ch08even - CHAPTER 8 MUNICIPAL SECURITIES ANSWERS TO...

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CHAPTER 8 MUNICIPAL SECURITIES ANSWERS TO QUESTIONS FOR CHAPTER 8 ( Questions are in bold print followed by answers.) 2. If Congress changes the tax law so as to increase marginal tax rates, what will happen to the price of municipal bonds? An increase in the maximum marginal tax rate for individuals will increase the attractiveness of municipal securities. This was seen with the Tax Act of 1990 which raised the maximum marginal tax rate to 33%. Ceteris paribus, an increase in tax rates will have a positive effect on the price of municipal securities as demand will increase. An increase in price is needed to restore the desired returns. On the other hand, a decrease in the maximum marginal tax rate for individuals will decrease the attractiveness of municipal securities. This was seen with the Tax Reform Act of 1986 where the maximum marginal tax rate for individuals was reduced from 50% to 28%. Ceteris paribus, a decrease in tax rates will have a negative effect on the price of municipal bonds as demand will decrease. The effect of a lower tax rate was once again seen in 1995 with congressional proposals regarding the introduction of a flat tax when tax-exempt municipal bonds began trading at lower prices. The higher the marginal tax rate, the greater the value of the tax exemption features. As the marginal tax rate declines, the price of a tax-exempt municipal security also declines. 4. Which type of municipal bond would an investor analyze using an approach similar to that for analyzing a corporate bond? Investors use a similar approach to analyze both municipal bonds and corporate bonds. As with corporate bonds, some institutional investors in the municipal bond market rely on their own in- house municipal credit analysts for determining the credit worthiness of a municipal issue; other investors rely on the nationally recognized rating companies. The two leading rating companies are Moody’s and Standard & Poor’s, and the assigned rating system is essentially the same as that used for corporate bonds. More details on the actual procedure are given below. In evaluating general obligation bonds, the commercial rating companies assess information in four basic categories. The first category includes information on the issuer’s debt structure to determine the overall debt burden. The second category relates to the issuer’s ability and political discipline to maintain sound budgetary policy. The focus of attention here usually is on the issuer’s general operating funds and whether it has maintained at least balanced budgets over three to five years. The third category involves determining the specific local taxes and intergovernmental revenues available to the issuer as well as obtaining historical information 165
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both on tax collection rates, which are important when looking at property tax levies, and on the dependence of local budgets on specific revenue sources. The fourth and last category of information necessary to the credit analysis is an assessment of the issuer’s overall
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ch08even - CHAPTER 8 MUNICIPAL SECURITIES ANSWERS TO...

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