Revenue Bond

A revenue bond is a municipal bond whose repayment is limited to a defined source of revenue. The SEC's investor glossary defines it as "A municipal bond not backed by the government's taxing power but by revenues from a specific project or source, such as highway tolls or lease fees." The MSRB's definition describes the mechanism: "A bond that is payable from a specific source of revenue. Pledged revenues may be derived from operation of the financed project, grants, or excise or other specified non-ad-valorem taxes. Generally, no voter approval is required prior to issuance of such obligations. Only the revenue specified in the bond contract is required to be used for repayment of interest and principal."

The municipal bond page introduces the revenue pledge alongside the general obligation pledge and answers how the two differ. This page is about the revenue pledge on its own terms: which revenues are pledged and how, what the bond contract requires the issuer to do with them, and how a holder measures whether the pledged stream is large enough. It also touches the conduit structure, where the revenue comes from a private borrower, in one place; the municipal bond page defines the conduit bond itself.

The pledge names the revenue and nothing else. A revenue bond issuer promises a specific stream: the receipts of a toll road, a water and sewer system, an airport, a parking system, a public hospital or university, or a designated non-property tax. The MSRB's term for a facility whose receipts repay its own financing is an enterprise activity, "A revenue-generating facility or system that provides funds necessary to pay debt service on securities issued to finance its construction or improvement," with airports, water and sewer systems and power supply systems as its examples. The pledged revenues are, in the MSRB's words, "The funds obligated for the payment of debt service and the making of other deposits required by the bond contract," and the pledge comes in two forms: a gross pledge, under which "all revenues received will be used for debt service prior to deductions for any costs or expenses," and a net pledge, under which "net revenues will be used for payment of debt service," meaning revenues after operating costs. A net pledge is the natural fit for an enterprise system, because the plant has to be run before anyone is paid.

The SEC's warning about recourse. In its bond guidance the SEC states: "Some revenue bonds are "non-recourse," meaning that if the revenue stream dries up, the bondholders do not have a claim on the underlying revenue source." A holder of such a bond cannot look to the issuer's other funds, and cannot look to the facility itself as collateral; the claim is on the cash the facility produces and stops when the cash stops. That is the fact that separates a revenue bond from a general obligation bond, and it is why the contract terms below exist.

The flow of funds is the plumbing. The MSRB defines the flow of funds as "The order and priority of handling, depositing and disbursing pledged revenues, as set forth in the bond contract." Revenues are deposited into a revenue fund and then disbursed, in a stated order, into accounts for operation and maintenance, a debt service fund into which the issuer makes periodic deposits so that principal and interest are on hand when due, a debt service reserve fund, and renewal and replacement. The order is the priority: a holder wants debt service to sit high in the waterfall.

The reserve fund is the cushion. The debt service reserve fund is, per the MSRB, "A fund in which funds are placed to be applied to pay debt service if pledged revenues are insufficient to satisfy the debt service requirements." Its size is fixed by the debt service reserve fund requirement, which "might be a fixed percent of the outstanding par value or the maximum annual debt service of the issue." The fund may be filled from bond proceeds at issuance, built up from revenues, or replaced by a surety policy or letter of credit, and if it is drawn on "the issuer usually is required to replenish the fund from the first available revenues." A reserve equal to a year's debt service buys the issuer a year to fix whatever went wrong.

Covenants are the promises, and the rate covenant is the important one. The MSRB defines covenants as "Contractual obligations set forth in a bond contract," and lists the common ones: "to charge fees sufficient to provide required pledged revenues (called a "rate covenant"); to maintain casualty insurance on the project; to complete, maintain and operate the project; not to sell or encumber the project; not to issue parity bonds or other indebtedness unless certain tests are met ("additional bonds" or "additional indebtedness" covenant)." A rate covenant obliges the issuer to set its charges high enough that revenues cover debt service by a stated margin; it is the enterprise's equivalent of a taxing power, exercised through the water bill rather than the tax roll. The additional bonds test protects existing holders from being diluted: the MSRB describes it as a test that "must be satisfied under the bond contract securing outstanding revenue bonds ... as a condition to issuing additional bonds," typically requiring that historical revenues "exceed projected debt service requirements for both the outstanding issue and the proposed issue by a certain ratio."

Coverage is the measurement. The MSRB defines coverage as "The ratio of available revenues available annually to pay debt service over the annual debt service requirement," also called "debt service coverage" or the "coverage ratio," and gives the example of $2,000,000 of available revenues against $1,200,000 of debt service, a coverage of about 1.66 times. A coverage of 1.0 means the pledged revenue exactly covers the payments with nothing to spare; every increment above it is margin for a bad year.

Liens rank, and the label says where. Where more than one series shares a revenue stream, the bond contract states the order. Senior lien bonds have "the priority claim against pledged revenues," junior lien bonds (or subordinate lien bonds) have a claim "subordinate to the claim against such pledged revenues or security of other obligations," and parity bonds "have the same priority of claim or lien against pledged revenues." Two revenue bonds of the same system can therefore carry different risk, and the lien position is part of the bond's name in the official statement.

When the revenue belongs to someone else. Some revenue bonds are conduit financings, in which the government issues the bonds on behalf of a private borrower such as a nonprofit hospital or college, and the private borrower's payments are the pledged revenue. The SEC notes that in such a case, "If the conduit borrower fails to make a payment, the issuer usually is not required to pay the bondholders." The municipal bond page defines the conduit bond and explains why its credit is the borrower's rather than the government's. Mortgage revenue bonds, which finance home loans for first-time buyers, are a category of private activity bond and belong to that page.

A governmental issuer builds or improves a facility that generates receipts, pledges those receipts under a bond contract, and sells bonds whose principal and interest are paid from the pledged revenue as the contract's flow of funds directs. The contract sets the rate covenant, the reserve requirement, the additional bonds test and the lien structure. Each year the issuer reports its revenues, expenses and coverage, and a holder watches the coverage ratio the way a lender watches a borrower's income.

A hypothetical example with invented figures. A municipal water utility issues revenue bonds with $2,000,000 of annual debt service. Its bond contract pledges net revenues, requires a debt service reserve fund equal to maximum annual debt service, and contains a rate covenant requiring net revenues of at least 1.25 times debt service.

In a normal year the utility collects $9,000,000 in customer charges and spends $6,000,000 operating the system. Net revenues are $9,000,000 − $6,000,000 = $3,000,000. Coverage is $3,000,000 ÷ $2,000,000 = 1.50 times, comfortably above the covenant's 1.25. The reserve fund holds $2,000,000, one full year of payments.

The following year a drought brings conservation and receipts fall to $8,200,000 while operating costs are unchanged. Net revenues are $2,200,000 and coverage is $2,200,000 ÷ $2,000,000 = 1.10 times. The bonds are still paid in full, since $2,200,000 exceeds $2,000,000, but the rate covenant has been breached, and the contract now obliges the utility to raise its charges. To restore 1.25 times coverage it needs net revenues of 1.25 × $2,000,000 = $2,500,000, so it must raise about $300,000 more, roughly a 3.7 percent increase on $8,200,000 of receipts.

Had receipts collapsed instead to $7,500,000, net revenues of $1,500,000 would not have covered the $2,000,000 payment. The debt service reserve fund would make up the $500,000 gap for that year, and the contract would require the utility to replenish it from the first available revenues afterward. The reserve is what turns one bad year into a covenant problem rather than a default. If bad years continued and the reserve ran out, a non-recourse bondholder would have no claim on the town's taxes; the utility's rate covenant, and the customers' capacity to pay higher bills, would be the whole of the security.

Pros

• Repayment is tied to a specific, measurable revenue stream, and the bond contract requires the issuer to keep charges high enough to cover it.
• Essential-service revenue bonds, such as water and sewer, are backed by receipts that customers have little choice but to pay.
• The flow of funds, reserve fund and additional bonds test are written into the contract and disclosed, so the protections can be read before buying.
• No voter approval is generally needed, so revenue bonds finance projects a referendum might delay, and they often yield more than GO bonds of the same issuer.

Cons

• There is no taxing power behind the bond; if the pledged revenue fails, a non-recourse holder has no claim on the issuer's other funds or on the facility.
• A single project's fortunes, such as traffic on a new toll road or enrollment at a college, determine repayment.
• Coverage can erode quietly through rising operating costs, deferred maintenance or political resistance to rate increases.
• Lien position matters: a junior lien bond on the same revenue stream is paid only after the senior bonds, and the label is easy to miss.
• In a conduit financing the real obligor is a private entity whose credit, not the government issuer's, is what the holder owns.