What Is a Revenue Bond?
A revenue bond is a type of municipal bond issued by state or local governments, or their authorized agencies, to finance specific capital projects or enterprises. Unlike other forms of public debt, the principal and interest payments of a revenue bond are exclusively repaid from the revenues generated by the project it funds. This makes revenue bonds a distinct instrument within municipal finance, as their viability and repayment depend directly on the success and income stream of the underlying venture. This dedicated revenue stream could come from tolls on a bridge, user fees from a water utility, or lease payments from a hospital.
History and Origin
The concept of revenue bonds, though formalized later, has roots in the financing of public infrastructure. While the earliest U.S. municipal bonds were often general obligation bonds backed by taxing power, revenue bonds gained significant traction through the 20th century. Their popularity grew because they allowed public entities to bypass voter referenda often required for general obligation debt and provided investors with a clearer, project-specific source of repayment. A key period for the innovation and expansion of revenue bonds was during the Great Depression. States began using these bonds to finance various projects, notably Mississippi's issuance of the first "industrial development bonds" (IDBs) to fund private ventures with public purposes, marking a significant evolution in their application.4
Key Takeaways
- Revenue bonds are a category of municipal bond used for project financing where repayment is tied solely to the revenues generated by the funded project.
- They are distinct from general obligation bonds, which are backed by the issuer's full taxing power.
- Common projects financed by revenue bonds include toll roads, airports, water and sewer systems, and public utility facilities.
- The credit risk of a revenue bond is primarily linked to the operational success and financial health of the specific project.
- Interest income from many revenue bonds is tax-exempt at the federal level, and potentially at state and local levels for in-state investors.
Interpreting the Revenue Bond
Interpreting a revenue bond involves a thorough analysis of the underlying project's financial projections, operational stability, and legal covenants. Investors assess the feasibility study of the project to understand its potential to generate sufficient revenue to cover debt service. Factors such as projected user demand, pricing power (ability to raise fees or tolls), and competitive landscape are critical. Bond covenants, which are legally binding agreements between the issuer and bondholders, often outline requirements for maintaining reserves, setting rates, and restricting additional debt. A strong bond rating for a revenue bond typically indicates confidence in the project's ability to generate consistent and adequate cash flow.
Hypothetical Example
Imagine the City of Lakeside wants to build a new bridge connecting two growing areas, aiming to alleviate traffic and foster economic development. To fund this $100 million project, the city decides to issue revenue bonds. Instead of using general tax revenues, these bonds will be repaid solely by the tolls collected from vehicles using the new bridge.
The city's financial authority conducts a feasibility study, projecting daily traffic volume, potential toll rates, and operating expenses. Based on these projections, they determine that the anticipated toll revenue will be sufficient to cover the annual principal and interest payments on the $100 million revenue bond issue over 30 years. Investors evaluating this investment would scrutinize these traffic and revenue forecasts, understanding that their return depends entirely on how many drivers use the new bridge and pay the tolls. If traffic is lower than expected, or maintenance costs are higher, the repayment capacity of the revenue bond could be jeopardized.
Practical Applications
Revenue bonds are widely used to finance self-supporting public enterprises and infrastructure projects. Their utility extends across various sectors where a dedicated stream of income can be established. Common applications include:
- Transportation: Toll roads, bridges, tunnels, airports, and seaports (repaid by tolls, landing fees, or user charges).
- Utilities: Water and sewer systems, electric power plants, and gas distribution networks (repaid by utility service fees).
- Healthcare: Hospitals and medical facilities (repaid by patient fees and operational income).
- Education: University dormitories and student unions (repaid by dormitory fees, tuition, or other student charges).
- Recreation: Sports stadiums, convention centers, and public parking garages (repaid by ticket sales, parking fees, or facility rentals).
The Securities and Exchange Commission (SEC) provides guidance on municipal bonds, including revenue bonds, outlining that they are repaid from specific project revenues or sources like highway tolls or lease fees.3
Limitations and Criticisms
While revenue bonds offer distinct advantages for debt financing specific projects, they come with inherent limitations and criticisms. The primary concern is that their repayment hinges entirely on the success of the particular project they fund. If the project's revenues fall short of projections due to economic downturns, unexpected competition, construction delays, or mismanagement, bondholders face the risk of default. This contrasts with general obligation bonds, which are typically backed by the full faith and credit of the issuing municipality, allowing them to tap into a broader tax base for repayment.
Historically, some notable municipal bond defaults have involved revenue bonds. For instance, the Washington Public Power Supply System (WPPSS) default in 1983, often referred to as "Whoops," involved bonds issued to finance nuclear power plants, with repayment tied to the sale of electricity from these plants.2 When some projects were abandoned due to cost overruns and declining demand, the projected revenue streams evaporated, leading to the largest municipal bond default at the time. Research by the Federal Reserve Bank of New York indicates that default rates for unrated municipal bonds, particularly certain types of revenue bonds like industrial development bonds (IDBs), can be significantly higher than widely cited figures for the overall municipal bond market, suggesting that project-specific risks are a critical factor.1 Investors must conduct thorough due diligence, assessing the project's viability, management expertise, and the legal strength of the bond's revenue pledge, as a revenue bond generally carries a higher credit risk compared to a general obligation bond.
Revenue Bond vs. General Obligation Bond
The fundamental difference between a revenue bond and a general obligation bond lies in the source of repayment and the security pledged to bondholders.
| Feature | Revenue Bond | General Obligation Bond |
|---|---|---|
| Repayment Source | Revenues generated solely by the funded project (e.g., tolls, user fees) | Issuer's general taxing power and full faith and credit |
| Security | Specific project revenues, often with reserve funds | Full faith and credit, backed by broad tax revenues (property, sales) |
| Voter Approval | Often not required, as debt is self-supporting | Frequently requires voter approval or referendum |
| Risk Profile | Higher, as it depends on project success; project-specific risk | Lower, backed by the broader financial health of the municipality |
| Yield | Typically offers a higher yield due to higher risk | Generally offers a lower yield due to lower risk |
Confusion can arise because both are types of municipal bonds issued by governmental entities for public purposes. However, their distinct repayment mechanisms lead to different risk profiles and, consequently, different yields for investors. Revenue bonds are more akin to corporate project finance, where the success of a venture determines the investor's return, whereas general obligation bonds rely on the governmental entity's ability to tax its residents.
FAQs
What types of projects are typically financed by revenue bonds?
Revenue bonds commonly finance projects that generate a dedicated stream of income, such as toll roads, bridges, airports, water and sewer systems, public power facilities, hospitals, and convention centers. These projects are designed to be self-sufficient, with their own user fees or charges covering the bond's debt financing.
Is the interest on a revenue bond always tax-exempt?
While a significant advantage of many revenue bonds is their tax-exempt status at the federal level, and sometimes at the state and local levels for residents of the issuing state, not all are. The tax-exempt status depends on the specific purpose of the bond and compliance with federal tax regulations. Some revenue bonds, particularly those benefiting private entities, may be taxable.
What happens if a project funded by a revenue bond does not generate enough revenue?
If a project financed by a revenue bond fails to generate sufficient revenue, the bondholders face the risk of delayed interest payments or even default on principal repayment. Unlike general obligation bonds, the municipality's general taxing power typically does not back revenue bonds, meaning there is no recourse to broader tax revenues. This highlights the importance of assessing the credit risk of the specific project.
How do credit ratings apply to revenue bonds?
Bond rating agencies assign credit ratings to revenue bonds based on an assessment of the project's financial strength, its ability to generate consistent revenues, the legal protections for bondholders, and the overall economic environment. A higher credit rating indicates a lower perceived risk of default and typically results in a lower yield for investors.