Introduction to Processing Municipal Debt Products

An article by New York Institute of Finance Brokerage Operations instructor David Weiss.

The processing of a municipal debt product has many differences when compared to other debt instruments. To serve as a reference, senior New York Institute of Finance faculty member David Weiss prepared this handy cheat sheet, outlining five key processing considerations.

1. Interest

Unlike corporate or government bonds, the interest paid on municipal bonds may be free of federal income tax and if it is owned by a party that resides in the state of issuance, the interest payments may also be free from state and local income taxes. The tax consequences of owning the instrument is established at the time of the offering. The interest paid by corporate bonds is fully taxable and the interest paid on U. S. Government debt is usually only taxed at the federal level. Therefore, the correct tax application must be employed for income tax reporting purposes.

Other differences affect the municipal instrument at the time of the trade and therefore affect the processing. For example:

2. Basis Prices

Most municipal bonds trade at basis prices. Corporate and U S Treasury bonds are said to trade at dollar prices. The term “basis prices” is short for “Yield to Maturity Basis”. A municipal bond may trade at 3.40 basis. That translates to the yield on the investment that the owner will receive if the bond is held until it matures. The 3.40 basis price will be converted into a dollar price that will yield the owner rate of 3.40% based on the purchase price paid and the coupon or interest rate the bond carries. During trade processing, the yield price will be converted in dollars, or other currencies, for settlement purposes. Dollar priced bonds reflect a percent of the bonds cost. A corporate bond, for example, trading at 98 will be converted into $980 per $1,000 of the bonds principal.

3. Bullet vs. Serial Form

Corporate and Treasury debt issued in bullet form, most municipal bonds are issued in serial form. In a bullet offering the entire issue has one reference interest rate, one maturity date and one CUSIP and or ISIN number. In a serial offering the instrument has a main offering description but is comprised of many bonds issued in chronological order with each having their own interest rate and maturity date. It is this reason where municipal debt differs from corporate and government securities. Those securities, because of the bullet offering, are usually large enough in size to sustain daily trading. Because of the serial form of underwriting, the component bond offerings are relatively small and sustained trading in a particular bond is almost non-existent. During the period of the serial bonds initial offering, there is activity in the component bonds as they go through the process of being sold (or placed), then the particular issue disappears from the market. Over time, pieces of the offering bonds float back into the market and are traded only to be placed (sold) again. Therefore, an investor interested in acquiring a municipal bond at a particular point in time is offered a “menu of bonds” that happen to be available at that time that fit the investors needs.

4. Volume

From an operation standpoint, as there are over one million three hundred thousand municipal bonds issued and outstanding, a relatively small percentage of those issues are on the market at one time. The possibility of the wrong bond; one with a very similar description, being processed is always present. Bond transactions that do not match or compare with the contra party during the clearing cycle, must be addressed and the differences reconciled quickly. This is to make sure that the desired bond was actually traded and is available for settlement.

5. Unilateral Netting

Due to the thinness of each bond’s trading market, the use of processing techniques that expedite settlement; such as unilateral netting (which is so effective in reducing the settlement obligations in heavily traded securities such as common stocks), loses its potency when applied to the trading of each particular issue, even though during that trading date many similar bonds issued by that particular state, were also traded.

While the security side of the transaction has its processing differences when compared to other instruments, the money side of the transactions is the same. Monies involved with the transactions are totaled and netted to one settlement figure.

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