue the bonds; that the bond issue is a legally binding obligation; and, in the case of tax-exempt bonds, that the bond interest is indeed exempt from specified taxes. The opinion does not address the issuer’s creditworthiness. The bond counsel may also draft or review various documentation, including bond contracts and official statements.

See also:

·         rating agency

A bond covenant is a legal provision in the bond contract that sets restrictions on the issuer to protect investors. For example, covenants may require the issuer to:

·         raise enough taxes and fees to pay debt service;

·         maintain the financed facility at an acceptable level and provide casualty insurance;

·         not issue new bonds or debt unless certain thresholds are met – e.g., revenues available for debt service are at least 1.25 times the amount needed for proposed and outstanding debt;

·         not take any action that would change the tax status of the bonds from tax-exempt to taxable.

When bonds are issued or sold for less than their par value, the bond discount is the difference between their price and their par value (i.e., face value).

When bonds are originally issued or traded later on the secondary market, they may sell for more or less than their par value. A bond’s price depends on how its coupon rate, or the interest rate it will pay to bondholders, compares to current market interest rates for similar credits.

If a bond’s coupon rate is lower than the current market rate, it will be less attractive to investors, and it will sell for less than its par value, or at a discount. For example, if $100 million of 20-year term bonds pay 3 percent interest while the market rate is 4 percent, the bonds may sell for $86 million: $100 million of par value less a $14 million discount.

The original issue discount is the bond discount when the bond is issued. After the bonds are issued, the issuer records them on its financial statements at their book value: their par value less the original issue discount. As time passes, the discount is accreted, or gradually decreased – as the discount decreases, the bonds’ book value correspondingly increases. Before the bonds mature, they are recorded on the issuer’s financial statements at $100 million, their par value.

See also:

·         accretion

·         book value

·         par value

Bond insurance is a type of credit enhancement where an issuer essentially pays money to increase the credit rating on its bonds. Through a bond insurance policy, an insurance company agrees to pay principal and interest on the insured bonds if the issuer defaults. The issuer’s lower bond rating on the issue prior to insurance is thus upgraded to the insurance company’s higher claims-paying rating (analogous to a bond rating). The premium the issuer pays to the insurance company is offset by the reduced bond interest the issuer pays to bondholders due to the enhanced credit rating.

Because the State of Tennessee has a triple-AAA bond rating — the highest possible rating — bond insurance is not needed to upgrade the ratings on its general obligation bonds.

See also:

·         credit enhancement

When bonds are issued or sold for more than their par value, the bond premium is the difference between their price and their par value (i.e., face value).

When bonds are originally issued or traded later on the secondary market, they may sell for more or less than their par value. A bond’s price depends on how its coupon rate – the interest rate it will pay to bondholders – compares to current interest rates on the market.

If a bond’s coupon rate is higher than the current market rate, it will sell for more than its par value, or at a premium. For example, if $100 million of 20-year term bonds pay 5 percent interest while the market rate is 4 percent, the bonds may sell for $114 million: $100 million of par value and a $14 million premium.

The original issue premium is the bond premium when the bond is issued. After the bonds are issued, the issuer records them on its financial statements at their book value, which is their par value plus the original issue premium. As time passes, the premium is amortized, or gradually decreased, and the bonds’ book value correspondingly decreases. Right before the bonds mature, they are recorded on the issuer’s financial statements at $100 million, their par value.

See also:

·         amortization

·         book value

A bond’s price is the amount of money paid to buy the bond, either when the bond is originally issued or sold later on the secondary market. Depending on how a bond’s coupon rate, or the interest it pays to investors, compares to current market interest rates, the bond’s price may be higher or lower than its par value. For example, if current interest rates are 3 percent, a $5,000 bond with 10 years to maturity and a 2.5 percent coupon may sell for $4,785.

When bonds are issued, the proceeds are the amount of money the issuer receives from the buyers, or underwriters. Depending on how the bonds’ coupon rates compare to current market interest rates, the proceeds may be more or less than the bonds’ par value. In other words, the issuer may receive more or less money when the bonds are originally sold than it will eventually repay in principal.

For example, if $100 million of 20-year term bonds are priced with a 4 percent coupon rate while current market rates are 3 percent, the issuer may receive $115 million in proceeds, or more than the $100 million of par value.

Bond proceeds may be used only for the purposes as provided in the bond contract or authorizing documents.

In general, a bond purchaser is any person or entity that buys a bond. The purchaser may be an underwriter; an institutional investor, such as a fund, bank, or insurance company; or a retail investor, such as a household or individual.

Through a bond referendum, voters of the entity that is planning to issue bonds vote on whether or not to allow the bonds to be issued.

In Tennessee, state bonds, school bonds issued by counties, and revenue bonds issued by local governments do not need voter approval to be issued. General obligation bonds of cities and counties, however, may be subject to a voter referendum.

As outlined in state law, after local governments adopt an initial resolution to issue general obligation bonds, they must publish notice in a local newspaper. If a petition objecting to the bonds is signed by at least 10 percent of voters and filed within 20 days, the bonds are subject to a referendum. If the vote fails, the bonds cannot be issued at that time, and the local government must wait at least three months before trying again.

The bond trustee, generally a trust company or a trust division of a bank, enforces the bond contract with the issuer. The trustee acts on behalf of the bondholders in a fiduciary capacity, rather than the issuer, ensuring compliance with bond covenants and overseeing operation within approved budgets.

When principal and interest payments are due, the issuer sends the money to the bond trustee. In practice, the trustee may serve in multiple capacities for the issuer, including as the registrar that maintains the list of bondholders and the paying agent that makes payments to investors.

See also:

·         trust indenture

A bond year is a figure used to calculate the weighted average maturity of an issue and its net interest cost. Regardless of the bond’s denomination – e.g., whether a bond is issued in multiples of $5,000 – a bond year is a unit of $1,000 of debt that is outstanding for a 12-month period.

To find the number of bond years, the amount of principal maturing in each year is multiplied by the number of years to maturity. The resulting figure – bond year dollars – is then divided by $1,000 to find bond years.

See also:

·         average coupon

·         net interest cost (NIC)

·         weighted average maturity (WAM)

A bond’s yield is its annual return to an investor based on its price, coupon rate, and how long the investor holds it before it matures or is sold. The yield may not match the stated interest rate on the bond.

If a bond’s coupon rate is higher than market interest rates, the bond will trade for more than its par value, or at a premium. For example, if current interest rates are 3 percent, a bond with a $5,000 par value and a 4 percent coupon may sell for $5,430. Although the investor will receive higher interest payments than it would have if it had purchased another bond with a lower coupon, it paid an additional $430 up front to purchase the bond. Thus, the bond’s yield, which takes into account both the bond’s price and coupon, will be lower than the 4 percent coupon rate.

Multiple yields may be calculated for the same bond based on structure and how long the investor holds it:

·         Yield to maturity (YTM) assumes the investor will hold the bond until it matures;

·         Yield to call (YTC) assumes the issuer will pay off the bond before its maturity date;

·         Yield to put (YTP) assumes the investor will force the issuer to repurchase the bond before it matures; and

·         Yield to worst (YTW) is the lowest of yield to maturity, yield to call, and any other associated calculation.

See also:

·         yield to maturity (YTM)

From an issuer’s standpoint, book value is the amount at which outstanding bonds are reported on its financial statements, or “carried on the books.” When the bonds are first issued, book value is the par value of the bonds, plus any premium or less any discount. As time passes, the premium is amortized or the discount is accreted, and the book value of the bonds is accordingly adjusted up or down. More specifically, each time the premium or discount decreases, the bonds’ book value approaches their par value. Immediately before the bonds mature, their book value will equal their par value.

Depending on how the market has changed since the bonds were issued, book value may not correspond to the bonds’ fair market value, or how much the bonds would sell for on the secondary market.

See also:

·         accretion

·         amortization

·         fair market value

Many companies act as both brokers and dealers, and are thus called broker-dealers.

A broker is a person or company that brings together buyers and sellers of securities, such as stocks or bonds. For example, if the broker’s customer wants to buy stock of a particular company, the broker finds a seller, facilitates the trade, and charges a commission on the transaction.

A dealer, by contrast, directly participates in the transaction. For example, a dealer may buy shares of stock from the other party for its own accounts, or sell shares it already owns. While brokers make their money off trade commissions, dealers make money on the difference between the money they pay for the security and the money they sell it for.

C

A call is a provision that allows the issuer to “call” in – redeem or pay off – an outstanding bond ahead of schedule. In doing so, the issuer pays bondholders the par amount of the bond, plus any interest that has been earned in the partial period before the next interest payment. Depending on the bond contract, the issuer may also pay an additional amount to bondholders, or a “call premium” if a call provision is included. If bonds are not subject to call, they are said to have “call protection.” 

Bonds are generally called when current interest rates drop below the interest rates on the existing bonds. For example, an issuer may have issued 20-year, 5 percent bonds that may be called after 10 years. If interest rates for a bond maturing in 10 years have dropped to 3 percent at the 10-year call date, the issuer may save money by calling in its existing 5 percent bonds and issuing new 10-year bonds that pay 3 percent interest.

As set in its debt management policy, the State of Tennessee has a preference for issuing long-term general obligation bonds that can be called.

With regard to callable bonds, the call date is the date the bonds may be redeemed and paid off early, as specified by the bond contract. The State of Tennessee’s debt management policy for general obligation bonds allows for call dates to be set no more than 10 years from the date the bonds were issued.

See also:

·         call

Capital appreciation bonds (CAB) do not pay periodic interest to bondholders. Like zero-coupon bonds, capital appreciation bonds are sold for substantially less than their par value, then pay out their full value at maturity. For example, a 10-year, $5,000 capital appreciation bond may sell for $3,365. Although the bondholder will not receive periodic interest over the ensuing 10 years, it will receive the full $5,000 when the bond matures.

See also:

·         zero-coupon bond

Capital projects involve large-scale projects, such as buying land, building a new facility, or renovating an existing building. Because these large assets last for many years, they may be financed with bonds to spread the cost of the project over its life.   

In a conduit financing, the entity issuing the bonds passes the proceeds to another governmental entity or to a nongovernmental entity, such as a private business or charitable organization, usually pursuant to a loan agreement.

Interest on state and local bonds is exempt from federal income taxes, so long as the bonds are used to finance public projects, such as government office buildings or parks. Bonds that primarily benefit private individuals or companies – private activity bonds – are generally taxable, unless they are used for certain purposes outlined in federal law. Among other things, these “qualified private activity bonds” may be used to build low-income housing or facilities for charitable organizations.

Because this subset of private activity bonds is tax-exempt, money may be borrowed by the government at lower interest rates than if the private entity issued its own taxable bonds. Thus, a governmental issuer, the “conduit issuer,” issues the bonds, and typically loans the proceeds to the private entity, or “conduit borrower.” The private entity is responsible for associated principal and interest payments.

See also:

·         private activity bond (PAB)

In a credit enhancement, an issuer pays a third party to provide a “backup” source of funding for principal and interest payments on its bonds. This added guarantee reduces the risk that payments will not be made to bondholders, and thus allows the issuer to obtain a higher credit rating for its bonds. The new bond rating is based on the credit rating of the entity providing the enhancement, rather than the issuer.

Bond insurance is an example of a credit enhancement: an issuer buys a bond insurance policy from an insurance company, and in return, the insurance company agrees to pay interest and principal on the insured bonds if the issuer defaults. The insurance company’s claims-paying rating — analogous to a bond rating — is used for the bonds.

A letter of credit from a bank is another form of credit enhancement. In this case, a commercial bank makes an irrevocable commitment to pay principal and interest if the issuer cannot make payments. When the bonds are issued, the bank’s credit rating, rather than the issuer’s, is used.

See also:

·         bond insurance

·         credit facility

A credit facility is an instrument, such as a bond insurance policy or letter of credit, that enhances an issuer’s credit. By using a credit enhancement, an issuer upgrades the rating on its bonds by paying a third party to provide a “backup” funding source for principal and interest payments.

See also:

·         credit enhancement

In a bond refunding, an issuer refinances its debt, often to take advantage of lower interest rates. In a current refunding, new bonds are issued within 90 days of the existing bonds being called, and the new refunding bond proceeds are immediately used to pay off the original refunded bonds. By contrast, in an advance refunding, the call date of the existing bonds is more than 90 days away.

For example, an issuer may have issued 20-year, 6 percent bonds that may be called after 10 years. After 10 years, interest rates for bonds maturing in 10 years may have dropped to 4 percent. The issuer may then issue new bonds maturing in 10 years at 4 percent interest. The issuer calls the existing 6 percent bonds and pays them off with the proceeds from the 4 percent bonds. In doing so, the issuer borrows the same amount of money overall, but saves money on debt service by paying less interest to bondholders.

See also:

·         advance refunding

·         call

CUSIP number stands for Committee on Uniform Security Identification Procedures number, and is a nine-digit code that uniquely identifies an individual financial instrument (e.g., a stock, a bond, a certificate of deposit).

The first six characters of each CUSIP number are unique for every company or issuer – for example, the first six digits for each issue of the state’s general obligation debt are 880541. The seventh and eight digits denote the type of security – debt or equity – and the ninth digit is a “check” figure based on the previous eight characters. 

D

In general, debt refers to borrowing money and repaying it with interest, sometimes over an extended period of time. Short-term debt is usually repaid within a year, whereas long-term debt may not be fully paid off for 20 years or more.

The Tennessee State Constitution does not allow the state to borrow money for its operating expenses unless it is repaid within the fiscal year. Local governments may issue long-term, so-called “funding bonds” for operating purposes only in extreme circumstances and under strict oversight by the state Comptroller’s Office.

Instead, the state and local governments typically use long-term debt to finance capital projects – large projects, such as office buildings, that will last for many years and may be too expensive to pay for at the time of construction with current funds. By repaying the debt over a longer period of time, the cost of the project is spread over its life. 

Bonds, notes, loan agreements, and capital leases are forms of debt.

See also:

·         bond

·         lease

·         long-term debt

·         note

·         short-term debt

Debt capacity refers to how much debt an entity, such as a state or local government, can support – in other words, how much it can afford to borrow based on its available resources. Various statistics and ratios can be used to measure debt capacity, including debt per capita and the ratio of revenues available for debt service compared to the money actually needed for debt service.

See also:

·         debt ratios

Debt limit refers to the maximum amount of principal an issuer may issue or have outstanding at any given time. This may be imposed by the State Constitution, statute, charter provision, or policy. For example, under state law, the State of Tennessee cannot issue additional general obligation bonds if the maximum annual debt service on its existing bonds is more than 10 percent of the state tax revenues allocated to the general fund, highway fund, and debt service fund.

There is not a statutory specified debt limit for local governments in Tennessee.

Debt ratios are statistics that provide a measure of an issuer’s outstanding debt in relation to various other economic or demographic factors. Rating agencies may use these ratios to determine the credit quality of the issuer or an individual bond issue.

Common ratios include:

·         debt per capita: the issuer’s total outstanding debt divided by its population.

·         debt service coverage: the ratio of revenues available to pay annual debt service – principal and interest – to the amount actually needed for debt service. For example, if an issuer will pay $15 million annually in debt service and has $20 million to do so, its coverage ratio is 1.33.

·         interest coverage: similar to the debt service coverage ratio, the interest coverage ratio considers the ratio of revenues available to pay annual debt service to the amount needed for interest payments.

Debt service is the amount of money needed to pay both interest on all outstanding bonds and the principal of any matured bonds.

 See also:

·         debt service schedule

An issuer defaults when it fails to pay bond interest or principal on time, or does not comply with other provisions in the bond contract.

·         In a monetary default, the most serious type of default, the issuer does not pay interest or principal to bondholders on time or in full.

·         In a technical or nonpayment default, the issuer continues to make payments on time, but may violate other conditions in the bond agreement. For example, a portion of the project financed with the bonds may be used for private purposes, changing the tax status of the debt from tax-exempt to taxable. 

An event of default may occur following a monetary default, or if a technical default is not corrected after a certain period of time. The bondholders may then demand the legal remedies outlined in the bond contract – for example, with a private activity bond default the entire amount of unpaid principal may become due immediately or in a general obligation bond default the government may be required to increase revenues to remedy the delinquent payment and to provide additional coverage for the future.

When securities, such as bonds, are sold, the delivery date is the date the transaction is completed and the bonds are “delivered” to the new owner. At that point, the new owner may sell the bonds to another investor.

The delivery date is generally a day or more after the trade date, or the day the buyer and seller agree on the transaction. In the past, when stocks and bonds had physical certificates, the delivery date may have lagged further behind the trade date while the certificate was transferred between brokers.

See also:

·         delivery versus payment (DVP)

·         Depository Trust Company (DTC)

Depreciation is a method of reducing the value of a large asset as it “wears out” over time.

Certain large assets – capital assets, such as buildings or expensive equipment – lose value as they age, but nevertheless last for many years. Thus, from an accounting perspective, these capital assets are not used up all at once. For example, a $100,000 piece of equipment that will last for 10 years does not “cost” the entire $100,000 in the first year it is purchased.

Through depreciation, the full cost of the equipment is spread out gradually while it is in use. One method of depreciation allocates the $100,000 purchase price evenly over the life of the equipment: each year, the equipment will depreciate and lose $10,000 in value.

See also:

·         amortization

·         useful economic life

A discount bond is sold for less than its par value. When a bond is originally issued or traded later on the secondary market, its price depends on how its coupon rate – the interest rate it will pay to bondholders – compares to current market interest rates.

If a bond’s coupon rate is lower than the market rate, it will be less attractive to investors. As a result, it will sell for less than its par value, or at a discount. For example, if a $5,000, 15-year term bond pays 2.5 percent interest while the market rate is 3 percent, it may sell for $4,700.

See also:

·         bond discount

E

In general, an escrow is an arrangement where a third party, such as a bank, holds money on behalf of one party. The third party then pays out the money in the escrow account to other parties based on contractual arrangements.

In the context of municipal bonds, escrow accounts are typically used in conjunction with advance refundings. In an advance refunding, interest rates drop before outstanding bonds may be called and paid off early. To “lock in” the lower interest rate and corresponding savings, new bonds are issued at the lower interest rate, and the proceeds are put into an escrow account.

The proceeds from the new bonds in the escrow are then used to pay periodic interest on the existing higher-rate bonds, plus principal when the original bonds eventually reach their call date and are redeemed.

See also:

·         advance refunding

·         refunding trust

·         verification agent

See default.

Event notices – sometimes referred to as material event notices – are the public disclosure of certain events related to municipal bonds that may be relevant to investors. Under the continuing disclosure requirements of Securities and Exchange Commission (SEC) Rule 15c2-12, underwriters must make sure that issuers of municipal bonds agree to provide ongoing information to the Municipal Securities Rulemaking Board (MSRB), including event notices.

Examples of event notices include:

·         delays or failures to make principal and interest payments;

·         unscheduled use of debt service reserves or credit enhancements;

·         changes in the bonds’ status from tax-exempt to taxable;

·         changes in credit rating; and

·         bankruptcy or insolvency.

See also:

·         continuing disclosure agreement/undertaking

·         SEC Rule 15c2-12

F

See par value.

A fiscal year is a 12-month period used for budgeting, accounting, and preparing financial statements. A fiscal year may or may not coincide with the calendar year; in Tennessee, for example, the state and local fiscal year runs from July 1 to June 30, as set in state law. The federal fiscal year begins October 1 and ends September 30.

An agreement that provides for the purchase of bonds or other obligations of a governmental entity when delivery of such bonds or other obligations will occur on a date greater than 90 days from the date of execution of such agreement.

In Tennessee, funding bonds allow local governments in extreme fiscal distress to issue long-term debt for current operations. Because best practices in fiscal management strongly discourage this practice, funding bonds have rarely been used and are subject to strict oversight by the state Comptroller’s Office.

Although state law allows local governments to issue funding bonds, the Tennessee state constitution forbids the state from issuing debt for operating purposes unless it is repaid within that fiscal year.

G

As opposed to a revenue bond, which is paid from the revenues generated by the project being financed, a general obligation (GO) bond is guaranteed by the issuing government at large. General obligation bonds are normally backed by the full faith and credit of the government, meaning that the government will use any money available – or raise taxes, if needed – to pay them off. Limited-tax general obligation bonds, however, may limit how much taxes may be raised in this case.

The State of Tennessee’s GO debt, for example, may be paid from any state tax revenues in the general fund, highway fund, and debt service fund that are not legally restricted. In other words, payment of the state’s GO bonds takes priority: unless money in those funds is already set aside in law for a specific purpose, it may be used for debt service, if necessary, rather than other state activities. 

See also:

·         revenue bond

Unlike bonds, loans, and notes, grants do not have to be repaid – in a sense, grant funding is “given” to the recipient. Grants are often made by higher levels of government to lower levels of government; for example, the federal government has many grants for state and local governments.

Although grant money does not have to be paid back, the entity making the grant (the grantor) typically requires that the entity receiving the grant (the grantee) use the funding for a specific purpose, such as a particular education program. Grants may contain clawback provisions where the grantor can take back the grant money if the grantee does not comply with all provisions of the grant.

Many grants are funded on a reimbursement basis. For example, the eventual grant recipient first spends its own money for the specified purpose, such as buying equipment. The grant recipient then sends supporting documentation, such as a receipt or an invoice, to the grantor. If the spending is approved, the grantor reimburses the grant recipient for the cost of the equipment.

See also:

·         grant anticipation note (GAN)

Grant anticipation notes (GANs) are a type of short-term borrowing. Many grants are funded on a reimbursement basis: the entity receiving grant funding must first spend its own money for authorized purposes, and is later repaid with grant funds. Rather than using its own funds for the initial expenditures, however, the grant recipient may instead spend money borrowed through grant anticipation notes. The notes are later paid off when the grant funding is received through the reimbursement process.

See also:

·         note

·         short-term debt

H

No terms

I

In general, when a person or entity borrows money, they must repay not only the original amount borrowed, or principal, but an additional amount, or interest, in return for using the borrowed money. This arrangement extends to most municipal bonds: a government promises to pay the bond’s principal at maturity, plus periodic interest until that date. Interest is generally expressed as an annual percentage of principal – a $5,000 bond that pays $200 in interest each year has a 4 percent interest rate, or a 4 percent coupon.

See also:

·         interest rate

The interest payment date is the date on which interest payments are due to bondholders. Municipal bonds typically pay interest semiannually, or twice a year.

See also:

·         accrued interest

·         coupon or coupon rate

·         interest

In general, when an entity borrows money, it must repay both the amount originally borrowed, or principal, and an additional amount, or interest, to compensate the lender for using the borrowed money. The amount of interest is based on an interest rate, often expressed as an annual percentage of the amount borrowed.

With regard to bonds, the interest rate – also called the coupon or coupon rate – is the amount of interest the issuer annually pays to investors. For example, if a $5,000 bond has a 3 percent coupon rate, it pays $150 in interest each year.

See also:

·         interest

With regard to bonds, the issuer is the entity borrowing money, such as a state government, county, or city.

In Tennessee, the authority for the state and local governments to issue bonds is found in the Tennessee Constitution and statutes. At the state level, the four primary debt issuers are:

·         the State Funding Board, which issues the state’s general obligation debt for capital projects, as authorized by the Tennessee General Assembly. 

·         the Tennessee Housing Development Agency (THDA), which uses bonds to finance low- and moderate-income home loan programs.

·         the Tennessee Local Development Authority (TLDA), which is authorized to issue bonds and notes to make loans to local governments, small businesses, and nonprofits for specific purposes, such as water and sewer recovery facilities.

·         the Tennessee State School Bond Authority (TSSBA), which uses bonds to finance capital projects for the state’s colleges and universities.

State law authorizes many local government entities to issue bonds, including counties, cities, metropolitan governments, utility districts, and Industrial Development Boards (IDBs). County and city school districts, however, do not have the legal authority to issue debt.

J

No terms

K

L

Rather than outright buying an asset, such as a building or piece of equipment, a lease is a contractual agreement that allows one party (the lessee) to use the asset in exchange for payments to the owner (the lessor).

From an accounting standpoint, there are two types of leases:

·         In a capital lease, certain specific provisions must be met regarding purchase options or the value of the lease payments in relation to the property. For example, the lessee may lease a building for 20 years, then purchase the building at the end of the lease for a nominal amount (e.g., $1).

·         In an operating lease, the lessee uses the asset, but does not purchase it at the end of the lease. Any lease that does not meet the criteria of a capital lease is considered an operating lease. 

See also:

·         debt

In general, a lien is a lender’s legal right to a borrower’s property to guarantee repayment – a bank may seize the borrower’s car if the car loan is not repaid, for example.

Generally in the context of municipal bonds, debt is backed by a lien on revenues, and not on the asset(s) financed. Although multiple bond issues may be repaid from the same revenue sources – e.g., sales tax or property tax – the payment of some issues may take priority over others in case of revenue shortfalls or bankruptcy.

·         Senior lien bonds have a priority claim on revenues pledged for debt service and take precedence over other debt.

·         Junior lien bonds, also called second lien bonds or subordinate lien bonds, are subordinate to other bonds with a more senior claim on revenues for debt service and would be repaid after other debt.

·         Parity bonds have the same priority claim on revenues for debt service – in other words, none of the individual bond issues takes priority over the others.

Liquidity is a measure of how quickly an asset or investment can be converted to cash. Stocks and bonds may generally be bought and sold quickly without losing value, and are thus liquid. On the other hand, real estate may take much longer to sell, and is therefore more illiquid. 

The Local Government Public Obligations Act of 1986 was intended to provide a uniform and comprehensive statutory framework for local government debt issuance. It provides the authorization for general obligation and revenue debt for various purposes. The Act made many existing statutory limits on local government indebtedness inapplicable. Certain provisions in the Act apply to state entities as well as local government entities.

The London Interbank Offered Rate (LIBOR) is the interest rate that large, global banks operating in London financial markets could pay other banks for short-term loans. LIBOR covers seven different maturities, from overnight to one year, in five different currencies.

LIBOR is often used as a benchmark for setting short-term interest rates. An interest rate may be set to the three-month LIBOR plus 20 basis points, for example. 

M

Tennessee’s commercial lending laws set a cap on the maximum interest rates for various types of loans and financing arrangements. Although specific types of loans may have their own limits, interest in general is limited to a “formula rate.” The formula rate is the average prime loan rate published by the Federal Reserve – the rate banks use when lending to their best customers – plus 4 percent, or 24 percent, whichever is lower. 

The Tennessee Commissioner of Financial Institutions calculates and publishes the formula rate each week. In calendar year 2018, the formula rate ranged from 8.5 to 9.45 percent.

While interest rate limitations in law apply to commercial banks and lenders, the State of Tennessee’s bond acts authorizing the issuance of state general obligation debt cap interest at the formula rate.

N

In the context of municipal bonds, arbitrage relates to the investment of bond proceeds. In the case of positive arbitrage, which is restricted by federal law, a state or local government issues tax-exempt bonds at relatively low interest rates, then invests those bond proceeds in the higher-yielding taxable market.

Negative arbitrage is essentially the opposite: a state or local government issues bonds and the proceeds, when invested, earn less than the interest paid on the bonds. For example, the government may issue bonds paying 3 percent interest; due to market conditions, however, the government may earn only 2 percent off the invested proceeds.

See also:

·         arbitrage

Unlike a bond, which is repaid over many years, a note is a form of short-term borrowing. In selling a note, the issuer promises to repay the amount of principal borrowed, plus interest, on a certain date. Notes are generally repaid in one year or less.

Types of notes include:

·         bond anticipation notes, sometimes used to fund the construction phase of the project and later paid off when bonds are issued;

·         commercial paper, a type of bond anticipation note;

·         grant anticipation notes, often issued to fund initial spending that is later reimbursed through a grant; and

·         tax and revenue anticipation notes, issued to provide operating money until other revenues are collected.

An additional type of note – capital outlay notes – may be used to finance the construction phase of large projects or to purchase smaller capital assets, such as vehicles or equipment. Capital outlay notes may remain outstanding for up to 12 years, but in some cases, may be used similarly to bond anticipation notes and eventually converted into bonds. Any note conversion that takes place more than two years after the note was issued requires approval from the state  Comptroller’s Office.

See also:

·         bond anticipation note (BAN)

·         capital outlay note (CON)

·         commercial paper (CP)

·         grant anticipation note (GAN)

·         short-term debt

·         tax and revenue anticipation note (TRAN)

O

When bonds are issued publicly, the issuer and its financing team prepare the official statement (OS). The document typically includes information regarding:

·         the terms of the bonds, such as minimum denominations, interest rates, maturity dates, and call provisions;

·         the revenue used to repay the bonds; and

·         financial information and economic data about the issuer, such as other outstanding debt, debt limits, and any pending legal issues (e.g., lawsuits) that may affect repayment.

Before the official statement is finalized, a preliminary official statement (POS) provides much of the same information, but may exclude prices, delivery dates, or other information that depends on the market when the bonds are issued.

Underwriters are required to submit official statements for municipal bonds to the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access (EMMA) website at https://emma.msrb.org.

An optional redemption, or call provision, allows the issuer to redeem or pay off its outstanding bonds ahead of schedule. In doing so, the issuer pays investors the par amount of the bond, plus any interest that has been earned in the partial period before the next interest payment. Depending on the bond contract, the issuer may also pay an additional amount to bondholders, or a “call premium.” 

Generally, optional redemptions cannot take place before a date specified in the bond contract (e.g., 10 years after the bonds have been issued).

See also:

·         call

P

A bond’s par value, or face amount, is the amount of principal that will be paid to the bondholder when the bond matures – the owner of a 20-year bond with a par value of $5,000 will receive $5,000 at the end of the 20-year term, in addition to any periodic interest previously paid.  

Depending on how the bond’s coupon rate compares to current market interest rates, the bond may be issued or traded for more or less than its par value. If the market rate is 5 percent, for example, a $5,000 bond with a 4 percent coupon will be less attractive to potential buyers than other investments. As a result, the bond will sell for less than $5,000, its par value, or at a discount. Conversely, a $5,000 bond with a 6 percent coupon will sell for more than its par value, or at a premium.

Parity bonds have the same priority or equal claim on revenues promised to pay debt service.

At any given time, a state or local government may have multiple bond issues outstanding – a government may issue new bonds for capital projects each year, for example. These bonds may be repaid from the same revenue sources, such as the sales tax or property tax.

If the issuer does not have enough money to pay debt service on all of its bonds, the issuer may have a classification scheme for which bonds to pay first. Parity bonds have the same priority claim on revenue for debt service – in other words, none of the individual bond issues take priority over the others in the order of payment.

All State of Tennessee general obligation indebtedness is secured on a parity, except that “Special Taxes” secure only general obligation bonds outstanding on July 1, 2013.

See also:

·         lien

A pension obligation bond is issued by a state or local government to fund its payment obligations to its pension plan, and hinges on the general concept of arbitrage. Best practices in fiscal management require an entity to fund its pension plan each year by contributing a portion of payroll costs for its current employees using currently available funds. It is anticipated that these contributions will grow with investment income all of which are available to pay benefits for those employees when they retire.

Governments generally contribute their own revenues – e.g., taxes – to their pension plans. Pension obligation bonds, however, are an alternative way to finance current pension funding obligations: the government issues bonds and contributes the bond proceeds to the pension plan in addition to, or in lieu of, its own revenues.   

Federal law specifies that pension obligation bonds must be taxable; while the issuer therefore pays more interest to bondholders than it would with tax-exempt bonds, the bond proceeds are not subject to arbitrage restrictions or earning restrictions.

After the bonds are issued, the proceeds are invested along with the rest of the pension plan. Although most governments invest their idle cash in low-risk, low-yield investments, pension plans often invest in a wider range of potentially riskier securities, such as stock, that may earn a higher return.

In some environments, stock or other pension investments may generate a higher return than the interest the government is required to pay on its pension obligation bonds. Thus, the government “makes money” off the difference, which may further reduce its unfunded pension liability and its required annual contribution. For example, a government may issue taxable pension obligation bonds that pay bondholders 6 percent interest, while the government’s pension plan may have a target 7.5 percent return on its investments.

In practice, pension obligation bonds may not ultimately save the government money, as the investments of the bond proceeds may not perform as well as anticipated. Furthermore, pension obligation bonds are often structured to postpone paying principal in early years, increasing overall borrowing costs.

Tennessee state law does not allow the state or local governments to issue pension obligation bonds.

See also:

·         arbitrage

Pledged revenues are revenues for paying debt service that have been promised in the bond contract. For example, all money in the state’s general fund, debt service fund, and highway fund is pledged for the payment of its general obligation debt, as well as any money held in the state treasury not otherwise legally restricted.

A bond or note’s principal is the face amount, or par value, that will be paid at the maturity date. Principal does not include any interest paid over the life of the bond. For example, a 4 percent, 20-year bond with a par value of $5,000 will pay $200 a year in interest to bondholders, or $4,000 over the full term. The $4,000 in interest is independent of the $5,000 principal.

Depending on how the bond market has shifted since the bond was issued, the bond may not trade for exactly the value of its principal. If the market rate is 5 percent, for example, the $5,000 bond with a 4 percent coupon will be less attractive to potential buyers than other investments. As a result, the bond will sell for less than $5,000, or at a discount. Conversely, a $5,000 bond with a 6 percent coupon will sell for more than its principal, or at a premium.

Federal law distinguishes between two general types of municipal bonds: governmental bonds and private activity bonds. Governmental bonds, as their name suggests, are used for public purposes, such as government office buildings, parks, or prisons. Private activity bonds, by contrast, are used for projects that primarily benefit private companies or individuals.

Generally, governmental bonds are exempt from federal, state, and local income taxes. Depending on their use and the type of project financed, private activity bonds may be taxable or tax-exempt. A municipal bond is considered a private activity bond if it meets one of two criteria:

·         More than 10 percent of the proceeds are for private business use, and principal or interest payments on more than 10 percent of the proceeds are secured by an interest in the property used for private business use or payments received from such use; or

·         More than the lesser of 5 percent or $5 million of bond proceeds are used to make loans to private entities.

Even if a municipal bond meets the above criteria and is thus a private activity bond used for private purposes, it may still be tax-exempt if it is used for a qualified project.

To be considered a qualified private activity bond, proceeds may be used for 27 types of projects grouped into seven overall categories:

·         Exempt facility bonds are used to build, renovate, or maintain facilities that may be privately owned or primarily used by private entities, including airports, high-speed rail lines, and other transportation-related projects; certain residential rental properties, such as low-income apartment complexes; and certain privately owned utilities, including water, sewer, and electricity.

·         Qualified mortgage bonds, sometimes referred to as single family mortgage revenue bonds, are used to make low-interest loans for first-time homebuyers within income limitations.

·         Qualified small issue bonds are bond issues used to finance manufacturing facilities.

·         Qualified redevelopment bonds are used to buy land or buildings in a blighted area, relocate inhabitants, rehabilitate the buildings, or clear the land for redevelopment.

·         Qualified veterans’ mortgage revenue bonds are used to make low-interest home loans to veterans.

·         Qualified 501(c)(3) bonds are used to finance facilities owned and used by charitable organizations.

In general, most of the qualified projects above count toward an overall state cap on the amount of tax-exempt private activity bonds that may be issued by each state every year. Federal law and regulations are complex, however, and some of the projects are not subject to the cap, or may have other restrictions. Each state receives either a flat minimum or, for more populous states, an amount based on population. In 2018, for example, states could issue up to $105 per capita in qualified private activity bonds; Tennessee’s cap was over $700 million.

In Tennessee, the Department of Economic and Community Development (ECD) allocates Tennessee’s state cap for qualified private activity bonds among the state and local governments. Thirty-five percent of Tennessee’s annual cap goes to the Tennessee Housing Development Agency (THDA) for single- and multi-family housing bonds. In past years, THDA has not used its full allocation in the year of receipt; unused allocations may be carried forward for up to three years.  

Local governments may apply to ECD for allocations to issue small issue bonds for manufacturing or exempt facility bonds for other qualified projects.

·         conduit financing

·         governmental bond

·         Tennessee Housing Development Agency (THDA)

Private placement is a method of selling a new issue of bonds. In a competitive sale and a negotiated sale, bonds are eventually offered to the public. In private placement, by contrast, the bonds will not be offered to the general public – instead, bonds are sold directly to a single investor, such as a bank, or a small number of investors. In some cases, the investor may be required to hold the bonds until they mature, or may be subject to other restrictions regarding selling them.

The State of Tennessee prefers to use competitive sale for its general obligation debt, but may consider private placement if the issue is too small or too complicated for public issuance, or if there are a limited number of potential investors.

See also:

·         competitive sale

·         method of sale

·         negotiated sale

Private use refers to when a project financed by municipal bonds is used in trade or business of an entity other than a state or local government entity. The amount of private use determines whether the bond interest is exempt from federal income taxes.

Bonds issued by state and local governments and related entities are tax-exempt if they are used to finance projects for state or local governmental purposes (e.g., an office building or state prison). Private use, by contrast, refers to use by a private entity, such as a corporation. Common examples of private use include management contracts, cafeterias with commercial food vendors, ATMs, and vending machines, as well as research contracts at higher educational facilities. Use by the federal government is also considered private use (e.g., a federal post office in an office building).

Private use is determined by looking at the aggregate of both direct and indirect use by all nongovernmental persons. Bonds may contain a certain amount of private use – e.g., 10 percent – and remain tax-exempt, but bonds with private use above the threshold are taxable.

Q

R

Rating agencies provide, for a fee, opinions on the credit quality of an entity that issues bonds, or a specific bond issue – in other words, how likely the issuer is to pay principal and interest on time. In determining a rating, the rating agency reviews, among other things, the issuer’s financial reports, tax structure and related laws, demographic data, and economic statistics.

The three major rating agencies are Moody’s Investors Service, Standard and Poor’s (S&P), and Fitch Ratings.

See also:

·         investment grade

·         non-investment grade

·         rating (bond or credit)

In a bond refunding, the refunded bonds are the issuer’s “original” bonds that are being refinanced. The refunding bonds, by contrast, are the “new” bonds issued to take advantage of lower interest rates and replace the refunded bonds.

See also:

·         advance refunding

·         current refunding

·         refunding bond

Virtually all municipal bonds are now issued in registered form: a list of owners is kept and updated each time a bond is sold or transferred. The registrar is the company that keeps track of bondholders for the issuer.

The registrar works closely with the paying agent, the entity responsible for making interest and principal payments to bondholders. In practice, the entity acting as registrar may serve in several roles for the issuer – the bond trustee may serve as registrar, paying agent, and transfer agent.

See also:

·         registered bond

See tax and revenue anticipation note (TRAN).

Unlike a general obligation bond, which is payable from a government’s general resources, a revenue bond is paid off only with certain specified revenues. These revenues may be generated by the project being financed – in other words, the project pays for itself.

The Tennessee State School Bond Authority (TSSBA), for example, issues revenue bonds for certain projects at the state’s universities and community colleges. These projects, such as parking garages or sports stadiums, generate fees or ticket revenue that is then used to pay off the bonds.

See also:

·         general obligation (GO) bond

Generally speaking, risk is the uncertainty associated with debt or the chance that something may occur that will affect the value of debt.

Various types of risks are associated with municipal bonds:

·         Credit risk is the risk that a borrower – e.g., an entity that has issued bonds – will default on its debt. Credit risk is lower for issuers and debt obligations with high credit ratings.

·         Interest rate risk, from a borrower’s standpoint, is the risk that interest rates will rise after issuing variable rate debt. As the interest on variable rate bonds and notes increases in tandem with a specific index (e.g., the London Interbank Offered rate, or LIBOR), the issuer must make larger interest payments to investors.  

·         Liquidity risk generally refers to several things. For one, when interest rates rise, investors may exercise a put option that requires the issuer to buy back its bonds, usually at their par value. If those bonds cannot immediately be remarketed to new investors, the issuer will have to come up with money other than from a remarketing to purchase them. Additionally, an issuer may purchase a liquidity facility – e.g., a standby bond purchase agreement – for a shorter term than the bonds’ maturity. For example, if the issuer purchases a 10-year facility for 20-year bonds, it may have to pay a higher fee after 10 years for a new liquidity facility, or may not be able to buy a new liquidity facility at all due to market conditions.

·         Political risk is the risk that legislative or regulatory changes may jeopardize the programs or projects being financed, or the funding used to pay debt service.

·         Tax risk relates to changes in the federal tax code or that a transaction may have unforeseen adverse tax consequences. Tax-exempt municipal bonds are attractive to investors because they keep the entirety of the interest earned, rather than paying a portion in taxes. As a result, investors are willing to invest in tax-exempt municipal bonds with interest rates lower than the rates for taxable bonds. If the federal tax code is changed to reduce or eliminate the tax exemption for municipal bonds, however, the benefit of holding a tax-exempt bond is lessened. In addition, bonds may lose their tax-exempt status if an issuer fails to fulfill its tax covenants.

Additional risks are associated with swap agreements:

·         Basis risk is the risk that payments from a swap dealer are not enough to make payments on the issuer’s variable rate bonds, and that the issuer must use its own money to make up the rest.

·         Counterparty risk is the possibility that the counterparty to a swap agreement (e.g., a swap dealer) will default and be unable to make payments to the issuer.

·         Operational risk is the risk that the issuer will not have the systems in place or technical expertise to make payments to the swap dealer or comply with other provisions of the swap agreement and that, as a result, the agreement will be terminated early.

·         Rollover risk comes into play when the term of a bond does not match the term of the associated swap. For example, an issuer may enter into a five-year swap agreement for 20-year bonds. After five years have passed, the issuer will need another swap agreement for the remaining 15 years until the bonds mature. Depending on how the market has shifted, the new agreement may be more expensive to the issuer.

·         Tax risk relates to the possibility the federal tax code might be changed to reduce or eliminate the tax exemption for municipal bonds. In that case, variable interest rates on municipal bonds may rise, and if the issuer has entered into an interest rate swap agreement, payments from the swap dealer may not cover the increase in interest payments to investors.

See also:

·         swap

S

When underwriters buy new issues of municipal bonds, Securities and Exchange Commission (SEC) Rule 15c2-12 requires the underwriters to make sure that the state or local government issuing the bonds has agreed to provide ongoing information to the Municipal Securities Rulemaking Board (MSRB). These continuing disclosures are periodically made over the life of the bonds, and include financial reports, notices that the issuer did not make principal or interest payments on time, and information regarding changes in credit ratings or the tax status of the bonds.

See also:

·         continuing disclosure agreement/undertaking

·         event notice

·         Municipal Securities Rulemaking Board (MSRB)

Security can refer to revenue or assets pledged to the repayment of debt or can refer to a financial instrument that has some sort of monetary value, and is bought, held, or sold by an investor to make money. Financial instrument securities fall into two general categories: debt and equity.

A term bond comes due in a single maturity several years after the date of its issuance – for example, $50 million of 20-year term bonds would pay interest every year for 20 years, with the entire $50 million in principal due at the end of the 20th year.

Serial bonds, by contrast, can be thought of as a collection or series of term bonds. A bond issue with serial bonds is structured so that rather than waiting to pay principal until the very end of the term, portions of principal are paid in installments every year, along with periodic interest. For example, to finance a project over 20 years, an issuer could structure a bond issue to have bonds maturing each year for 20 years, with an amount of principal payable each year, in addition to interest. This could be structured with equal amounts of serial bonds maturing each year or having level payments of principal and interest.

Each set of serial bonds in a bond issue may have different interest rates based on their maturities. Maturities toward the beginning of the overall term usually have lower interest rates than maturities toward the end of the term. 

See also:

·         debt service schedule

·         term bond

In the case of term bonds, interest is paid each year, but the entire amount of principal matures at once at the end of the term. A sinking fund may be used to “save up” in advance for the one large principal payment when the bonds mature, or it may be subject to so-called mandatory redemption requirements. Under these requirements, the term bond is subject to redemption in part by lot on payment dates, usually beginning a few years prior to the maturity date. By reducing the amount of bonds held by bondholders, the issuer pays less in debt service each year; thus, in some respect, a sinking fund arrangement is functionally similar to later maturing serial bonds. For example a term bond issued in 2019 maturing in 2040 may have redemption dates beginning in 2036.

See also:

·         term bond

A special assessment bond is repaid with revenues from a special assessment, rather than general revenues.

Most municipal bonds finance projects that benefit the general public, such as a new office building for county employees that will benefit all residents of the county. Some projects, however, primarily benefit a specific area – e.g., sidewalks or sewer lines in a particular area that comprises a local improvement district.

In the case of special assessment bonds, rather than repaying the bonds with revenue paid by the general public – sales tax or property tax, for example – the bonds are repaid with a special assessment. The special assessment is levied only on residents and businesses in the areas that benefit from the projects. In this manner, those benefiting from the project bear the cost, rather than the general public.

See Tennessee Local Development Authority (TLDA).

A surety bond is a contract between three parties that is often intended to keep one of the parties accountable to another. Although surety bonds are not insurance and differ in their use and technical aspects, both are designed to protect against losses.

Public officials – e.g., county trustees – may be required to purchase a surety bond upon taking office. If the public official does not fulfill his or her official duties, the surety company will pay up to the bonded amount to the appropriate government. Unlike insurance, the public official must repay the surety company for the total amount of the government’s claim.

With regard to municipal bonds, surety bonds may be used to guarantee funds for a debt service reserve fund in lieu of funding it with cash (whether from additional bond proceeds or the issuer’s other revenue). If money must be drawn from the reserve fund, the company providing the surety bond will provide the funding, up to a predetermined amount to be repaid at a later date by the issuer.

A swap is a type of derivative. Derivatives have no intrinsic value of their own; instead, their value is “derived” from, or based on, some underlying investment or agreement. For example, a derivative may make greater payments as interest rates on a debt obligation increase.

While some investors use derivatives to make money, governments typically use them to hedge against risk, or protect from future uncertainty and changes in the market. Governments may also use derivatives to try to lower their borrowing costs. The State Funding Board has published guidelines for interest rate and forward purchase agreements which are available on the Comptroller’s website. Tennessee law requires swaps to be connected with debt issues and there is no authority to enter into purely speculative swaps.

In a swap agreement, two parties “swap” payments or some type of financial instrument. Generally, retail investors – households and individuals – do not enter into swap agreements. Instead, swap dealers, such as banks and insurance companies, make up most of the swap market. To help evaluate the complexities of swap agreements, governments and other purchasers should hire a swap advisor.

Interest rate swaps are the most common type of derivative for governments. A government may issue variable rate bonds linked to a specific index – the bonds may pay the one-year LIBOR rate, plus 50 basis points, for example. In a floating-to-fixed-rate swap, the government “swaps” the variable rate interest payments with another party (the counterparty) and essentially converts the variable rate debt to fixed rate debt. The government makes unchanging, fixed payments – e.g., equivalent to 3 percent interest on the bonds’ principal amount – to the counterparty on schedule with interest payments. The counterparty pays the government a variable amount equal to the interest payments on the debt, which fluctuates over the life of the agreement.

The International Swap and Derivatives Association (ISDA), a trade association, has developed the ISDA master agreement to help govern swap transactions. While parties to swap agreements still negotiate the various financial terms – rates, prices, and maturities, for example – the ISDA master agreement sets general conditions regarding defaults and events that may end swap agreements early, among other things.  

See underwriter.

T

See tax and revenue anticipation note (TRAN).

Rather than paying a portion of principal each year, a term bond comes due in a single maturity, or bullet maturity. For example, a 20-year, $5,000 term bond would pay interest each year, but would not pay any principal until it matured at the end of 20 years.

Issuers of term bonds may set aside money each year in a sinking fund. Even though principal may not be paid to bondholders for many years, money for the eventual payment is periodically saved in advance so that it is available when the bond matures.

See also:

·         balloon indebtedness

·         serial bond

A trust indenture is a contract between the issuer and the bond trustee, the entity that enforces the bond contract on behalf of bondholders. The trust indenture outlines the revenues that are pledged to pay debt service, the issuer’s responsibilities, and the bondholders’ rights. While other documents, such as the official statement and bond purchase agreement, describe or reference some of the same information about the bonds as the trust indenture, the trust indenture is the source of investors’ legal protections.

In some cases, municipal issuers may use a bond resolution, rather than a trust indenture, to set forth the rights of the bondholders.

See also:

·         bond trustee

U

In the context of municipal bonds, an underwriter is a company, such as an investment bank, that buys a new issue of bonds directly from the issuer. Rather than selling the bonds directly to hundreds or thousands of individual investors, the issuer instead sells the entire issue to the underwriter. After purchasing the bonds, the underwriter then sells them to investors, such as companies or individuals. If it cannot find enough buyers, the underwriter holds the remaining bonds until it can sell them at a favorable price.

The underwriter makes its money off the underwriting spread, or the difference between the price it pays the issuer for the bonds and the price at which it sells the same bonds to other investors. The underwriter may purchase the bonds through a competitive bid or negotiated sale.

To share the risks or pool their money for a large issue, multiple underwriters may form a group called a syndicate. The senior managing underwriter takes the lead role, and often works closely with the issuer in a negotiated sale. The senior manager, also called the bookrunning manager, allocates the bonds to be sold to investors between itself and the other underwriters (co-managers) according to the agreement among underwriters.

A smaller selling group may be formed within the syndicate. Broker-dealers may be part of the selling group without being co-managers. While members of the selling group help sell the bonds to investors, they are not required to hold or underwrite any bonds that cannot be sold. In return, they receive a smaller share of the profits.

See also:

·         underwriter’s discount

V

W

X

No terms

Y

The yield curve shows the relationship between returns on investment and maturity dates (e.g., three months, one year, 20 years) for bonds of similar quality. The yield curve may have three basic shapes:

·         A normal yield curve slopes upward – in other words, bonds with longer maturities have higher returns on investment than bonds with shorter maturities. Because there is more risk and uncertainty involved in holding a bond for a longer time period – interest rates may change unfavorably for the investor, for example – investors typically require higher yields in exchange for tying up their money for long periods of time. The variation in interest rates is generally greater for bonds with shorter maturities.  While a two-year bond has double the maturity of a one-year bond, from the investor’s standpoint, a 25-year bond and a 30-year bond are both similarly long-term investments and thus have similar yields.

·         An inverted yield curve slopes downward: bonds with longer maturities have lower returns on investment than bonds that will mature sooner. Inverted yield curves are unusual, and have historically preceded many economic recessions. When investors anticipate that interest rates will decrease in the future, they may purchase more long-term bonds to lock in the yields. Increased demand then lowers the yield on bonds with longer maturities.

·         A flat yield curve has relatively equal yields for short-, medium-, and long-term bonds. The yield curve may flatten when adjusting between normal and inverted shapes.

See also:

·         bond yield

Yield to maturity (YTM) is a measure of an investor’s return on a bond, assuming the investor holds the bond until it matures. A bond’s yield to maturity may be different than its coupon rate, the interest payments it makes to investors. If a bond’s coupon rate is lower than current market interest rates for similar investments, the bond will trade at a discount, or for less than its par value – if current interest rates are 3 percent, a bond with a $5,000 par value and a 2 percent coupon may sell for $4,570, for example.

Although the investor will receive smaller interest payments, it will receive an additional $430 when the bond matures. As a result, the bond’s yield to maturity – the investor’s overall rate of return – will be higher than the 2 percent coupon rate.

See also:

·         bond yield

Z

Acronyms

AAU           agreement among underwriters

AMT          alternative minimum tax

BQ             bank qualified

BP              basis point

BAN           bond anticipation note

BPA            bond purchase agreement

BAB            Build America Bond

CAB            capital appreciation bond

CON           capital outlay note

COP            certificate of participation

CPPN         certificate of public purpose and necessity

CFO            chief financial officer

CP               commercial paper

CAFR          comprehensive annual financial report

COB           convertible option bond

DSRF          debt service reserve fund

DVP            delivery versus payment

EMMA        Electronic Municipal Market Access

EESI             Energy Efficient Schools Initiative

GO               general obligation

GAAP          generally accepted accounting principles

GAN             grant anticipation note

IDB               industrial development board

ITIF               Intermediate Term Investment Fund

IRC               Internal Revenue Code

LOC              letter of credit

LGIP             Local Government Investment Pool

LIBOR          London Interbank Offered Rate

MADS         maximum annual debt service

NRMSIR      Nationally Recognized Municipal Securities Information Repository

NIC               net interest cost

NPV              net present value

OS                 official statement

OID               original issue discount

OIP                original issue premium

OPEB            other post-employment benefits

PILOT            payments in lieu of taxes

POB              pension obligation bond

PAC               planned amortization class

POS              preliminary official statement

PV                 present value

PAB              private activity bond

PBA              Public Building Authority

P3                 Public Private Partnership

QECB           Qualified Energy Conservation Bond

QSCB            Qualified School Construction Bond

QZAB            Qualified Zone Academy Bond

RAN              revenue anticipation note

RCA               revolving credit agreement

RCF                revolving credit facility

SLGS              State and Local Government Series

SIF                  State Infrastructure Fund

SPIF               State Pooled Investment Fund

SRF               State Revolving Fund

TRAN          tax and revenue anticipation note

TAN             tax anticipation note

TIF               tax increment financing

TIC              true interest cost

VRDB         variable rate demand bond

VRDO         variable rate demand obligation

WAL           weighted average life

WAM         weighted average maturity

YTM           yield to maturity