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Most but not all municipal bonds are tax-exempt, meaning that the interest received by the bondholder is exempt from federal income tax. Accordingly, municipal bonds are issued subject to stringent requirements imposed by the Internal Revenue Service.
Tax-exempt municipal bonds provide low-interest, long-term capital project financing for 501(c)(3) nonprofits (such as charities and many educational and healthcare organizations). Under IRS rules, in order to qualify for tax exempt treatment to the holder, the proceeds must be used by the nonprofit either for a qualifying capital project or for refinancing existing tax-exempt debt. The bonds are issued in “conduit financing arrangements” in which a governmental financing authority (the "issuer") issues the securities and lends the proceeds to the NFP (the "conduit (bond) obligor" or "conduit borrower"). Although the securities bear the name of the governmental issuer, the issuer has no obligation for repayment of the debt. Instead, principal and interest is paid solely from resources of the NFP, generally through payments made by the NFP to the issuer under the loan agreement.
The majority of tax-exempt (and taxable) municipal bonds issued on behalf of NFPs are revenue bonds (i.e., bonds secured by a pledge of the entity's future revenues). In most cases, they are serial bonds with maturity dates spread over 20-40 years. They may bear interest at a fixed rate or a variable rate and may provide for a single interest rate structure for the life of the obligation, or a multi-modal structure providing the issuer the ability to convert from one interest rate mode to another.
Variable-rate (also called floating-rate) bonds bear interest at a rate that is reset from time to time. The interest rate may be based upon financial indices available in the market or may be determined by an actual remarketing of the bonds. Two forms of variable-rate bonds discussed in this chapter are variable-rate demand obligations (see NP 11.2.1) and auction rate securities (see NP 11.2.2).
Bonds may be sold in public offerings or privately placed. Bonds sold in public offerings are exempt from registration under the Securities Act of 1933 but are subject to SEC enforcement and indirect oversight (see NP 11.7.1). After new bonds are issued, they trade in a decentralized, over-the-counter dealer market rather than on a centralized exchange. Most bonds sold in public offerings are subject to SEC requirements to provide financial and operating information regarding the borrower (including the conduit obligor) to investors on an annual basis (or more often) for as long as the bonds are outstanding. NFPs with publicly-issued bonds may be subject to more extensive disclosure requirements than other NFPs and in some cases may be required to adopt new FASB standards on the same timetable as SEC registrants. See NP 1 for a discussion of the various definitions of “public entity” for purposes of determining adoption dates and the applicability of various FASB standards to conduit bond obligors.
Tax-exempt municipal bonds are subject to strict IRS requirements both at the time of issuance and throughout the life of the bonds (see NP 11.7.1). Because of the low interest rates on municipal borrowings, the IRS prohibits investing borrowed funds in other financial instruments merely to benefit from an interest rate arbitrage opportunity (that is, benefiting from the spread between what can be earned from investing the borrowed proceeds and the cost of borrowing). Taxable bonds carry a higher interest rate and are subject to fewer IRS restrictions on their use.

11.2.1 Variable-rate demand obligations

Variable-rate demand obligations (VRDOs), sometimes referred to as variable-rate demand notes, are bonds that pay interest based on a floating rate that resets periodically. Although they are viewed as long-term debt by issuers, a demand feature allows bondholders to “put” or “tender” the bonds back to the issuer on the interest reset dates, making the bonds permissible investments for money market funds.
Under normal market conditions, if a bondholder exercises the "put" feature, a remarketing agent usually can obtain funds to repay the bondholder by reselling the bonds to another investor. If a new investor cannot be located within the time period for remarketing, a “failed remarketing” occurs. To provide for liquidity in this event, most VRDO issues are accompanied by a liquidity facility from a financial institution. The liquidity provider purchases the bonds, thus providing the resources needed to pay the former bondholder. The bonds that were not successfully remarketed then become "bank bonds," and the issuer must pay off the resulting obligation pursuant to the liquidity facility's contractual terms (for example, over a stipulated period of months or years rather than the bonds’ original stated maturities, and at an interest rate negotiated with the bank, rather than the bonds’ coupon rate).
The liquidity facilities used take the form of either an irrevocable letter of credit (LOC) or a conditional standby bond purchase agreement (SBPA). Although each provides liquidity that enables bondholders to sell their holdings on short notice, the mechanics of the LOC and SBPA arrangements differ. The LOC’s commitment is unconditional; with an SBPA, the liquidity provider may have the right to terminate the liquidity support under certain conditions (termination events). Further, an SBPA provides only liquidity support, while the LOC also typically guarantees the payment of all scheduled principal and interest payments to bondholders.
Some issuers with high credit quality and substantial liquid resources may set aside their own assets to fund liquidity for puts (“self liquidity”).

11.2.2 Auction-rate securities

Auction-rate securities (ARS) have a variable interest rate that is designed to regularly reset through a Dutch auction. In these auctions, bids are submitted by buyers and sellers, with the rate determined after all bids to buy or sell have been submitted. The auction agent receives orders to sell and orders to buy from various broker-dealers (acting for their clients) and determines the lowest interest rate at which all of the securities that have been offered for sale will clear (the “clearing rate”). The intervals at which the interest rate resets will occur (generally 7, 28, or 35 days) are established when the bonds are issued.
In some ways, ARS resemble VRDOs in that both are long-term instruments that trade at par but are tied to short-term interest rates with periodic rate resets. The significant difference between them is the put feature embedded in VRDOs. VRDO holders can put bonds back to the issuer and demand repayment, while ARS holders can only sell to other investors.
If a "failed auction" occurs (that is, an auction where the number of investors wishing to sell exceeds the number of investors wishing to buy), the interest rate resets to a maximum rate defined for the issue (typically a multiple of a reference rate, typically LIBOR historically, or a fixed percentage). The maximum rate is designed to compensate the holder for the loss of liquidity resulting from a failed auction and to encourage the issuer to consider restructuring or redeeming the securities if future auctions also fail. The market for ARS froze during the recession of 2008. While many auction-rate issuers subsequently repurchased (and retired) their bonds, the market has remained largely frozen for ARS that remain outstanding.
An issuer of ARS has the right to redeem (or “call”) the bonds early, on any interest payment date. Generally, this is accomplished either by issuing new debt (e.g., VRDOs or fixed-rate bonds) to obtain proceeds to pay off the outstanding ARS (a refunding, discussed at NP 11.4.1) or, if the ARS were structured as "multi-modal," by exercising an "interest mode conversion" option (NP 11.4.2).

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