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Course 209
Revenue Bonds

Introduction

Revenue bonds make up the vast majority of municipal bonds. They are available in a variety of issues, with each issue varying by what it finances. Investors who want to buy revenue bonds need to know the varieties on the market, as well as how the projects they fund will produce income.

What Are Revenue Bonds?

Revenue bonds are municipal bonds that are secured by specific income of the issuer. The method of securing the loan is what distinguishes them from their municipal cousins, the general obligation bonds (or GO bonds). GO bonds are secured by the full faith and credit of the municipality that issues them.

States, cities, and municipal subdivisions issue municipal bonds. Their purpose is to fund municipal projects, such as housing, hospitals, lighting systems, parking ramps, stadiums, factories, sewer systems, and dozens of other community enterprises. Revenue bonds are municipal bonds that finance income-producing projects. The income generated by these projects pays revenue bondholders their interest and principal. Projects funded by revenue bonds serve only those in the community who pay for their services. GO bonds, in contrast, finance projects that do not produce income but provide services for the entire community.

Most revenue bonds are sold in $5,000 units and mature in 20 to 30 years. However, not all the bonds in the issue mature at the same time; they may have staggered maturity dates. Bond issues with staggered maturity dates are known as serial bonds.

Income from a municipal enterprise is put into a revenue fund. From this fund, expenses for operations are paid first. Only after operations expenses are paid do revenue bondholders receive their payments.

Because they are not backed by the full faith and credit of a municipality as are general obligation bonds, they carry a somewhat higher default risk for which they offer higher interest rates.

Revenue Bond Security

Unlike unsecured general obligation bonds, revenue bonds are secured by specific collateral--the income produced by the projects they fund. The revenues (fees, tolls, concessions, rent, etc.) produced by the projects are used to pay investors. Revenue bonds are not paid by taxes as general obligation bonds are.

Some municipal projects receive additional funding from endowments. The interest from these endowments is sometimes used as revenue bond collateral. Revenue bonds offer higher interest than do general obligation bonds. This is due to the fact that the income from the projects they fund cannot be predicted with certainty. This adds to the perception of lower safety. If the projects do not produce enough revenue, the bonds may default. In that case, the issuer will defer payments to bondholders.

Investors who are willing to risk the possibility of default may choose revenue bonds over general obligation bonds. Some investors protect themselves from default by insuring their revenue bonds.

Ratings firms rate revenue bond issuers for their ability to pay back interest and principal. Bond analysts study the issuers' ability to produce income sufficient to make payments to investors. They also evaluate the cash flow of the income sources, since the success of the bonds ultimately depends on the projects' ability to produce revenue.

Types of Revenue Bonds

The types of municipal revenue bonds are as numerous as the kinds of projects they are used to fund. As you can see, most of them are named for the projects that they finance. Here are the major types:

  • Airport revenue bonds fund the construction of airports. Landing fees, fuel fees, and lease payments secure these bonds.
  • Industrial revenue bonds finance public projects such as factories, industrial parks, and stadiums. Fees, concessions, and lease payments provide the backing.
  • Public power revenue bonds pay for power plants. The sale of electricity provides the revenues.
  • Hospital revenue bonds fund construction and renovation of hospitals and the buying of equipment. Hospital revenues, such as those from Medicare, are used to repay bondholders.
  • Housing revenue bonds fund the construction of housing. They may cover single-family or multi-family housing units. Mortgage payments are the security. New Housing Authority bonds finance low-income housing.
  • Student loan revenue bonds finance loans taken by college and university students.
  • Transit revenue bonds pay for public transportation. Fares and government subsidies secure them.
  • Water revenue bonds finance water and sewer projects. Connection fees and usage fees provide the revenues.
  • Highway revenue bonds are used to build revenue-producing facilities such as bridges and toll roads.
  • Toll road bonds are a sub-type, the revenues of which come from tolls. Gas tax revenue bonds are another sub-type of highway revenue bonds. Gas taxes, license fees, and other non-toll sources secure them.
  • Special tax bonds are backed by excise taxes such as those on cigarettes and alcohol. They may also be backed by special assessments on those who will benefit directly from a particular project.
  • College and university revenue bonds finance the construction of centers of higher learning. Bondholder payments include dorm fees and tuition payments.
  • Double-barreled bonds receive backing from both revenue and the municipality's creditworthiness. They are a hybrid, and they may finance a variety of projects.

Revenue Bonds Finance Revenue-Paying Projects

Revenue bonds are municipal bonds that are collateralized by revenue produced by the projects they fund. Because they are not backed by the full faith and credit of a municipality, the way general obligation bonds are, they carry a somewhat higher default risk, but pay higher yields in return. To evaluate a revenue bond, it is important to understand the type and cash flow of the project that will be providing the revenue.

For more information on municipal bonds in general, and about their tax advantages, consult Investing Classroom's other bond courses.

Quiz 209
There is only one correct answer to each question.

1 Revenue bondholders receive their interest and principal payments from…
a. Taxes.
b. Municipal stock.
c. Project income.
2 In order to assess a project's ability to repay bondholders, which part of the project do bond analysts study?
a. Plans
b. Cash flow
c. Completion time
3 What are revenue bonds that include backing by a municipality's credit called?
a. Special tax bonds
b. General obligation bonds
c. Double-barreled bonds
4 Factories are likely to be financed by which of the following type of revenue bond?
a. Industrial
b. Public power
c. Special tax
5 Which of the following does NOT secure a revenue bond?
a. Fees
b. Tolls
c. Income taxes
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