What it means
When a city, state or agency wants to build something that will earn money, it can raise the funds by issuing revenue bonds. The fees, tolls or charges paid by users go into a dedicated account, and that money is used to pay interest and repay the principal.
Bondholders look only to this income stream for repayment. The main contrast is with a general obligation bond, which is backed by the issuer's power to tax.
A revenue bond has no such backing, so a weak project can leave investors unpaid even if the issuer itself is wealthy. This is why investors read the project's forecasts closely.
Because of this extra risk, revenue bonds often pay slightly higher interest than comparable general obligation bonds. Investors assess the project's demand, pricing power and costs before buying.
They also compare the forecasts with the experience of similar projects. The bond documents usually contain protections.
These include a rate covenant (a promise to set charges high enough to cover the debt), a reserve fund for emergencies and a rule that debt must be paid before other costs are covered from the revenue. In the United States, interest on many municipal bonds is exempt from federal income tax, which lowers the interest rate the issuer must pay.
Tax treatment depends on the type of project and the rules of the investor's country, so this should always be checked. Tax treatment depends on the type of project and the rules of the investor's country, so this should always be checked.
Rating agencies and analysts focus on the debt service coverage ratio. A project that earns well above its annual repayments has a cushion if revenue falls.
A ratio close to the covenant level leaves little room for error.
In practice
Real-world examples
Example 1
A city water authority issues $50,000,000 of revenue bonds to replace old pipes. Water bills from households repay the bonds over 25 years. The authority sets rates each year at a level that keeps coverage above its covenant. Public hearings are held before any large increase.
Example 2
A regional airport sells revenue bonds to build a new terminal, backed by landing fees and passenger charges. When flights fall sharply during a downturn, coverage drops towards the minimum. The airport manager cuts costs and raises fees to protect investors. The reserve fund is not touched.
Example 3
A state university issues bonds to build student housing, repaid from rents. An investor compares the project's occupancy rates and rent levels with the debt payments. Occupancy of 95% gives comfortable coverage, while 70% would not. He decides to buy only a small amount.
Think of it
Imagine you buy a food truck by taking out a loan that can only be repaid using the money you earn selling burgers from that exact truck, leaving your personal savings account completely safe.
Formula
Calculation
Debt service coverage ratio = Net revenues / Annual debt service
Suppose a toll road earns $12,000,000 a year after paying operating costs, and the annual interest and principal on its bonds total $8,000,000. The coverage ratio is 12,000,000 / 8,000,000 = 1.5 times. If the bond terms require a minimum of 1.25 times, net revenues could fall to 8,000,000 x 1.25 = $10,000,000. That is a fall of 12,000,000 - 10,000,000 = $2,000,000, or 2,000,000 / 12,000,000 = about 16.7%, before the covenant is breached.Case study
Seen in the real world
Cardinal Bridge Authority is an illustrative, fictional public body that issued $120,000,000 of revenue bonds to build a toll bridge. Traffic forecasts predicted 15,000 vehicles a day at a $4 toll.
After opening, actual traffic was 11,000 vehicles a day because a competing free route was improved. Annual toll revenue was about 11,000 x 4 x 365 = $16,060,000 compared with a forecast of 15,000 x 4 x 365 = $21,900,000.
The shortfall pushed coverage below the covenant, and the authority had to raise the toll and draw on its reserve fund. In this illustrative story, bondholders were paid, but the bonds were downgraded and traded at a lower price until traffic recovered. The authority later published a clearer traffic report each year.
Watch out
Common mistakes
- Assuming a revenue bond is as safe as a general obligation bond, when its repayment depends on the project's income alone.
- Looking only at the issuer's credit rating, when the strength of the specific project matters more.
- Ignoring covenants and reserve funds, which are major protections for bondholders and shape the real level of risk.
Questions
People also ask
What is the difference between a revenue bond and a general obligation bond?
A revenue bond is repaid from the income of a specific project, while a general obligation bond is backed by the issuer's power to tax.
Are revenue bonds tax-free?
In some countries the interest on certain public bonds is exempt from income tax, but this depends on the project and the investor, so tax advice is needed. The official statement for each bond issue explains the position.
What happens if the project does not earn enough?
The issuer may be forced to raise charges or use reserves, and in the worst case bondholders may be paid late or take a loss.