Marketing New Municipal Bond Products to Traditional Municipal Bond Investors: Win Win Win

DECEMBER 2009 WHITE PAPER Tim Coffin Vice President, Municipal Finance 617-563-0391 Marketing New Municipal Bond Products to Traditional Municipal B...
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DECEMBER 2009 WHITE PAPER

Tim Coffin Vice President, Municipal Finance 617-563-0391

Marketing New Municipal Bond Products to Traditional Municipal Bond Investors: Win – Win – Win. ƒ ƒ ƒ

Bond issuers can benefit with increased distribution. Bond investors can benefit with improved access, parity and transparency. The market can benefit with increased secondary market liquidity.

Do retail investors have an appetite for taxable municipal bond income, either in retirement or brokerage accounts? Does a 6% tax credit sound potentially more enticing than a 5% coupon payment to an individual investor? Even if you’re not a fixed income investor, it is likely you may identify with why many average investors would answer “yes” to at least one, and likely both of these questions.

Individual and middle market investors have consistently been a reliable source of liquidity for municipal bond issuers. To clarify, middle market refers to institutional investors who manage money on behalf of individual investors – in separately managed accounts (“SMAs”). The proliferation of the SMA business over the last several years has been an upshot of effective portfolio management software and market-tool products such as Bloomberg®. This has been a boon for bond issuers since SMAs can provide an efficient bridge to large pools of professionally managed high net worth retail assets. Although retail generally means individual investors, bond issuers should consider focusing equally on the financial representatives (aka retail brokers) who service individual investors. They too are can be an efficient bridge to pools of retail assets. Together these investors create the order flow on retail order periods. The success of marketing taxable municipal bonds will not meet its greatest potential if the marketing is done at the exclusion of traditional municipal bond buyers. Unlike publicly traded corporate bond issuers, which in consideration of their stock price strategically tend to surprise the market with “shotgun” style sales, municipal bond issuers can enjoy the luxury of time. Practically speaking, since they have no share price to protect there is no strategic incentive for municipal bond issuers to be limited to corporate bond underwriting procedures. Additionally, there is no clear reason why premarketing a taxable bond sale to retail investors would potentially confuse or discourage institutional investors. Premarketing and retail order periods work with tax free bonds, and could prove to be just as effective for taxable municipal bonds.

The success of marketing taxable municipal bonds will not meet its greatest potential if the marketing is done at the exclusion of traditional municipal bond buyers.

200 Seaport Boulevard, Boston, MA 02210 Fidelity Capital Markets is a division of National Financial Services LLC, Member NYSE, SIPC 539768.1.0

When it comes to execution, institutional investors tend to care about price and liquidity, not necessarily who else may be buying bonds at the original offering. Price is a matter of relative value to the investor, but liquidity is one of the factors underwriters and bond issuers have the power to cultivate through broader distribution – particularly for the more fragmented sectors of the market. Many larger institutional investors generally peg their portfolios to bond indexes. Not all taxable municipal bonds may end up in a bond index, and it may take demand from the middle markets and retail to help support the broader secondary market. Accordingly, even large “index eligible” municipal bond issuers should consider having a long term interest in staying connected with their traditional investor base. Both investors and issuers may benefit, and ultimately the market could too.

Price is a matter of relative value to the investor, but liquidity is one of the factors underwriters and bond issuers have the power to cultivate...

For the retail investors and their proxies (SMAs) the potential benefits of premarketing are clear. First, retail order periods provide a mechanism through which an individual investor can be reasonably assured of getting his/her order filled. It is a process unique to new-issue municipals which literally puts the individual investor first. Second, customers can be assured that their order, regardless of size, will be filled at the same level as those of the largest institution. This is a message which resonates with individual investors and their proxies and has the power to possibly tether them to the primary market.

A Wider Selection of Municipal Bond Products For retail bond investors, the American Recovery and Reinvestment Act (“ARRA”) has in fact produced a somewhat wider selection of municipal investment products. Municipal bonds are an asset class individual investors generally already understand and value. Continued improvements in disclosure and transparency may encourage investors to explore these products more aggressively. It is reasonable to assume investors with the financial means to buy individual municipal bonds would potentially have some appetite for tax credit bonds as well. Presenting tax credit bonds to retail investors is logical, and may be in the best long term interest of the market. As background; tax credit bonds are authorized by Congress pursuant to legislation that permits state and local governments to borrow at a nominal or zero interest rate cost by issuing bonds that carry a tax credit. Municipalities can attach the tax credit to their bonds in lieu of - or as a supplement to - interest bearing coupons. The bond issuers typically follow specified procedures in order to receive a tax credit allocation from the US Treasury and the authority to issue bonds bearing a tax credit. Tax credit rates are set by the US Treasury on a daily basis; meaning the municipality doesn’t set the tax credit rate on their bonds.

200 Seaport Boulevard, Boston, MA 02210 Fidelity Capital Markets is a division of National Financial Services LLC, Member NYSE, SIPC. 539768.1.0

Once the tax credit is attached to the bonds its rate remains fixed. The market level for tax credit bonds often varies from the U.S. Treasury’s set tax credit rate – the way the market varies for coupon bonds based on credit and market yields, in which case the tax credit can be supplemented with either an interest bearing coupon, or an original issue discount on the value of the bonds, depending on what the legislation relating to the particular program allows. Tax credit bonds have been around for many years, but primarily for qualified institutional investors. More recently the Treasury has allotted tax credits for school construction and stipulated that the subsequent bonds issued may be purchased by individual investors. Treasury’s ambition is to help broaden the market and foster liquidity, an objective both issuers and underwriters should consider embracing. There is no reason why the product should not have potential broad appeal to individual investors as well, especially for those who are managing their portfolios for tax efficient returns. Although tax credit bonds may sound complicated or speculative, the model is simple; bonds are issued with tax credits attached to them, instead of a coupon. With a regular municipal bond if a client buys 100M bonds ($100,000) with a coupon attached that pays 5%, the customer receives $5,000 per year in income. This of course is to compensate the purchaser of the bonds (the lender) for taking all the risks associated with lending money for a number of years. If the same investors were to buy 100M bonds ($100,000) with a 5% tax credit attached, the customer would receive a tax credit of $5,000 per year until the bonds mature. For individual investors in a high tax bracket this may be very appealing – depending on the rate of return and their specific tax exposure. The tax credit on Qualified School Construction Bonds (“QSCBs”) for example, accrues quarterly and is includible in the bond holder’s gross income. The tax credits from QSCBs are applicable against both regular federal taxes and the Alternative Minimum Tax. Tax credits from QSCBs can be carried forward if no taxes are due in a given year.1 Investors should consult their own tax advisors to determine the potential effect of tax credits on their tax positions and their income levels, and to learn more about additional federal and state tax law considerations, which are beyond the scope of this whitepaper. The risks and rewards for an investor to consider are similar to those of a coupon bond: what will $5,000 in tax credit be worth over the life of the loan and how should that be valued in today’s dollars? Of course the credit quality of the issuer needs to be considered as well. What is the risk the borrower won’t be able to pay the principal when the bonds mature? Tax credit bonds are not backed by the U.S. Treasury. They are obligations of the specific municipal borrower, backed by the taxing power or revenue pledge of the issuer. Like tax free bonds and Build America Bonds, tax credit bonds must be issued in accordance with regulations enforced by the Internal Revenue Service (“IRS”), and there are a variety of risks, including the validity of the tax credit to the investor if the issuer fails to comply with the regulations.

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The information provided above is general in nature and should not be considered legal or tax advice. 200 Seaport Boulevard, Boston, MA 02210 Fidelity Capital Markets is a division of National Financial Services LLC, Member NYSE, SIPC. 539768.1.0

There are a range of tax credit bonds distinguished by characteristics including their authorized purpose and who can purchase them, but the concept is the same. A newer category of tax credit bonds can be issued by municipalities as authorized by ARRA, the same legislation that authorized Build America Bonds. For years tax credit bonds have been issued as an institutional product as authorized by the Energy Tax Incentive Act of 2005 for Clean Renewable Energy Bonds (“CREBS”) and for the for the benefit of qualified school districts in the form of Qualified Zone Academy Bonds (“QZAB”). QZABs, the tax credit bond program created in 1998, served as a precursor for the ARRA authorized Qualified School Construction Bonds (“QSCBs”). The Treasury allots a set amount of tax credits for QSCBs each year, (presently authorized through 2010). Again, individual investors may purchase QSCBs. Accordingly, individual investors have been stepping into the market, but almost exclusively through their proxies (investment managers). Historically, insurance companies and regional banks have been a primary buyer of tax credit bonds. Like any new market, the market for tax credit municipal bonds can be thin and illiquid. Thin and illiquid markets may largely benefit speculators at the possible expense of issuers. It is an unavoidable expense in getting any market off the ground, but more than ever, municipal bond issuers are well positioned to take a proactive role in helping to accelerate the process. Given its fragmented nature, the municipal bond market is remarkably efficient, and for the most part has treated bond issuers very well. The public finance industry should consider encouraging the same for Build America Bonds and tax credit bonds, leveraging resources to potentially engage the broadest range of investors. Fostering the market today may benefit both issuers and investors over the long term.

Thin and illiquid markets may largely benefit speculators at the possible expense of bond issuers. It is an unavoidable expense in getting any market off the ground, but more than ever municipal bond issuers are well positioned to take a proactive role in helping to accelerate the process.

200 Seaport Boulevard, Boston, MA 02210 Fidelity Capital Markets is a division of National Financial Services LLC, Member NYSE, SIPC. 539768.1.0

About Fidelity Capital Markets Fidelity Capital Markets is a full service underwriter and broker / dealer of municipal bonds; serving as the conduit to the capital markets for the various distribution channels of Fidelity Investments’ brokerage companies. We have integrated institutional, intermediary, and retail businesses to create one of the largest trading networks and liquidity pools in the world. For more information please contact one of our municipal finance offices. Tim Coffin Vice President, Municipal Finance Fidelity Capital Markets 200 Seaport Boulevard, Z2H Boston, MA 02210 (O) 617-563-7691 (M) 857-383-8694 [email protected]

Lourdes German Vice President, Municipal Finance Fidelity Capital Markets 640 Fifth Avenue, IN2A New York, NY 10019 (O) 212-335-5039, (M) 617-501-2604 [email protected]

Kim Edwards Vice President, Municipal Finance Fidelity Capital Markets 7000 North Mopac, 2nd Floor Austin, TX 78731 (O) 512-514-6625, (M) 512-284-2927 [email protected]

Mark Kim Vice President, Municipal Finance Fidelity Capital Markets One North LaSalle, Suite 3300 Chicago, IL 60602 (O) 312-551-3214, (M) 312-350-5040 [email protected]

For Investment Professional use only. Not for distribution to the public as sales material in any form.

200 Seaport Boulevard, Boston, MA 02210 Fidelity Capital Markets is a division of National Financial Services LLC, Member NYSE, SIPC. 539768.1.0