What it means
When a city or public authority needs to fund a project like a new water treatment plant, it can issue revenue bonds. These bonds are not backed by general taxes.
Instead, the issuer pledges the income from the project or system, such as customer water bills. The key word is net.
A net revenue pledge means bondholders are paid from revenue after the operating and maintenance costs of the system have been deducted. In effect, the utility must first pay for staff, power and repairs, and only the remaining cash is available for debt service.
This puts bondholders in a weaker position than a gross revenue pledge, where they are paid first and costs come second. Because they stand behind operating costs, investors usually expect a higher yield or stronger protections.
The most common protection is a rate covenant, which requires the issuer to set charges high enough that net revenues exceed the annual debt payments by a stated margin. Analysts measure the strength of the pledge using the debt service coverage ratio.
A ratio above 1.0 means net revenues exceed the amount due, and covenants often require a cushion such as 1.2 or 1.25 times. Weaker coverage may restrict the issuer from borrowing more.
The nuance is that the definition of net revenue sits in the bond documents and can vary. Some documents allow certain costs to be excluded or add in other income, so the same utility could report different net revenue under different agreements.
Investors therefore read the legal definition carefully. For a non-specialist, the practical lesson is that a revenue bond is only as good as the business behind it.
A water system with a steady customer base and the power to raise prices is a stronger credit than a new toll road with uncertain traffic. Investors therefore study demand, pricing power and the cost base before they look at the yield on offer.
In practice
Real-world examples.
Example
A regional airport authority issues $80,000,000 of bonds backed by net revenues from landing fees and parking. After costs, it has $9,000,000 available and owes $6,000,000 a year in debt service. Coverage is 1.5 times, which satisfies the covenant comfortably.
Example
A municipal electricity utility needs to rebuild a substation. Its bond documents require it to raise customer tariffs if net revenues drop below 1.2 times debt service. When fuel costs rise, the board approves a 4% tariff increase to protect the pledge.
Example
A toll road operator pledges net revenues to repay a $200,000,000 loan. After a year of lower traffic, net revenue is $14,000,000 against $12,500,000 of debt service. The 1.12 times coverage prompts the lender to ask for a management plan.
Formula
Calculation
Net revenues = gross revenues - operating and maintenance expenses
Debt service coverage = net revenues / annual debt service
A city water utility collects gross revenues of $10,000,000 in a year and spends $6,000,000 on operating and maintenance expenses. Net revenues = $10,000,000 - $6,000,000 = $4,000,000. Annual debt service on its revenue bonds is $3,200,000, so coverage = $4,000,000 / $3,200,000 = 1.25 times. If the covenant requires 1.25 times, the utility has no room to spare, and a $500,000 fall in revenue would breach it.Case study
Seen in the real world.
Eastbrook Water Authority is a fictional utility, and this illustrative story shows how a pledge works in practice. It issued $50,000,000 of revenue bonds under a net revenue pledge with a covenant requiring 1.3 times coverage. In its first year, net revenues of $5,200,000 covered debt service of $3,500,000 about 1.49 times.
Two years later, a cold winter damaged pipes, raising maintenance costs by $1,000,000 and cutting net revenues to $4,300,000. Coverage fell to 1.23 times, below the covenant. The board raised the average customer charge by 3%, adding $600,000, which lifted coverage back to 1.4 times and avoided a default event.
Watch out
Common mistakes.
- Confusing a net revenue pledge with a gross revenue pledge. Under a gross pledge, bondholders are paid before operating costs, which gives them stronger protection.
- Treating revenue bonds like general obligation bonds. General obligation bonds rely on the issuer's taxing power, while revenue bonds rely only on the enterprise's income.
- Ignoring the rate covenant. It is the main tool that forces the issuer to adjust prices when coverage weakens.
Questions
People also ask.
What is a good coverage ratio?
It depends on the sector and the covenant, but a figure comfortably above the required minimum is a positive sign for investors.
Who sets the definition of net revenues?
The bond documents, usually in a trust indenture or resolution, define exactly which items count.
Can an issuer borrow more against the same revenue?
Often yes, if it meets an additional bonds test showing that coverage will remain adequate.
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