What it means
Cities and public utility districts often need large sums to build treatment plants, pipes or power lines. Instead of raising taxes, they sell bonds and promise to repay investors with the money collected from customers.
The bonds are secured by net revenues, which are the revenues left after paying day-to-day operating costs. This differs from a general obligation bond, which is backed by the government's power to tax.
A revenue bond is only as good as the project's income, so investors look closely at the customer base, the rates charged and the cost of running the system. A growing area with a stable customer base is a strong sign, while a shrinking one is a warning.
The key test is the debt service coverage ratio, which compares net revenues with the annual payments of principal and interest. A ratio above 1.0 means the system earns more than it owes.
Bond documents often include a rate covenant, a promise to set customer charges high enough to keep the ratio above a stated level, such as 1.25 or 1.5 times. Many utility revenue bonds issued by public bodies pay interest that is free of federal income tax for investors, so the issuer can pay a lower interest rate than a business could.
This helps keep customer charges down. The tax treatment depends on the use of the funds and the rules at the time, so investors and issuers check it for each issue.
Bond documents also contain protections for holders. These include a reserve fund that holds a cushion of cash, limits on issuing more debt that ranks equally and requirements to keep the system insured and maintained.
Finance staff at the utility must report on these obligations regularly. For a non-specialist, a utility revenue bond is a useful example of how a project can be financed by its own income.
It also shows why rates for water and power change: the bond promises mean the utility cannot simply cut charges if it needs the money to cover debt payments.
In practice
Real-world examples.
Example
A town issues $40,000,000 of revenue bonds to replace ageing sewer pipes. Residents' sewer charges are the only source of repayment, so the town council raises rates by 4% a year for five years to meet its promise.
Example
A pension fund considers buying bonds issued by a public electricity authority. Its analyst studies the number of customers, the cost of fuel and the coverage ratio before deciding how much to invest.
Example
A regional water district plans to build a $25,000,000 treatment plant. Its finance team models different rate levels to ensure that revenues will cover both running costs and debt payments.
Formula
Calculation
Debt service coverage ratio = net revenues / annual debt service
Suppose a city water system collects $12,000,000 from customers in a year and spends $7,500,000 on operations and maintenance. The net revenues are 12,000,000 - 7,500,000 = $4,500,000. The annual debt service on its bonds is $3,000,000. The coverage ratio is 4,500,000 / 3,000,000 = 1.5 times. If the bond documents require 1.25 times, the system has a comfortable margin, because net revenues could fall to 1.25 x 3,000,000 = $3,750,000 before the covenant is broken.Case study
Seen in the real world.
Clearwater Valley Water Authority is an illustrative, fictional public body that wants to borrow $30,000,000 to upgrade its treatment works. The authority issues revenue bonds secured by customer income and agrees to keep its coverage ratio above 1.3 times.
In the first year, a drought cuts water use and net revenues fall to $4,200,000, while debt service is $3,500,000. The ratio drops to 4,200,000 / 3,500,000 = 1.2 times, below the covenant.
In this illustrative story the authority's board must raise customer rates by 8% to restore the ratio. The finance director explains that the rate rise is not a choice but a legal promise made to investors, and she builds a larger reserve for future dry years.
Watch out
Common mistakes.
- Treating a revenue bond like a general obligation bond, when it is repaid only from the project's income and not from taxes.
- Looking only at last year's coverage ratio, when falling demand or rising costs can reduce it quickly.
- Assuming interest on every public bond is tax-free, when the treatment depends on the use of the funds and the rules that apply.
Questions
People also ask.
What is a rate covenant?
It is a promise to set charges high enough to keep net revenues above a stated multiple of debt payments.
How is a revenue bond different from a general obligation bond?
A revenue bond is paid from the project's income, whereas a general obligation bond is backed by the government's power to tax.
Why do customers' bills rise after a bond issue?
Because the authority must collect enough to pay the debt as well as running costs.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%Related