CFA Practice Question

CFA Practice Question

Which of the following securities is not a form of "tax-backed" municipal debt.
A. Higher education revenue bonds.
B. General obligation bonds.
C. Debt obligations supported by Public Credit Enhancement Programs.
Explanation: "Higher education revenue bonds" is not an example of a tax-backed municipal security, rather this issue represents a "revenue bond."

Municipal securities are debt obligations issued by state and local governments of the United States and the various organizations they establish. Municipal securities are often referred to as "tax-exempt debt" because the majority of municipal securities are exempt from federal income tax. Additionally, many states allow purchasers of municipal securities who are residents of the state in which the security is issued to escape tax on the income generated by the security. In this respect, a municipal security can be considered "tax-exempt." However, it is important to remember that while the income produced by a municipal security is often tax exempt, any capital gains produced by a municipal security is not. Additionally, there are issues of municipal securities whose coupon payments are not tax-exempt. Largely, however, the income produced by municipal securities is not taxable.

Municipal securities can be broadly categorized into two groups - tax-backed debt and revenue debt. Tax-backed debt is defined as any municipal obligation whose coupon payments and/or principal is backed by the taxing power of the issuer. There are three basic types of tax-backed debt - General obligation debt, appropriation-backed debt, and debt obligations supported by Public Credit Enhancement Programs. Tax-backed debt is considered "safer" than revenue debt because the principal of a tax-backed debt issue is often backed by the full faith and credit of the issuer (issues that are backed by the full faith and credit of the issuer are referred to as "unlimited tax general obligation debt," and represent the strongest form of general obligation pledge).

Revenue debt is defined as any municipal debt obligation whose cash flows are funded by the revenues produced by a specific project. Municipalities frequently employ the issuance of revenue bonds to fund specific revenue-generating projects, such as toll-roads, state universities, hospitals, and water-treatment facilities. Revenue bonds are backed by the revenue producing capacity of the project for which they were issued, and are not backed by the taxing power of the municipality. So said, revenue bonds frequently warrant higher yields than a comparable tax-backed municipal security.

User Contributed Comments 3

User Comment
danlan B and C are two types of tax-backed debt.
kaliokale very good explanation..
aragarwal refreshed all the concepts.!!!
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