Revenue bonds are a type of municipal debt security financed by the income generated from a specific public project. Unlike general obligation bonds backed by general tax revenue, revenue bonds rely on the project's earnings to repay investors. These bonds offer both opportunities and risks, making it essential for investors to understand their characteristics before investing.
What Is a Revenue Bond?
A revenue bond is a municipal bond backed by the income generated from a specific project, such as a toll bridge or airport. Unlike general obligation bonds supported by general tax revenue, revenue bonds rely on the project's earnings to repay investors. These bonds are often issued by government agencies operating like businesses, with their own revenue streams and expenses.
How do revenue bonds work?
State and local governments are motivated to undertake infrastructure projects that enhance community welfare. To finance these initiatives, municipalities issue revenue bonds to investors.
Once the necessary funding is obtained, state and local governments can commence the project. As revenue generated from the project begins to flow in, investors receive their principal and interest payments. Revenue bonds typically have longer maturities, often ranging from 20 to 30 years, and tend to offer higher returns compared to general obligation bonds.
Structure of Revenue Bonds
The bond's value is referred to as its face value, which represents the amount that is paid to the investor or bondholder upon maturity. Some revenue bonds feature staggered maturity dates, meaning they do not all mature simultaneously; these are known as serial bonds.
Investors can acquire a revenue bond by paying the face value upfront and, in exchange, receive interest payments throughout the bond's duration. At maturity, the face value is returned to the investor, assuming there is enough revenue generated from the project to facilitate the repayment. If the project fails to produce sufficient revenue, investors risk losing their entire investment.
Characteristics of Revenue Bonds
Revenue bonds possess several key characteristics that distinguish them from other municipal bonds:
- Secured by Project Revenue: The primary feature of a revenue bond is its reliance on income generated from a specific project to service the debt. This income stream acts as collateral for bondholders.
- Higher Yield: To compensate for the increased risk, revenue bonds typically offer higher interest rates than general obligation bonds.
- Long Maturity: Given the nature of infrastructure projects, revenue bonds often have longer maturity periods, typically ranging from 20 to 30 years.
- Project-Specific Credit Analysis: Investors must carefully evaluate the project's revenue-generating potential, operating costs, and competitive environment to assess the bond's creditworthiness.
- Potential for Call Provisions: Some revenue bonds may have call provisions, allowing the issuer to redeem the bonds before the maturity date under specific conditions.
Types of Revenue Bonds
Revenue bonds can vary significantly as each one is designed to finance distinct projects, each associated with unique revenue streams. Here are some of the more common types of revenue bonds:
- Toll Revenue Bond: This type of municipal bond pays back the principal and interest based on the toll revenues collected. While there is a risk of default if the project does not generate the anticipated toll revenue, such occurrences are relatively rare.
- Public Purpose Bond: These municipal bonds are issued to finance projects that provide public benefits, such as roads or government buildings.
- Airport Revenue Bond: This municipal bond is utilized to fund the construction, expansion, or redevelopment of a local airport. The expectation is that the airport will generate sufficient revenue, after covering operating and maintenance expenses, to repay the initial investors.
- Mortgage Revenue Bond (Housing Bonds): This type of municipal bond is issued to finance mortgages for low-income taxpayers or first-time homebuyers. Housing finance agencies (HFAs) issue these bonds to provide mortgages at below-market interest rates.
- Utility Revenue Bond: These bonds are issued to raise capital for infrastructure related to public utilities, including water, electricity, and waste management services. Customer fees can be utilized to repay bondholders once the project is completed.
- Hospital Revenue Bond: Issued to finance the construction or expansion of hospitals, these bonds rely on fees generated from specific hospital projects to pay back bondholders over time.
- Industrial Revenue Bond: These municipal bonds are issued on behalf of private companies, typically to finance the acquisition of equipment for industrial production. In this case, the private company is responsible for making principal and interest payments to bondholders.
Example: Toll Revenue Bonds for a Highway Project
Project Overview: A state government plans to construct a new toll highway to improve transportation efficiency and reduce congestion in a growing metropolitan area. To finance the project, the government issues toll revenue bonds.
Bond Issuance:
- The state issues $100 million in toll revenue bonds, with an interest rate of 5% and a maturity of 30 years.
- Investors purchase these bonds, essentially lending money to the state for the construction of the highway.
Revenue Generation:
- Once the highway is completed, it operates as a toll road. Drivers must pay a fee to use the road, generating revenue for the project.
- The revenue collected from tolls is designated specifically for repaying the bondholders, covering both principal and interest payments.
Repayment Structure:
- The bondholders receive interest payments semi-annually, based on the toll revenues generated by the highway.
- As the highway generates sufficient toll revenue, the state is able to pay back the principal amount to the bondholders at maturity.
Revenue bonds present an investment avenue with the potential for higher returns but also carry inherent risks. Investors should carefully evaluate the project's financial viability, creditworthiness of the issuer, and market conditions before investing in revenue bonds. Diversifying your investment portfolio with a mix of bond types can help mitigate risks and optimize returns. Investors can also invest in Compound real estate bonds which offer 8.5% APY and flexibility to withdraw your funds anytime.
