Revenue Bonds

Revenue Bonds are a special type of municipal bond used by state and local governments to finance income-producing projects. Unlike their more famous cousins, general obligation bonds (GO bonds), revenue bonds are not backed by the government's full taxing power. Instead, they are secured solely by the revenue generated from the specific project they fund—think tolls from a new bridge, ticket sales from an airport, or utility bills from a water treatment plant. If the project fails to make enough money, bondholders might not get paid, and they can't ask the government to raise taxes to cover the shortfall. This direct link between a project's financial success and an investor's return makes analyzing revenue bonds feel more like analyzing a business than a government entity. For this reason, they typically offer a higher yield to compensate for the added risk.

The mechanics are refreshingly straightforward. A public entity, like a port authority or a university, identifies a need for a new capital project—say, expanding a container terminal. To raise the money, it issues revenue bonds to investors. The proceeds from the bond sale are used to build the terminal. Once operational, the fees collected from shipping companies using the new terminal are placed in a dedicated fund. This money is then used to pay the semi-annual interest and eventual principal back to the bondholders. The entire process is governed by a legal contract called a trust indenture, which spells out the rights of the bondholders and the obligations of the issuer, including how the revenue must be handled.

This is a classic matchup of security versus yield. Understanding the difference is crucial for any bond investor.

• Backing: GO bonds are backed by the government's “full faith and credit,” meaning its ability to levy taxes on the public to pay its debts. Revenue bonds are backed only by the specific project's revenue.
• Risk: GO bonds are generally considered much safer because the government's taxing power is a very reliable backstop. Revenue bonds carry project risk—if the toll road is a ghost town, your investment is in trouble.
• Yield: To compensate for that higher risk, revenue bonds almost always offer a higher interest rate (yield) than GO bonds from the same issuer.
• Voter Approval: Issuing GO bonds often requires voter approval since it pledges future tax revenues. Revenue bonds usually don't, making them a more flexible financing tool for governments.

For a value investor, revenue bonds are fascinating. They require you to roll up your sleeves and analyze the underlying “business” of the project. Your return depends on its operational success, not just a government promise.

This is where the real work lies. Before investing, you must scrutinize the project's economic viability as if you were buying the whole business.

• Essentiality: Is the project a critical piece of infrastructure? A bond for a municipal water and sewer system (an essential service with a captive customer base) is fundamentally safer than one for a new convention center that competes with three others in the region.
• Demand & Competition: For a toll road, you'd want to see independent traffic studies, population growth projections, and the availability of free alternative routes. For a university hospital, you'd look at local demographics, the quality of its medical programs, and the presence of other major hospitals.
• Management: Who is running the show? An experienced and competent management team is crucial for the project's long-term success.

The trust indenture contains promises, or covenants, designed to protect bondholders. These are your safety net and must be read carefully.

• The Rate Covenant: This is a crucial pledge by the issuer to set rates and fees high enough to cover all operating expenses and debt payments. In short, it's a promise to run the project like a business and not give the service away for free.
• The Debt Service Coverage Ratio (DSCR): This is the single most important metric for gauging the safety of a revenue bond. It's calculated as the project's net revenue (after operating expenses) divided by its total debt payments (principal and interest).
  1. Formula: DSCR = Net Operating Revenue / Total Debt Service
  2. A DSCR of 1.0x means the project is generating just enough cash to pay its debts. A value below 1.0x signals big trouble. A healthy project will have a DSCR of 1.25x or higher, providing a comfortable cushion. The trust indenture will often require the issuer to maintain a minimum DSCR.

Weighing the pros and cons is key to deciding if revenue bonds fit in your portfolio.

• Higher Yields: As mentioned, you're typically paid more for taking on project-specific risk compared to the safer GO bonds.
• Tax Advantages: Like most municipal bonds, the interest income from revenue bonds is usually exempt from federal income tax. If you buy a bond issued in your home state, it's often exempt from state and local taxes too, making them especially attractive for investors in high tax brackets.

• Project Failure: This is the primary risk. If the project is poorly conceived, badly managed, or faces unexpected competition, it may not generate enough revenue. In a worst-case scenario, the issuer could default on the bonds.
• Economic Downturns: A recession can hit project revenues hard. Fewer people traveling means less income for airports and toll roads. A housing crash could reduce fees for new water hookups.
• Interest Rate Risk: This affects all fixed-income investments. If market interest rates rise after you buy your bond, the market value of your lower-yielding bond will fall.