What is Revenue Bonds?
Revenue bonds are bonds issued by municipal corporations where the revenue from income-producing projects such as toll bridge, highway, sewer facilities, airport construction, roads, local stadium are used in repaying the debt obligation (both interest and principal component). These are often issued by the government agency and revenue is backed by income generated from the projects. There are issues with a face value of 1000 & 5000 with semi-annual payments. Some are issues in the form of zero-coupon bonds.
Let’s Consider an Example
Peter invests in fixed income securities. He identifies that a local municipality is raising $10 million to finance the construction of the new bridge by issuing revenue bonds. After carefully evaluating the creditworthiness of the projects, he is quite confident that the project will be successful in generating sufficient revenue to repay the proceeds, he decides to buy it.
Characteristics of Revenue Bonds
#1 – Longer-Term in Nature
These bonds are used to fund long term projects, so the maturity date often ranges from 20 to 30 years. Interest and principal payments are both made after meeting the operating expenses of the projects. If the project does not generate enough funds, payment can be deferred to a later date.
#2 – Higher Return
They provide a higher return than the general obligation bonds since they are secured by the revenue generated from the project, there is a greater risk of non-payment of the promised return, so the investor is compensated with a higher return as compared to general obligation bond to attract them.
#3 – No Claim on Assets
Bondholders do not have any claim on the assets of the projects. If the projects do not turn out to be successful, bondholders cannot repossess the toll roads or equipment.
#4 – Issues with Call Provision
These bonds are issued with a catastrophe call provision, which allows the issuer to call back the bonds if the revenue-producing facility is destroyed.
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#5 – Insurance or Guarantee in Case of Default
Such bonds are exposed to credit, interest, call, and market risks similar to other class of debt. To avoid defaulting on its obligation, the issuer often provides insurance on their bonds. In some cases, federal agencies also provide a guarantee.
Revenue Bonds Types
- Industrial bonds finance public projects like parks, the stadium they will generate usage feed when booked for concerts, sports events, meetings.
- Airport bonds to fund construction of airports, landing fees, fuel fees, lease payments to secure the bonds.
- Public utility bonds which fund through the sale of electricity.
- Hospital bonds that fund hospital construction, renovation, equipment purchase.
- Highway bonds used to build revenue-producing facilities such as bridges and toll roads.
- Transportation bonds are issued to finance local public transportations such as buses, subway systems.
- Special tax bonds-generate funds by levying a tax on a particular activity or asset, for e.g., the special tax may be levied on the sale of alcohol or tobacco.
- Sewerage projects where cash is generated from usage fees, assessment fees, connection feed is used for paying bonds.
One of the advantages of investing in revenue bonds is that interest income is usually exempted from federal, state, or local taxes. So, it is quite beneficial for investors with a high-income tax bracket. Due to this advantage, it is popular in high tax rate states. Consider an investor with a total portfolio of $500000. He considering alternative ways of investment out of which he chooses two option below:
- Option 1 To purchase corporate bonds which provide a total annual yield of 7%, i.e., $35000
- Option 2 To purchase tax-free municipal bonds @yield of 5%, i.e., $25000 interest income per year.
If he chooses option 1, he is still liable to pay income tax of say 30%(applicable in that state), i.e., $10500, which reduces his interest income to $24500. However, in the latter case, he does not have to owe anything to tax authorities and can keep the full amount.
#1 – Municipal Bonds can be Considered Less Volatile
Short-duration bonds are lesser volatile, and their value does not frequently fluctuate as compared to bonds with longer duration. However, there is a trade-off between risk and reward where returns tend to lower for shorter maturity bonds.
#2 – Bondholders are Quite Emotionally Attached
When a bondholder buys a municipal bond which is used by the government or local authorities to finance hospital, school, or gymnasium in the locality, this helps to improve the lifestyle of an average person, so the bondholder does hold it until maturity
#1 – Higher Default Risks
Because they are not backed by full faith and credit of the municipality, they are subject to higher default risks as compared to general obligation bonds
#2 – Inflation Puts Downward Pressure on the Return
The inflation rate drastically impacts the returns generated from these bonds. However, variable-rate revenue bonds do offer some protection against inflation.
#3 – Tax Exemption Advantage can be Revoked
Pending tax legislation does impact the value of revenue bonds if the state or federal tax rate is reduced. In other words, these bonds provide maximum benefit to the high tax environment where a high tax bracket individual gets tax exemption advantage. As an exemption, these tax exemption advantages provided to revenue bonds can be revoked by an IRS.
Key Points to Remember
- Rating agencies rate these bonds based on their abilities to pay back interest and principal. They also evaluate the cash-generating ability of the projects.
- Mutual funds and municipal bonds investment trust are the most common way to invest in revenue and other forms of municipal bonds.
- Just like normal bonds, revenue bonds are inversely related to interest rate, i.e., price falls are interest rate rise and vice versa.
- These bonds may be issued in the form of a staggered maturity date and are known as serial bonds.
- They differ from general obligation bonds which do not invest in income-generating projects but provide service to the entire community whereas projects funded by such bonds only charge those community which pays for the service.
- The lower the tax bracket more favorable corporate bonds investment as the tax charges increase. Municipal bonds appear more attractive.
Revenue bonds make up the vast majority of municipal bonds. Investors willing to buy these bonds must know the varieties available, as well as how the project will produce the promised return on a consistent basis.
This has been a guide to What is Revenue Bonds & its Definition. Here we discuss the revenue bond types and characteristics along with the example, advantages, and disadvantages. You can learn more about from the following articles –