Revenue Bond

A Revenue Bond is a special type of municipal bond that isn't backed by the government's general taxing power. Instead, it's secured by the revenue, or income, generated from a specific project or public enterprise. Think of it as a self-funding loan for public works. When a state or city wants to build a new toll bridge, airport, or public utility, they can issue revenue bonds to finance the construction. The tolls collected from drivers, the fees paid by airlines, or the monthly water bills from residents are then used to pay back the bond's principal and interest to investors. This makes the financial success of the underlying project the single most important factor for a bondholder. If the project flourishes and generates plenty of cash, payments are secure. If it flops, investors could be in for a rough ride.

Imagine your city wants to build a new, state-of-the-art sports stadium but doesn't want to raise taxes to pay for it. The city's stadium authority, the issuer, can issue revenue bonds to raise the necessary hundreds of millions of dollars. The deal is straightforward: investors buy the bonds, and the money is used to build the stadium. Once it's open, the revenue generated—from ticket sales, concessions, parking, and naming rights—is pledged specifically to repay those bonds. This revenue stream is kept separate from the city's general funds. The entire agreement, including how the revenue is collected and paid out, is detailed in a legal document called a bond indenture. This contract is the bondholder's best friend, as it lays out all the rules of the game and the protections in place for investors. The core promise is that the project's income is the primary source of repayment.

Not all municipal bonds are created equal. The main alternative to a revenue bond is a General obligation bond (GO bond), and for an investor, understanding the difference is critical.

• Revenue Bonds:
  1. Repayment Source: Income from a specific project (e.g., tolls, utility fees).
  2. Risk: Higher credit risk. Repayment depends entirely on the project's financial health. A poorly conceived project can default.
  3. Yield: Usually offer a higher yield to compensate for the additional risk.
  4. Investor's Focus: You must analyze the project like a business. Is it essential? Does it have a monopoly? Are the financial projections realistic?
• General Obligation (GO) Bonds:
  1. Repayment Source: Backed by the “full faith and credit” of the government issuer. This means the government can use its general tax revenue to pay back the debt.
  2. Risk: Lower credit risk. The government has a broad tax base to draw from, making default much less likely.
  3. Yield: Typically offer a lower yield due to their higher safety.
  4. Investor's Focus: You must analyze the government's overall financial health, its tax base, and its economic stability.

In short, buying a revenue bond is like lending money to a specific business, while buying a GO bond is like lending money to the entire city or state.

From a value investing perspective, a good revenue bond is backed by a durable, cash-gushing asset. The key isn't just to find a high yield, but to find a safe and predictable stream of income. Here’s what to scrutinize:

The best revenue bond projects are often essential public services with little to no competition. Think about:

• Water and Sewer Systems: Every resident needs water. These are classic, powerful monopolies.
• Major Airports: A large city's primary international airport is a gateway that airlines and travelers must use.
• Essential Toll Roads: A bridge or tunnel that provides the only practical route between two major areas.

Projects with strong competitive advantages generate predictable revenues, which is exactly what a bond investor wants to see. A bond for a speculative convention center in a city that already has three is far riskier than one for the local electric utility.

This is perhaps the most important metric for a revenue bond. The Debt service coverage ratio (DSCR) measures how many times the project's annual net income can “cover” its annual debt payments (principal and interest).

• Formula: DSCR = Net Operating Income / Total Debt Service

A DSCR of 1.0x means the project is generating just enough cash to pay its debts—a scary thought! A healthy margin of safety is crucial. Value investors should look for a DSCR of at least 1.5x, and a figure of 2.0x or more is even better. A high DSCR shows the project has a thick financial cushion to absorb unexpected downturns or rising costs without missing a payment. The bond's offering documents will almost always disclose this ratio, which is often calculated based on a professional feasibility study.

The bond indenture is your rulebook, and it contains promises called covenants that protect you. Two of the most important are:

• Rate Covenant: A promise by the issuer to set rates and fees (e.g., water rates, bridge tolls) high enough to maintain a minimum DSCR. This is a powerful protection that forces the project to be managed responsibly.
• Additional Bonds Test: A rule that prevents the issuer from taking on more debt unless the project's revenue meets certain thresholds. This stops the issuer from diluting your claim by piling on new loans.

For many investors, especially those in higher tax brackets, the interest income from municipal bonds is tax-exempt at the federal level. If you buy a bond issued in your home state, it may be exempt from state and local taxes, too. This “tax-equivalent yield” can make a 4% municipal bond more attractive than a 6% corporate bond. Furthermore, a bond backed by a strong, monopolistic project can provide one of the most predictable income streams available in the investment world.

The biggest risk is that the project fails to generate the expected revenue. A new toll road might see less traffic than projected, or a hospital could face competition or mismanagement, leading to bankruptcy. Unlike a GO bond, there is no government tax base to fall back on. If the project's revenue dries up, bondholders may face delayed payments, partial payments, or, in the worst-case scenario, a complete loss of their investment. This is why doing your homework on the project's viability is not just important—it's everything.