Late last year, the Sterling Report shone a light on specific U.S. Municipal Bonds that we believed were undervalued. During the second half of 2010, these instruments were receiving a lot of negative press as analysts and traders were worried about the growing deficits of some of these entities as well as a slow U.S. economic recovery. In fact, a few financial industry experts predicted widespread defaults among issuers of U.S. Municipal bonds. The news spread like wildfire and naturally, billions of dollars flowed out of the market, depressing bond prices and creating an invaluable opportunity for the prudent investor. Further depressing prices was the surplus of Municipal Bond issuance on the market, as the Build America Bond program ended on January 1st 2011. However, with the ongoing European Debt crisis, the prices of U.S. Municipal Bonds have skyrocketed in the second quarter of the year as investors have flown to the U.S. as a safe haven for their investments.

As a refresher, debt securities issued by state and local Governments in the United States are called Municipal Bonds. However, as with most financial instruments, there is a wide array of municipal bonds.

Municipal bonds can be issued by State Governments, counties, towns, cities, and various other local government subdivisions. These bonds are often issued as serial bonds. This means that one large bond issuance is usually divided into a series of smaller issues, each with a different maturity date and coupon rate. This gives investors the flexibility to choose a tenor and rate that is in line with their objectives and risk appetites.

One of the most common distinctions made among municipal bonds is their status as a “tax backed bond” or a “Revenue backed bond”. Tax backed bonds are also called “General Obligation” bonds and are backed by the full faith, credit and taxing power of the issuing entity. In other words, if the issuer does not have enough money to meet the debt service payments, it can raise taxes to obtain the shortfall in funding. Issuers sometimes include some limitation on the extent to which they are liable to “tax” to repay the bonds. For example, “Limited tax General Obligation Debt” as the name suggests, is subject to certain limits on the type and amount of taxes that can be raised to repay the bondholders. In contrast, “Unlimited Tax General Obligation Debt” is the most common type of General Obligation bond and means that bondholders are secured by the full faith and credit of the borrower and its unlimited taxing power.

Revenue bonds are secured by and repaid from the revenues generated by specific projects that are funded with the proceeds of the bond issuance. For example, revenue bonds can be issued to fund the construction of transport systems, detention facilities, schools, housing developments, and other types of infrastructure for which the entity can generate an income stream. The revenue generated from the project is used to repay the bondholders.

The difference between a revenue bond and a general obligation bond is important to bondholders because the issuer of a revenue bond is usually relying on the revenue from the project to repay bondholders as the principal and interest payments become due. In the case of a General Obligation bond, the issuer is able to rely on all the sources of tax income generated by the municipality and to raise taxes if necessary, to meet its debt obligations. As such, revenue bonds tend to attract slightly higher yields at issuance than general obligation bonds.

Marian Ross is a business development officer at Sterling Asset Management. Sterling provides medium to long term financial advice and instruments in US and other world market currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm