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    The Fundamentals of Municipal Bonds
    The Fundamentals of Municipal Bonds
    The Fundamentals of Municipal Bonds
    Ebook518 pages6 hours

    The Fundamentals of Municipal Bonds

    By SIFMA

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    About this ebook

    The definitive new edition of the most trusted book on municipal bonds

    As of the end of 1998, municipal bonds, issued by state or local governments to finance public works programs, such as the building of schools, streets, and electrical grids, totaled almost $1.5 trillion in outstanding debt, a number that has only increased over time. The market for these bonds is comprised of many types of professionals—investment bankers, underwriters, traders, analysts, attorneys, rating agencies, brokers, and regulators—who are paid interest and principal according to a fixed schedule. Intended for investment professionals interested in how US municipal bonds work, The Fundamentals of Municipal Bonds, Sixth Edition explains the bond contract and recent changes in this market, providing investors with the information and tools they need to make bonds reliable parts of their portfolios.

    • The market is very different from when the fifth edition was published more than ten years ago, and this revision reasserts Fundamentals of Municipal Bonds as the preeminent text in the field
    • Explores the basics of municipal securities, including the issuers, the primary market, and the secondary market
    • Key areas, such as investing in bonds, credit analysis, interest rates, and regulatory and disclosure requirements, are covered in detail
    • This revised edition includes appendixes, a glossary, and a list of financial products related to applying the fundamentals of municipal bonds
    • An official book of the Securities Industry and Financial Markets Association (SIFMA)

    With today's financial market in recovery and still highly volatile, investors are looking for a safe and steady way to grow their money without having to invest in stocks. The bond market has always been a safe haven, although confusing new bonds and bond funds make it increasingly difficult for unfamiliar investors to decide on the most suitable fixed income investments.

    LanguageEnglish
    PublisherWiley
    Release dateOct 25, 2011
    ISBN9781118166840
    The Fundamentals of Municipal Bonds

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      The Fundamentals of Municipal Bonds - SIFMA

      Chapter 1

      Overview of the Municipal Bond Market

      INTRODUCTION

      Municipal bonds, or municipal securities, represent a promise by state or local governmental units (called the issuers) or other qualified issuers to repay to lenders (investors) an amount of money borrowed, called principal, along with interest according to a fixed schedule. Municipal bonds generally are repaid, or mature, anywhere from 1 to 40 years from the date they are issued. At the end of 2010, there were $2.9 trillion in municipal bonds outstanding, representing the cumulative issuance of bonds over many years. These bonds have been used to finance a vast array of projects; a small sample includes:

      Elementary and secondary school buildings.

      Streets and roads.

      Government office buildings.

      Higher-education buildings, research laboratories, and dormitories.

      Transportation facilities, including bridges, highways, roads, airports, ports, and surface transit.

      Electric power-generating and -transmission facilities.

      Water tunnels and sewage treatment plants.

      Resource recovery plants.

      Hospitals, health-care and assisted living facilities, and nursing homes.

      Housing for low- and moderate-income families.

      The municipal bond market is composed of thousands of dedicated professionals throughout the United States who have the diverse skills needed to raise money in the capital markets for state and local governments. Distinct roles are played by state and local government officials, public finance investment bankers, underwriters, salespeople, traders, analysts, lawyers, financial advisors, rating agencies, insurers, commercial bankers, investors, brokers, technology developers and vendors, the media, and regulators; yet all are working together toward the common goal of providing funds to state and local government units to build needed public projects and infrastructure.

      Municipal securities are also commonly called tax-exempt bonds, because the interest paid to the investor is subject neither to federal income taxes nor (often) to state or local taxation. With regard to tax exemption, it must be noted that each household and organization's tax status is unique and different. Although this book delineates the general principles of municipal bonds, investors should consult with their own financial advisors when considering the purchase or sale of municipal securities.

      The American Recovery and Reinvestment Act of 2009 created Build America Bonds and other categories of municipal bonds where the interest is taxable to investors. The issuing municipalities received a grant from the federal government equal to 35 percent of the interest payments, which meant that the effective cost to the issuer was comparable to, or sometimes better than, the rate they would pay on a conventional tax-exempt municipal bond. The Build America Bonds program expired on December 31, 2010, and at the time of this writing had not been renewed.

      In addition, a small market exists for taxable municipal bonds typically issued for purposes that are not eligible for either tax exemption under the U.S. tax code or a federal interest subsidy. Throughout this book, references to municipal bonds are to tax-exempt securities or Build America Bonds, except where it is expressly stated that they are taxable bonds that do not qualify for the federal interest subsidy.

      One statistic that is key to understanding the municipal bond market is the dollar volume of new bond issues that are sold each year. Fluctuations in volume can reflect national economic trends as well as events that are unique and specific to the municipal bond market. The causes and effects of volume changes in the municipal market will be examined in detail throughout this book, which also includes a general discussion of the overall level of interest rates. Table 1.1 tracks 25 years of new-issue volume.

      Table 1.1 Total Long-Term and Short-Term Municipal Issuance 1986 to 2010 ($ billions)

      Table 1-1

      The municipal bond market consists of the primary market, which deals in the new securities of issuers, and the secondary market, where securities are bought, sold, and traded after they have been issued. Figure 1.1 presents the flow of funds through the primary market.

      Figure 1.1 Flow of Funds in the Primary Market

      Source: Securities Industry and Financial Markets Association.

      ch01fig001.eps

      The process begins when an issuer sees a need for money to pay for capital improvements or to fill gaps in its cash flow. The issuer then takes a series of steps that lead to the primary market. There, the municipal bond dealer, usually a securities firm or a bank, purchases the issuer's bonds through a process called underwriting. The bonds are resold to institutional and individual investors, who pay the dealer directly for the debt they have purchased. The dealer uses these funds to reimburse itself for its capital that was used to purchase the bonds from the issuer. If an issue is underwritten and there are not enough buyers for all the bonds being issued, the underwriter assumes the risk of holding the bonds in inventory until they are eventually sold. Both principal and interest are paid to the investors by the issuer, usually through a bank acting as paying agent, on a fixed schedule.

      The secondary market consists of the trading and other activity in securities after they have been sold as new issues. This market also supports the primary market by providing liquidity to investors who are more likely to buy a security if they know they can sell that security at a fair market price prior to its stated maturity. Most municipal bond dealers have trading departments that make secondary markets in outstanding bond issues.

      THE ISSUERS

      According to the 2007 U.S. Economic Census, there were more than 89,500 units of state and local governments. The Census categorizes governmental units as states, counties, municipalities, towns and townships, school districts, and special districts. Municipal bonds are issued by state and local governmental units, either directly under their own names or through a special authority. An authority is a separate state or local governmental issuer expressly created to issue bonds or to run an enterprise, or both. Authorities such as those for transportation or power can issue bonds on their own behalf. Other authorities can issue bonds for the benefit of other, qualified, nongovernmental parties, such as not-for-profit hospitals, private colleges, and certain private companies.

      Municipal bonds are authorized and issued pursuant to express state and local laws, which impose restrictions on the size and financial structure of the debt. Moreover, each new issue usually requires the approval of the governing body of the issuer, sometimes through an ordinance or resolution. Bonds are generally sold to provide funds for capital improvement projects—for the bricks and mortar that make up the public infrastructure. With few exceptions, bonds are not sold to finance the normal, everyday operating expenses of government, such as employees’ salaries and benefits. States and local governmental units—such as counties, municipalities (which include cities), and school districts—issue bonds for roads, parks, courthouses, and schools. These securities are usually general obligation bonds (GOs) for which the full faith, credit, and taxing power of the issuer is pledged to and obliged to be used for the repayment of the bonds. Depending on the governmental issuer, approval by voter referendum is frequently required for the issuance of GOs. The public purpose projects funded by GOs provide benefits for the common good and so are repaid by taxes on everyone who is subject to taxes in that governmental unit. There are times when it is not feasible or possible to provide a general obligation pledge, so other forms of tax-backed or tax-supported bonds have been developed to provide a financing structure. Tax-backed bonds are discussed in greater depth throughout the book.

      State and local governments also sell securities for which specific revenues, not governments’ full faith, credit, and taxing power, are the source of repayment. These obligations are known as revenue bonds. The issuer can be the government itself or a separate authority. Revenue bonds are issued for the construction of facilities and plants that provide electric power, water, wastewater treatment, and resource recovery and transportation, among others. Revenues and user fees that can be pledged to the bonds include electric rates and charges, water and sewage usage fees, waste disposal and tipping fees, and tolls and landing fees.

      Table 1.2 shows the average issuance in each of eight broad categories of state and local governmental issuers in the 10-year period from 2000 through 2009 as a percentage of the total new-issue market by dollar volume. State authorities, including housing, economic development, transportation, and other state-level authorities, were the largest category of issuers, followed by similar bodies created at the local or regional level. Cities, towns, and villages were the largest government issuers, followed by states and counties or parishes.

      Table 1.2 Issuers of Long-Term Municipal Bonds, 2000 to 2009

      Note: Average annual issuance as a percent of dollar volume.

      Source: Thomson Reuters.

      Table 1.3 Major Uses of Municipal Debt, 1989 and 2009

      Source: Thomson Reuters.

      Although municipal bonds are issued for thousands of unique projects, they can be classified in a few broad categories, which may change over time. Table 1.3 lists the purposes for which bonds were issued in 1989 compared to 2009. In 1989, the top two categories, general purpose/public improvement and education, accounted for 40 percent of debt issuance. By 2009, the share of debt sold to support projects in these two categories had increased to 54 percent. The snapshots of issuance over 20 years clearly show that general governmental purposes and education have continued to dominate the market. These bonds have not always been issued with traditional general obligation security, however. Many novel tax-backed security structures have evolved that permit issuers to raise money for general governmental purposes without a general obligation pledge.

      MUNICIPAL BOND DEALERS

      In order to raise money in the market, the issuer works with a municipal bond dealer. The municipal bond dealer is most often found in a department of a securities firm or bank that provides other financial services. Public finance investment banking, underwriting, marketing, and trading municipal securities are jobs undertaken by the municipal bond departments of securities firms and banks. Some municipal bond departments are fully integrated as one department, with all the functional areas organized as one business unit. In other firms, those areas are divided between a firm's fixed income division and the investment-banking division. Any number of other organizational combinations are possible, too. Because of the broad range and regional nature of the business, some dealers operate solely in the municipal bond market, and may even concentrate on a single market sector. Others do mostly retail business, working with individual or household investors.

      Public Finance

      Public finance is the investment-banking arm of the municipal bond business. The investment bankers work with existing clients and develop new business with other issuers. Public finance specialists, with support from underwriters and traders, respond to the issuers’ needs and the needs of investors with traditional and innovative financing structures. Investment bankers are responsible for coordinating and responding to the many written and oral Requests for Proposals (RFPs) that are sent to them by issuers. These RFPs, which include detailed plans and financial analyses of the issuer, form the basis of the issuer's selection of a municipal bond dealer in a negotiated underwriting (discussed in greater detail below in the underwriting section). This selection of underwriters for a negotiated sale is highly competitive, as many firms vie for an issuer's business.

      Public finance departments can be organized along geographic, market-sector, or product lines. Sometimes they also perform financial advisory work.

      Underwriting

      The underwriters set prices and yields on new issues. The two main ways that an underwriter can purchase bonds from an issuer are through a competitive sale or a negotiated sale. A competitive sale is a type of auction where sealed bids for the bonds are submitted to the issuer at a specific time on a specific date. Normally, more than one underwriter will submit a bid to the issuer. The bonds are awarded to the underwriter who offers the issuer the lowest interest cost. Underwriters will often bid on bonds as part of a syndicate, a group of two or more firms who agree to make a bid together to an issuer in order to share underwriting risk. Competitive sales are also called advertised sales or sealed bid sales.

      In a negotiated sale, the issuer, prior to the public sale date, selects the lead underwriter or senior manager, whose job is to coordinate and manage the financing through all its many stages. The selection process (sometimes for one transaction and sometimes for a series of transactions), which usually includes presenting a written response to the RFP, often also entails an oral interview at which the public finance investment bankers, underwriters, and other key members of the firm present and defend their proposed financing strategies. The issuer often selects other managers from competing firms to act as comanagers. The managers, acting together or with more firms through a syndicate, make an offer to purchase the bonds from the issuer at a price that will produce the lowest possible interest cost to the issuer while still enabling the underwriter to sell the bonds to investors. There is greater flexibility in structuring the bonds and in reacting to the most current market conditions in a negotiated sale. As in a competitive sale, the underwriters work closely with traders and salespeople to determine the right price for a new issue.

      Trading

      Traders maintain the secondary market for securities by actively buying bonds from, and selling bonds to, other dealers and investors. A good trader is familiar at all times with the bonds available in the municipal market and factors affecting their prices as well as overall conditions in the other fixed income markets. Typically, traders specialize in one sector of the market, such as hospital bonds; in certain bond maturities, such as 1 to 10 years; or in dollar bonds (bonds that are quoted and traded in dollar prices rather than in terms of yield). Retail orders are sometimes executed on electronic trading platforms, but large institutional orders are typically handled in person by a conventional trading desk.

      Sales

      The salespeople develop and maintain direct contact with institutional investors. They sit in the trading room close to the underwriters and traders. In addition to selling new issues that the firm has underwritten, the salesperson is familiar with investors’ portfolios and looks for opportunities to serve investors in the secondary market. The sales force can be organized in various ways: geographically, by client relationships, by the maturity of the bond, or by a combination of any of these.

      Sales Liaison

      Securities firms that have a client base with many individual investors often have a retail sales liaison force. The sales liaison staff is normally located in the trading room and works with the account executives (variously known as stockbrokers, registered representatives, financial advisors, account executives, or private client service representatives) in the firm's main and branch offices. The account executive calls the sales liaison with inquiries and orders, and the liaison works with the underwriter or trader to fill the investor's needs. Several securities firms also have regional trading departments similar to their main office trading operations on a smaller scale. The salespeople and liaison staffs in these regional offices work in much the same way as they do in the main office.

      Research and Credit Analysis

      The complexity of the municipal market, the financial challenges of some state and local governments, and the post-2008 reduction in the use of third-party credit enhancement have led municipal bond dealers to place greater emphasis on the creditworthiness of municipal issuers. Dealers have research and credit analysts who are responsible for reviewing and monitoring issuers in the primary and secondary market. Research analysts may prepare a short opinion that can be distributed internally (within the firm) or externally to investors on competitive or negotiated issues coming to market, or they may write comprehensive reports on specific market sectors or on market strategy. In some firms, research and credit analysts work with the public finance investment bankers on responding to RFPs and, once the firm is awarded the negotiated business, on credit and rating issues as well. Research and credit analysts are responsible for reviewing official statements under the disclosure rules at many firms.

      Rating agencies, bond insurers, and institutional investors also employ research and credit professionals.

      Capital Markets

      Capital markets blend investment banking and market expertise. They are responsible for creating financial and investment products such as derivatives, swaps, and synthetic products that are used by both municipal issuers and investors. These products are created with information from the users and with the firm's own risk management team. They may also create financial products for the firm's own proprietary trading. A firm will often have a special, more highly rated subsidiary that enters into derivative transactions to offer the issuer the most secure counterparty structure.

      Operations

      Operations involves the complex processing associated with the buying and selling of municipal securities. The adoption of industry-wide requirements for orders, record keeping, and confirmations has largely automated and standardized the functions of the operations group. Its duties include processing orders and payments, verifying and delivering securities, issuing confirmations, and maintaining customer accounts and other required documentation. The operations rules of the Municipal Securities Rulemaking Board (MSRB, a self-regulatory organization) are discussed in detail throughout this book.

      THE LAWYERS

      Lawyers of various specialties play important roles in the financing process.

      Bond Counsel

      Virtually every municipal security is accompanied by an opinion of bond counsel, who represents the legal interests of the bondholders. That opinion addresses the main legal issues: that the bonds constitute legal, valid, and binding obligations of the issuer, and that interest on the bonds is exempt from federal income taxation under applicable tax laws (or, in the case of a Build America Bond, that the issue qualifies for the federal interest rate subsidy). In rendering the opinion, a bond counsel (1) undertakes a review and examination of all applicable laws authorizing the issuance of securities, (2) ascertains that all required procedural steps have been completed to assure proper authorization and issuance of the securities, and (3) determines that all federal tax laws governing the issuance of the bonds have been complied with. In connection with a review of laws and procedure, bond counsel assembles all relevant documentation into a transcript of proceedings. The transcript serves as a permanent record and reference of the steps taken to issue the bonds and of the underlying payment and security arrangements.

      Underwriter's Counsel

      Underwriter's counsel represents the underwriters in a negotiated issue. The underwriter's counsel conducts a thorough due diligence analysis of the issuer. Due diligence involves questioning the issuer and any important related parties about their financial condition, plans, reports, and other factors that are important for a purchaser to know in order to make an investment decision. At the closing, underwriter's counsel provides a 10-b-5 certificate to the underwriter stating that nothing material to the transaction has been omitted from the disclosure process and that everything material to making an investment decision has been included. Underwriter's counsel also prepares the bond purchase agreement or contract, pursuant to which the debt is sold to the underwriter.

      Other Counsel

      Because of the diverse and complex nature of the municipal market, some issues may require opinions in addition to those normally provided by bond counsel and underwriter's counsel. These opinions may include those of special tax counsel, bank counsel, disclosure counsel, outside bond counsel, and/or borrower's counsel. Chapter 4 discusses in detail the roles of the counsels.

      FINANCIAL ADVISORS, SPECIALISTS, AND OTHER CONSULTANTS

      State and local governments often seek the advice of a financial advisor and other professional experts. Financial advisors perform a variety of tasks, including (1) analyzing the financing needs of the issuer, (2) helping to choose an underwriter or organize a competitive sale, (3) structuring the issue, (4) working with the rating agencies and credit enhancers, (5) helping negotiate a purchase price on a negotiated financing, and (6) advising on other matters related to the issuer's debt and capital plans. Bond issuers sometimes retain dealers to serve as financial advisors.

      Capital improvement projects often require the advice of specialists in addition to that given the financial advisors. Some consultants, for example, advise solely on the feasibility of health-care projects; others take on the financial, engineering, and architectural aspects of airports; still other specialists evaluate toll roads or public utilities. The issuer's accountants also play a part in the financing process. The opinions of consultants are important not only for establishing the merits of a particular project but also for attracting voter approval and promoting investor acceptance and confidence in the bonds.

      Municipal derivatives specialists, or swap advisors, are financial advisors who specialize in advising on transactions involving derivatives. They provide advice on a wide range of services, including structuring transactions involving interest rate swaps and pricing swaps and other derivatives, among others. Arbitrage rebate specialists also may be part of a larger organization or stand alone; they advise on compliance with arbitrage regulations and offer reporting services. They work with issuers on bond rebate calculations, bond verifications, allocations of commingled funds, cash flow models, yield computations, and reporting systems.

      A broker, dealer, or municipal securities dealer may also engage consultants on its behalf subject to MSRB Rule G-38. A written consultant agreement must be entered into before the consultant engages in any direct or indirect communication with an issuer on behalf of the broker, dealer, or municipal securities dealer. The use of a consultant must also be disclosed to the issuer and to the MSRB.

      THE RATING AGENCIES

      There are tens of thousands of municipal issuers. Because of the large number of issuers and the variety of security structures in the market, bond or debt ratings play a prominent role in the municipal market. A rating is an alphabetic and/or numeric symbol used to give relative indications of credit quality. A rating is generally considered obligatory for the sale of any major issue. Some issues may be marketed on a nonrated basis if, for example, they are privately placed, their credit standing is well known to the investors buying the bonds, or they cannot achieve an investment-grade rating.

      Underwriters or financial advisors are sometimes involved in preparing or making presentations to rating agencies on behalf of issuers prior to a bond sale. In addition to providing an initial rating, rating agencies review their ratings periodically and analyze issuers' ongoing financial and operational information. In addition, the agencies provide a review process for municipalities seeking an upgrade or improvement to their ratings; lists of bonds with potential rating changes; analyses of credit trends; and other rating services.

      The three dominant rating agencies for municipal securities are Moody's Investors Service, Standard & Poor’s, and Fitch Ratings. All three are headquartered in New York City. Moody's has been rating municipal bonds since 1909, Standard & Poor's since 1940, and Fitch since 1913. All three rate long-term issues, short-term notes, commercial paper, and obligations secured by insurance, bank, and other credit enhancements. Although each agency has unique features in its own rating scale, triple-A is the highest rating for each one, and each scale descends down the alphabet as the opinion of creditworthiness declines. Moody's ratings within certain categories are modified by numbers (1, 2, and 3), whereas those of Standard & Poor's and Fitch are modified by + and – symbols. The lowest investment grade rating for Moody's is Baa3, and for Standard & Poor's and Fitch it is BBB–.

      Ratings can be classified in the general categories listed in Table 1.4.

      Table 1.4 Credit Ratings

      Table 1-4

      BOND BROKERS

      Municipal bond brokers, or brokers’ brokers, trade only for municipal bond dealers and dealer banks; they do not work directly with either institutional or individual investors. Brokers are sometimes able to facilitate trades in a more efficient way than if the dealers did the trades themselves. For example, dealers often try to sell bonds in their inventories through brokers by asking a broker to seek bids from other dealers. This is known as the bid-wanted process. In other cases, a dealer who is looking for particular bonds for a customer may tell the bond broker the specified yield or price at which he or she would be willing to buy the securities. In this instance, the broker will seek these bonds from other dealers.

      THE CREDIT ENHANCERS

      Credit enhancement is a term denoting the credit of a stronger, more highly rated entity that is used to strengthen or enhance the credit of a lower-rated entity. Credit enhancement grew substantially in the 1990s and early 2000s for many reasons, including (1) investor concerns about the credit quality of underlying issuers, (2) increasingly complex security features, (3) increased issuance in the short-term market, and (4) cost efficiency in the pricing of insurance. Its use has plummeted since 2008, when many bond insurers encountered financial difficulties that undermined the value of their credit enhancement. The major forms of credit enhancement are private bond insurance, bank letters of credit and lines of credit, which are discussed in this section. Public forms of credit enhancement are discussed in Chapters 3 and 7. A bond is said to be unenhanced if it carries only its own rating and not that of a third-party enhanced provider.

      Bond Insurers

      Bond insurance is a legal commitment by an insurance company to make payments of principal and interest on debt in the event that the issuer fails to make those payments on time. Generally, such payments will be made as originally scheduled, and the principal will not be accelerated (paid earlier than its scheduled date). Bond insurance typically covers the full maturity range of the bonds.

      Although bond insurance provides significant additional security to the investor, the issuers are the first source for payment of principal and interest on their bonds. For that reason (and for other technical and tax-related considerations), not all insured bonds carry identical prices and yields. The perceived strength of the insurer by the market is a major determinant of that insurer's trading value. The relative quality of insurers is evaluated by their financial strengths and by the portfolios of bonds that they have previously insured.

      The role of municipal bond insurance in the market is threefold: (1) to reduce interest costs to issuers, (2) to provide a high level of security to investors, and (3) to furnish improved secondary-market liquidity and price support. From 1985 through 2005, there was tremendous growth in the use of bond insurance, as shown in Table 1.5. Bond insurance grew from 16.2 percent of the $147.6 billion new-issue, long-term market in 1986 to more than 57.3 percent of the $406.4 billion new-issue, long-term market in 2005.

      Table 1.5 Bond Insurance as a Percentage of the Long-Term New-Issue Market, 1986 to 2010

      Table 1-5

      Beginning in late 2007, most of the major bond insurers encountered severe financial difficulties due to losses on structured debt and other instruments not related to municipal bonds. The rating agencies downgraded the major bond insurers, which they considered less capable of making investors whole in the event of issuer default. Investors refocused on the credit quality of underlying issuers and were no longer willing to pay a significant premium for most insured bonds. Issuers saw no reason to pay for insurance if the lower interest rate it achieved did not offset the cost. The use of bond insurance plummeted as a result; in 2010, insured bond issues accounted for just 6.2 percent of the new-issue long-term market.

      Table 1.6 Letters of Credit as Percentage of the Long-Term New-Issue Market, 1986 to 2010

      Table 1-6

      Banks

      Bank letters and bank lines of credit are other forms of credit enhancement. Bank letters of credit are typically written for a much shorter term (anywhere from 1 to 10 years) than bond insurance. A letter of credit pays the investor principal and accrued interest if an event of default has occurred. It is stronger than a line of credit, which has many more conditions that must be satisfied before the issuer can draw money to pay principal or interest to investors. Issues with bank letters of credit receive the rating of the bank. This may be the short-term rating, the long-term rating, or both. Issues with lines of credit do not necessarily get the bank rating. Analysts look at the conditions under which the line will pay in addition to the financial condition of the issuer.

      The use of letters of credit has fluctuated greatly over the years, as shown in Table 1.6. Usage typically increases at times of stress in the overall credit markets, such as 1994, 2000, and 2008. Usage decreases when credit is more readily available in the market, hitting cyclical lows in 1993, 1998, 2003, and 2007. High interest rates prompt issuers to rely on shorter-term financing such as variable rate demand notes, which require a letter of credit to assure investors that cash will be available if an event triggers their right to put the notes (sell the notes back to the issuer at 100 percent of par). The variability in bank credit enhancement is related to many factors, including (1) the credit quality of banks, making the credit substitution less cost efficient when credit quality declines; (2) cost of the letter of credit; and (3) availability of alternative forms of credit enhancement.

      In late 2008, a severe credit crisis effectively shut down the new issue market for long-term municipal bonds for several weeks. The only way issuers could access the market was through short-term debt or variable rate demand notes. In addition, many issuers converted auction rate securities to variable rate bonds that required letters of credit. The proportion of issues backed by letters of credit

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