Revenue Bonds

Security, approval and the feasibility study

The security is the pledged revenue of the project, defined precisely in the trust indenture. Because no taxing power is pledged and no general obligation is created, revenue bonds are generally issued without a voter referendum and are not counted against the issuer's statutory debt limit. That is the practical reason so much municipal financing takes this form: it can be done.

Before issuance, an independent consultant prepares a feasibility study projecting usage, revenues, operating costs and the resulting ability to service debt. For a toll road it estimates traffic; for a hospital, admissions and payer mix. The feasibility study is the single most important document in the credit, and the exam asks about it as the distinguishing analytical input for revenue bonds — where a GO analysis looks at the tax base, a revenue analysis looks at the feasibility study.

An analyst then examines the sources of revenue and their stability, the competitive position of the facility (is there a free bridge next to the toll bridge?), the quality of management, the protective covenants, the financial reports and outside audits, and any credit enhancement such as bond insurance or a letter of credit.

Flow of funds

The indenture specifies the order in which revenue is applied. The full sequence, which is worth memorizing because questions ask for the position of one item within it, runs: revenue is deposited into a revenue fund; then operations and maintenance; then the debt service fund, covering current interest and principal; then the debt service reserve fund, typically holding a year's debt service; then a renewal and replacement fund for capital repairs; then any reserve maintenance and contingency funds; and finally the surplus fund, which may be used for redemption, additional construction or other lawful purposes.

That ordering — operations and maintenance before debt service — is a net revenue pledge, and it is by far the more common structure. The reasoning is practical: a facility that is not maintained stops generating revenue, so paying the operators first protects bondholders in the long run.

A gross revenue pledge reverses the first two, paying debt service before operations and maintenance. It is stronger for the bondholder in the short term and is found where the revenue stream is not dependent on ongoing operations in the same way — some special tax and sales tax bonds, for example. When a question asks which pledge is more advantageous to the bondholder, the answer is gross; when it asks which is more common, the answer is net.

Covenants and the additional bonds test

Because there is no taxing power, the bondholder's protection is contractual. The standard covenants in a revenue bond indenture are worth learning as a list.

Rate covenant: the issuer will set rates and charges sufficient to cover operating expenses and debt service by a stated margin.

Maintenance covenant: the facility will be kept in good repair.

Insurance covenant: the facility will be insured.

Books and records covenant, with an audit by an independent accountant.

Non-discrimination covenant: no free or preferential service that would erode revenue.

Additional bonds test: the conditions under which more bonds may be issued on a parity with the outstanding issue. A closed-end indenture prohibits additional parity debt, or permits it only as junior debt; an open-end indenture permits it if a stated earnings test is met. Closed-end is stronger for the existing holder, exactly as with the closed-end mortgage bond in lesson 3.3, and the exam draws that parallel.

Catastrophe or calamity call: if the facility is destroyed, insurance proceeds are used to call the bonds. This is an extraordinary mandatory call — the holder is redeemed regardless of market conditions.

Coverage

Debt service coverage is net revenue available for debt service divided by annual debt service. A coverage ratio of 1.5 means the facility earned one and a half times what it owed.

Coverage above one is necessary but not sufficient; the rate covenant usually specifies a minimum, often between 1.1 and 1.5 depending on the sector, and a facility operating just above its covenant is a facility with no cushion. Coverage is computed from net revenue under a net revenue pledge and from gross revenue under a gross pledge, which is why a question must tell you which pledge applies before the number means anything.

Compare this with the GO ratios of the last lesson and the difference in the whole analytical frame becomes clear: a GO analyst asks whether the community can pay, a revenue analyst asks whether the facility earns.

The types, and the AMT problem

The outline names a spread of revenue bond types and each has a characteristic risk.

Utility revenue bonds — water, sewer, electric — are the strongest, because demand is inelastic and the service is essential. Transportation bonds — toll roads, bridges, airports — depend on traffic and on competing free alternatives. Hospital revenue bonds depend on reimbursement policy and on competition. Housing revenue bonds are supported by mortgage payments and often by federal subsidies, and carry prepayment risk. Public power, port authority and special facility bonds each carry the risk of their sector.

Industrial development bonds, also called industrial revenue bonds, are the important special case. A municipality issues the bonds and uses the proceeds to build a facility that it leases to a private corporation; the lease payments service the debt. The municipality's name is on the bond, but the credit is the corporate lessee's — a bond that looks municipal and is analysed as corporate. An IDB is only as good as the company leasing the facility.

IDBs are private activity bonds, and here is the consequence the exam always tests: interest on most private activity bonds issued after 1986 is a tax preference item for the alternative minimum tax. The interest remains exempt from regular federal income tax, but a customer subject to the AMT may find it taxable in practice. So an AMT-exposed customer should not be sold a private activity bond on the strength of its tax exemption, and any yield comparison for such a customer has to be run after AMT.

Certificates of participation are a related structure: investors buy a share of lease payments made by a municipality, usually for equipment or a building, in a form that avoids the debt limit and referendum requirements precisely because it is legally a lease rather than debt. That legal characterization is also the weakness — lease payments are typically subject to annual appropriation, so a COP carries appropriation risk that a GO does not.