What Is Parity Bonds?
Parity bonds are debt instruments that hold equal claim or seniority to a specific revenue stream or general obligation of an issuer. This concept is particularly common in the context of Fixed Income Securities, especially within the Municipal Bonds market. When bonds are issued on a parity basis, it means that all bondholders of that specific issue, or series of issues, have an equivalent legal right to the pledged revenues or assets, without any one series having a superior claim over another. This equal standing applies to the payment of both interest and the return of Principal. The structure of parity bonds ensures that no single bond series can be paid before another from the designated revenue source, reinforcing a level playing field among investors in these obligations.
History and Origin
The concept of parity in bond structures has evolved alongside the development of public finance and the increasing complexity of municipal and corporate debt issuance. Historically, as governmental entities and corporations began to issue multiple series of Bonds to fund various projects over time, the need to clarify the ranking of these claims became essential for investor confidence. Early bond indentures and state statutes began to define the terms under which new debt could be issued on par with existing debt. This often involved meeting specific financial ratios or conditions to ensure that the issuer's capacity to pay was not unduly strained by additional debt. The Securities and Exchange Commission (SEC) has long emphasized the importance of transparent disclosure in the municipal securities market, which includes clear information about the seniority and parity of bond issues to help investors make informed decisions.4
Key Takeaways
- Parity bonds share an equal claim on an issuer's pledged revenues or assets.
- They are frequently found in the municipal bond market, particularly with general obligation and revenue bonds.
- This structure ensures that no specific bond series has a superior legal right to repayment over others from the same revenue source.
- For investors, parity signifies that all bondholders with parity claims are treated equally in terms of repayment priority.
- The terms establishing parity are typically detailed in the bond's official statement and Bond Covenants.
Interpreting Parity Bonds
Understanding parity bonds is crucial for assessing the security of an investment. When bonds are on parity, it means that if the issuer encounters financial difficulties, all bondholders with a parity claim will share equally in the available revenue or assets. No single group of parity bondholders will receive preferential treatment. For example, if a city issues several series of General Obligation Bonds, and all are designated as parity bonds, they all have an equal claim on the city's general taxing power. This contrasts with situations where debt might be structured with different levels of Credit Risk or seniority. Investors evaluating parity bonds must still consider the overall financial health of the issuer, as equal claim does not mitigate the risk of a collective shortfall.
Hypothetical Example
Consider the City of Evergreen, which decides to finance several infrastructure projects over a decade. In 2010, Evergreen issues Series A Revenue Bonds to fund a new water treatment plant, pledging the revenues from water utility fees. The bond covenants state that any future bonds issued for water system improvements may be on parity with Series A, provided certain financial conditions are met.
In 2018, Evergreen needs to upgrade its water distribution network and issues Series B Revenue Bonds. Before issuance, the city's financial advisor confirms that the water utility's revenues meet the debt service coverage ratio required by the Series A covenants for parity issuance. As a result, both Series A and Series B are designated as parity bonds. This means that if the water utility's revenues were to decline, reducing the funds available for debt service, both Series A and Series B bondholders would have an equally strong legal claim to those diminished revenues. Neither group would be paid before the other; rather, they would share the available funds on a pro-rata basis based on their outstanding principal amounts.
Practical Applications
Parity bonds are most commonly observed in the issuance of municipal debt, particularly for large, ongoing infrastructure projects or general funding needs. State and local governments often rely on these structures to finance public works such as schools, hospitals, water systems, and transportation networks. For instance, a municipal utility might issue multiple series of revenue bonds over time to fund expansions, all secured by the same utility system's revenues and operating on a parity basis. This approach allows issuers to access capital markets incrementally without continuously needing to subordinate new debt, which could increase borrowing costs. Financial institutions serving as Underwriter for these issues play a role in structuring these agreements. During periods of market distress, like the COVID-19 pandemic, the ability of state and local governments to access financing via the municipal bond market was supported by facilities such as the Municipal Liquidity Facility established by the Federal Reserve, which underscored the systemic importance of these markets for local economies.3
Limitations and Criticisms
While parity bonds offer an equal claim for bondholders, they are not without limitations. The primary criticism revolves around the fact that, even with parity, the total debt burden on the issuer can grow, potentially increasing the overall Default Risk. If the pledged revenue stream or general obligation capacity becomes insufficient to cover all parity debt, all parity bondholders face the same proportional loss, rather than one group being insulated. This collective exposure can be a significant concern for investors, especially if an issuer takes on excessive debt or faces unexpected economic downturns or natural disasters. For example, municipalities heavily reliant on specific revenue sources may face increased financial strain if those sources are impacted by long-term shifts, such as those related to climate change.2 Furthermore, while parity terms dictate the legal claim, practical recovery in a default scenario can still be complex and protracted. Investors should also be aware of other risks, such as Interest Rate Risk, which affects the market value of bonds regardless of their seniority.1
Parity Bonds vs. Senior Bonds
The distinction between parity bonds and Senior Bonds lies in their relative priority of claim on an issuer's revenues or assets. Parity bonds indicate that all obligations within a specific class or series have an equal and undifferentiated claim to the pledged revenue source. No bond within that parity group has a superior right of payment over another; they are treated as equals. In contrast, "senior bonds" (or senior debt) refer to debt that has a higher claim to an issuer's assets and income than other types of debt, often referred to as subordinated or junior debt. If an issuer has both senior and subordinated debt outstanding, the senior bondholders would be paid in full before any payments are made to the subordinated bondholders in the event of default. Parity bonds, therefore, define equality among themselves, whereas senior bonds define superiority over other, lower-ranked debt. It is possible for parity bonds to collectively be "senior" to other forms of debt, but the key characteristic of parity is the equal standing among all bonds in that specific series or group.
FAQs
What does "parity" mean in the context of bonds?
In the context of Bonds, parity means that multiple bond issues or series have an equal and shared legal claim on the issuer's designated revenue stream or general taxing power. This ensures that no single bond issue within the parity group has a superior right to payment over another.
Are parity bonds safer investments?
The safety of parity bonds depends on the overall financial health and stability of the issuer. While parity ensures equal treatment among bondholders with that specific claim, it does not eliminate the Default Risk if the issuer's financial capacity declines. A strong Credit Rating for the issuer generally indicates lower risk.
How does parity affect the yield of a bond?
The Yield of a parity bond is influenced by the issuer's creditworthiness, prevailing market interest rates, and the bond's Maturity, similar to other bonds. The parity feature itself does not directly dictate a higher or lower yield compared to non-parity bonds, but rather defines the bond's standing relative to other debt issued by the same entity.
Can new bonds be issued on parity with existing bonds?
Yes, new bonds can be issued on parity with existing bonds, provided the issuer meets specific conditions outlined in the original bond covenants. These conditions often include tests related to the issuer's financial performance and debt service coverage ratios, ensuring that the additional debt does not unduly impair the ability to repay existing parity obligations.