Revenue bonds

What is a Revenue Bond?

A revenue bond is a type of municipal bond issued to finance specific projects, such as transportation, sewer systems, or public utilities. Unlike general obligation bonds, which rely on the full faith and credit of the bond issuer, revenue bonds are backed by the revenue streams generated by the projects they fund. These bonds typically fund essential services, and interest payments are exempt from federal income tax. Investors interested in income tax benefits may find revenue bonds appealing, as they can help reduce income tax bills.

Revenue Bonds Explained

State and local governments play a crucial role in advancing community infrastructure projects, aiming to enhance public services and facilities. To fund these initiatives, municipalities often opt to issue revenue bonds, a type of fixed-income security.

In the issuance process, state and local governments utilize the funds raised through municipal revenue bonds to initiate the designated infrastructure project. These bonds, categorized as special tax revenue bonds or essential service revenue bonds, are tied directly to the revenue generated by the specific project they finance.

Investors who purchase these revenue bonds become entitled to principal and interest payments as the project generates revenue over time. The repayment period for revenue bonds typically extends over longer durations, usually ranging from 20 to 30 years. In return for the extended commitment, investors are offered higher returns compared to general obligation bonds.

It's essential to note that the nature of revenue bonds introduces a higher level of risk compared to bonds backed by general tax revenue. This heightened risk stems from the fact that the success of a particular project is not guaranteed and may face challenges that could affect its financial viability.

While the likelihood of default on revenue bonds is generally considered remote, it is more plausible than with bonds backed by general tax revenue. This risk factor is inherent in the dependence on the success and profitability of the specific project associated with the revenue bonds.

Types of Revenue Bonds

1. Airport Revenue Bond. An airport revenue bond is a municipal bond issued by a municipality or airport authority to finance airport facilities. The revenues generated by the airport support these bonds, making them a type of public-purpose bond. If over 10% of the benefit goes to the private sector, it becomes a private bond.

2. Toll Revenue Bond. A toll revenue bond is a municipal security utilized for public projects like bridges, tunnels, or expressways. The principal and interest payments on the bond are covered by toll revenues collected from users of the public project.

3. Utility Revenue Bond (Essential Services Bond). Utility revenue bonds finance public utility projects, with the utility obligated to repay bondholders directly from project revenues, bypassing the general tax fund.

4. Hospital Revenue Bond. A hospital revenue bond is issued to support the construction of new hospitals, nursing homes, or related facilities. The revenue generated by these healthcare institutions is used to repay bondholders.

5. Mortgage Revenue Bond (MRB). Mortgage revenue bonds are issued by Housing Finance Agencies (HFAs) at the state or local level. These tax-free bonds finance affordable mortgages for low- and middle-income individuals.

6. Industrial Revenue Bond (IRB). Industrial revenue bonds are municipal debt securities issued by a government agency on behalf of a private sector company. They are intended for building or acquiring factories and heavy equipment. The bond repayment relies on the success and revenue of the private enterprise.

Advantages and Disadvantages

Advantages

1. Higher Expected Return. Revenue bonds often offer a higher expected return compared to general obligation (GO) bonds due to their slightly riskier nature, making them attractive to income-oriented investors.

2. Predictable Income. As fixed-income securities, revenue bonds provide investors with a predictable income stream, usually in the form of semi-annual interest payments.

3. Federal Tax Exemption. Interest earned from revenue bonds is typically exempt from federal income taxes, which can be beneficial for investors in higher tax brackets.

4. State Tax Exemption. In some cases, interest earned from revenue bonds may also be exempt from state income taxes, particularly for in-state investors. This can further enhance their after-tax returns.

5. Supporting Local Projects. Investing in revenue bonds can be a worthwhile way to support local public transportation projects, repair city sewer systems, or funding public projects that benefit the community.

Disadvantages

1. Higher Default Risk. Revenue bonds generally have a higher probability of default compared to GO bonds, as their repayment relies on the success of the specific project or pledged revenues.

2. Minimally Competitive Rates. While revenue bonds may offer higher returns initially, their rates may only be minimally competitive in the long run compared to other fixed-income investments.

3. Inflationary Pressure. Revenue municipal bonds are subject to inflationary pressure, which can erode the purchasing power of their fixed interest payments over time.

4. State Tax Applicability. Out-of-state investors may be subject to state or local taxes on the interest earned from revenue bonds, depending on the issuing jurisdiction.

5. Alternative Investments. Investors might find higher real returns in equities or other investment vehicles, depending on their risk tolerance and investment objectives.

Structure of Revenue Bonds

1. Maturity. Revenue bonds typically mature in 20 to 30 years, although maturity dates can vary depending on the specific project and issuer. Some revenue bonds have staggered maturity dates, known as serial bonds, which do not mature at the same time.

2. Face Value. The value of a revenue bond is called its face value, which represents the amount paid to the investor or bondholder at the bond's maturity. Revenue bonds can be issued in various increments, such as $1,000 or $5,000.

3. Interest Payments. Investors purchase a revenue bond by paying the face value amount upfront. In return, they receive interest payments over the life of the bond. These interest payments are usually semi-annual and are funded by the revenue generated from the specific project, such as tolls from a toll bridge or fees from public power electric utilities.

4. Repayment. At the bond's maturity, the face value amount is returned to the investor, provided there was sufficient revenue from the project to pay back the bond. If the project fails to generate enough revenue, investors may be at risk of losing their entire investment, as revenue bonds are not backed by the full faith and credit of the issuing government.

5. Project-Specific Revenues. Revenue bonds are issued to fund public projects that generate revenue, such as transportation revenue bonds for toll roads or sewer revenue bonds for waste management systems. The revenues generated from these projects are used to pay off the bond, including interest and principal payments.

6. Debt Service. The process of repaying a revenue bond, including both interest and principal payments, is known as debt service. Revenue bonds allow municipalities to avoid reaching legislated debt limits, as they are not considered general revenue obligations.

Example

• St. Louis issues tax-exempt revenue bonds, which are a part of the broader revenue bond market, to finance projects like multi-family housing, publicly owned facilities, pollution control facilities, and fixed assets such as land and buildings. These bonds help fund affordable housing, with a minimum of 20% of the units set aside for households meeting specific income guidelines. The maturity of most issues ranges from 20 to 30 years, and the interest earned is generally tax-exempt from federal and most state income taxes, making them attractive to investors seeking tax-exempt income. This tax-exempt status allows the issuer to pay a lower interest rate, making the financing more cost-effective. Investors may consider the security's tax-exempt status when evaluating these bonds, especially in light of the alternative minimum tax (AMT).

• In February 2016, the MTA decided to offer Green Bonds, which are a type of special tax revenue bond, to finance planned infrastructure renewal projects, including upgrades on its railroads. The MTA used $500 million of the proceeds from these bonds, which were issued under its Transportation Revenue Bond program. The bonds are backed by the agency's operating revenue and subsidies received from New York State. By utilizing revenue bonds, the MTA can raise funds for essential infrastructure improvements while offering investors an opportunity to earn tax-exempt income, which is an important consideration for investors seeking to minimize their tax liability. These bonds can be included in a municipal bond portfolio or invested through bond funds and mutual funds, which may incur management fees.

The performance of these revenue bonds can be tracked using indices like the Bloomberg Municipal Bond Index, which is provided by Bloomberg Index Services Limited. The index includes various types of municipal bonds issued by local and state governments, such as general obligation (GO) bonds, education revenue bonds, health care revenue bonds, and hospital bonds. Investors can use these indices as a municipal bond market source to evaluate investment grade munis outstanding and assess the potential impact of rising interest rates on their municipal bond portfolio.