Who are the parties to a letter-of-credit–backed municipal bond, and what are their responsibilities?

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A letter-of-credit (LOC) agreement is the strongest type of support available from a commercial bank. There are three parties to an LOC: LOC provider, municipal issuer, and bond trustee. The duties of these three parties are discussed below.

The LOC provider `is the bank that issues the LOC and is required to advance funds to the trustee if one of any specified events occurs. The municipal issuer is the municipality that is requesting the LOC in connection with the offering of the bond. The municipal issuer agrees to two things: (1) to reimburse the LOC provider for any payments that the LOC provider had to make under the agreement, and (2) to make an LOC fee payment periodically to the LOC provider. The LOC fee is typically from 50 basis points to 200 basis points of the outstanding principal amount of the bond issue.

A direct-pay LOCgrants the trustee the right to request that the LOC provider provide principal and/or interest for the LOC-backed municipal bond if there is a specified event or default or an inability of the municipal issuer to meet a contractual interest payment or principal at the maturity date. The trustee can make this demand for funds on the LOC provider without requesting that the municipal issuer make the payment first. In contrast to a direct-pay LOC, the other two types of LOC arrangements (standby LOC and confirming LOC) require that the trustee must first request any contractual payment from the municipal issuer before drawing down on the LOC.

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