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-couponZero-couponIn contrast to a typical coupon-bearing bond, a zero-coupon bond (also known as a Pure Discount Bond or Accrual Bond) is a bond that is issued at a discount to its par value and does not pay periodic interest. In other words, the annual implied interest payment is included into the face value of the bond, which is paid at maturity. As a result, this bond has only one return: the payment of the nominal value at maturity. bonds.
Let’s Consider an Example
Peter invests in fixed income securitiesFixed Income SecuritiesFixed income investment is a type of investment in which the investor receives a fixed and relatively stable stream of income in the form of dividends or interest over a period of time. Companies and governments typically issue fixed investments in the form of debt 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.
- 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 trustInvestment TrustAn investment trust is a publicly traded financial institution that operates as a closed-end fund (CEF) and invests in shares or financial assets on behalf of its investors or other organizations. The value of the amount of money invested in an investment trust is dependent by the demand and supply for the invested share or financial asset, as well as the underlying value of the assets owned. 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 bondsGeneral Obligation BondsGeneral Obligation Bonds are a type of bond that is supported or guaranteed by agencies like municipalities where repayments are prompt and have very low default rates as municipals are authorized by the government to increase the tax amount that is receivable from the public to pay off the dues and debts associated with the repayments to the investors. 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.
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 expensesOperating ExpensesOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit. 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 bondsGeneral Obligation BondsGeneral Obligation Bonds are a type of bond that is supported or guaranteed by agencies like municipalities where repayments are prompt and have very low default rates as municipals are authorized by the government to increase the tax amount that is receivable from the public to pay off the dues and debts associated with the repayments to the investors. 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 bondsBondsA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually. if the revenue-producing facility is destroyed.
#5 – Insurance or Guarantee in Case of Default
Such bonds are exposed to credit, interest, call, and market risksMarket RisksMarket risk is the risk that an investor faces due to the decrease in the market value of a financial product that affects the whole market and is not limited to a particular economic commodity. It is often called systematic risk. 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 paymentsLease PaymentsLease payments are the payments where the lessee under the lease agreement has to pay monthly fixed rental for using the asset to the lessor. The ownership of such an asset is generally taken back by the owner after the lease term expiration. 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 levyingLevyingA levy is a lawful process where the debtor's property is seized when the debtor cannot pay the outstanding debts. It is different from liens, as a lien is only a claim against a property, whereas a levy is an actual property takeover to fulfill the obligation. 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 incomeInterest IncomeInterest Income is the amount of revenue generated by interest-yielding investments like certificates of deposit, savings accounts, or other investments & it is reported in the Company’s income statement. 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 bondsCorporate BondsCorporate Bonds are fixed-income securities issued by companies that promise periodic fixed payments. These fixed payments are broken down into two parts: the coupon and the notional or face value. which provide a total annual yield of 7%, i.e., $35000
- Option 2 To purchase tax-free municipal bondsMunicipal BondsA municipal bond is a debt security issued by a national, state, or local authority to finance capital expenditures on public projects related to the development and maintenance of infrastructures such as roads, railways, schools, hospitals, and airports. @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 exemptionTax ExemptionTax-exempt refers to excluding an individual's or corporation's income, property or transaction from the tax liability imposed by the federal, local or state government. These exemptions either allow total relief from the taxes or provide reduced rates or charge tax on some items only. advantages provided to revenue bonds can be revoked by an IRS.
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 –