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What Is a Revenue Bond?

A revenue bond is a type of municipal bond issued by state or local government entities to finance specific public projects. Unlike other types of government debt, the repayment of a revenue bond, including both interest payments and principal repayment, is derived solely from the revenues generated by the project it funds, rather than from general tax revenues. This distinguishes them within municipal finance as a form of self-supporting debt financing. These bonds are crucial for funding income-producing initiatives such as toll roads, airports, water and sewer systems, and hospitals.

History and Origin

The origins of revenue bonds can be traced to the early 20th century in the United States, emerging as a distinct financial instrument to fund public works without obligating general taxpayer funds. While general obligation bonds, backed by a government's taxing power, existed much earlier, the concept of linking debt repayment directly to specific project revenues gained prominence as municipalities sought alternative financing methods. A notable early example is the issuance of industrial revenue bonds. The state of Mississippi, through its "Balance Agriculture with Industry" program in 1936, authorized the first U.S. industrial revenue bonds, issued by the city of Durant to construct a factory.¹² This innovative approach allowed communities to attract or retain industry by offering tax-exempt financing tied to the revenue streams of the funded enterprise.¹¹ Over time, the use of revenue bonds expanded to encompass a wide array of infrastructure projects that generate dedicated income, providing a flexible tool for public development.

Key Takeaways

• Revenue bonds are municipal bonds whose repayment depends solely on the income generated by the specific project they finance.
• They are used to fund income-generating public projects such as toll roads, airports, utilities, and public housing.
• The bonds are generally considered tax-exempt from federal income tax, and often from state and local taxes for residents of the issuing state.
• A feasibility study is critical before issuing revenue bonds to assess the project's ability to generate sufficient income.
• Revenue bonds typically carry higher interest rates than general obligation bonds due to their reliance on a single revenue source.

Interpreting the Revenue Bond

Interpreting a revenue bond involves assessing the viability and reliability of the project's future income stream. Because repayment hinges entirely on these dedicated revenues, investors and analysts conduct extensive due diligence, often reviewing detailed feasibility study reports that project future user fees, tolls, or charges. The financial health of the enterprise generating the revenue is paramount; a project with stable, predictable cash flows is typically viewed more favorably than one subject to volatile market conditions or discretionary public use.¹⁰ Unlike general obligation bonds, the issuer's general taxing authority is not a backup for a revenue bond. Therefore, understanding the specific bond covenants that govern the collection and application of revenues, as well as any reserve fund requirements, is essential for evaluating the security of the investment.

Hypothetical Example

Imagine the City of Lakeside wants to build a new public parking garage near its bustling downtown area. The projected cost is $50 million. Instead of using general tax funds, the city decides to issue $50 million in parking garage revenue bonds.

Here’s how it works:

1. Issuance: The City of Lakeside's Public Works Authority issues the revenue bonds to investors. These bondholders provide the $50 million needed for construction.
2. Project Operation: Once built, the parking garage begins operations, charging hourly and daily fees for parking.
3. Revenue Stream: All parking fees collected from the garage form the dedicated revenue stream.
4. Repayment: These revenues are then used to make regular interest payments to the bondholders and to repay the original principal repayment when the bonds mature.

If the parking garage generates more revenue than expected, the bonds are well-covered. However, if fewer people use the garage, the revenue stream might be insufficient, posing a risk to bondholders. The success of this revenue bond is directly tied to the financial performance of the parking garage itself.

Practical Applications

Revenue bonds are widely used by state and local governments, as well as special authorities, to fund a diverse range of income-generating public projects. These applications span various sectors:

• Transportation Infrastructure: Toll roads, bridges, airports, and seaports are frequently financed by revenue bonds, with repayment coming from tolls, landing fees, or passenger facility charges.
• Public Utilities: Water, sewer, electric, and gas utilities issue utility revenue bonds, repaid by the charges for their services.,
  ⁹*⁸ Healthcare Facilities: Hospitals and nursing homes may issue hospital revenue bonds, with debt serviced by patient fees and other operational income.
• Higher Education: University dormitories, student unions, and athletic facilities can be financed by revenue bonds, paid for by student housing fees or facility charges.
• Housing Projects: Mortgage revenue bonds issued by housing finance agencies help fund affordable mortgages, with repayment linked to the mortgage payments.

⁷These bonds allow governments to undertake significant capital expenditures without burdening the general tax base, making large-scale infrastructure development more financially feasible. The Municipal Securities Rulemaking Board (MSRB) provides ongoing disclosure requirements for municipal securities, including revenue bonds, through its Electronic Municipal Market Access (EMMA®) website, ensuring transparency for investors.,

⁶#⁵# Limitations and Criticisms

Despite their utility, revenue bonds come with inherent limitations and criticisms, primarily stemming from their reliance on a single, often project-specific, revenue source. One significant drawback is the elevated default risk compared to general obligation bonds. If the project's revenues fall short due to lower-than-expected usage, economic downturns, or unforeseen operational issues, the ability to make scheduled interest payments and principal repayment can be jeopardized., So⁴me revenue bonds are "non-recourse," meaning bondholders have no claim on the issuing authority's general funds if the dedicated revenue stream fails.

A³nother criticism relates to the thoroughness of the initial feasibility study. Overly optimistic projections of demand or user fees can lead to financial distress for the project and its bondholders. While municipal bond defaults are generally rare, revenue bonds are more susceptible to the specific challenges of their underlying enterprise. For instance, a toll road bond may suffer if a new, free highway is built nearby, diverting traffic. Investors must carefully assess the project's economic fundamentals and the strength of the bond covenants that protect their interests.

Revenue Bond vs. General Obligation Bond

The primary distinction between a revenue bond and a general obligation bond lies in their repayment source and the backing provided by the issuing authority.

Confusion can arise because both are types of municipal bonds issued by government entities. However, the critical difference in their security—project-specific revenue versus general governmental taxing authority—makes them distinct in terms of credit rating and investor risk.

FAQs

What types of projects are typically funded by revenue bonds?

Revenue bonds commonly fund projects that generate their own income streams, such as toll roads, airports, public utilities (water, sewer, electricity), hospitals, public housing, and university dormitories.

A²re revenue bonds tax-exempt?

Yes, the interest earned on revenue bonds is generally tax-exempt from federal income tax. It may also be exempt from state and local taxes if the bondholders reside in the state or locality where the bond was issued.

What happens if a project funded by a revenue bond fails to generate enough revenue?

If a project's revenue falls short, the issuer may face difficulties making interest payments and principal repayment to bondholders. Unlike general obligation bonds, there is no recourse to the issuer's general tax fund. This can lead to default or restructuring of the debt.

H¹ow do investors assess the risk of a revenue bond?

Investors assess the risk of a revenue bond by scrutinizing the financial projections and feasibility study of the underlying project, evaluating the experience and management of the operating entity, and reviewing the specific bond covenants that protect bondholders. They also consider the bond's credit rating, though this should be just one factor in their analysis.