What is Revenue Bonds?

Let’s Consider an Example

Peter invests in fixed income securitiesFixed Income SecuritiesFixed income investment is a type of investment in which the investor receives a fixed and relatively stable stream of income in the form of dividends or interest over a period of time. Companies and governments typically issue fixed investments in the form of debt securities.read more. He identifies that a local municipality is raising $10 million to finance the construction of the new bridge by issuing revenue bonds. After carefully evaluating the creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more of the projects, he is quite confident that the project will be successful in generating sufficient revenue to repay the proceeds, so he decides to buy it.

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Characteristics of Revenue Bonds

#1 – Longer-Term in Nature

These bonds are used to fund long term projects, so the maturity date often ranges from 20 to 30 years. Interest and principal payments are both made after meeting the operating expensesOperating ExpensesOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit.read more of the projects. If the project does not generate enough funds, payment can be deferred to a later date.

Key Takeaways

  • Rating agencies rate these bonds based on their abilities to pay back interest and principal. They also evaluate the cash-generating ability of the projects.Mutual funds and municipal bonds investment trustInvestment TrustAn investment trust is a publicly traded financial institution that operates as a closed-end fund (CEF) and invests in shares or financial assets on behalf of its investors or other organizations. The value of the amount of money invested in an investment trust is dependent by the demand and supply for the invested share or financial asset, as well as the underlying value of the assets owned.read more are the most common way to invest in revenue and other forms of municipal bonds.Just like normal bonds, revenue bonds are inversely related to interest rate, i.e., price falls are interest rate rises and vice versa.These bonds may be issued in the form of a staggered maturity date and are known as serial bonds.They differ from general obligation bondsGeneral Obligation BondsGeneral Obligation Bonds are a type of bond that is supported or guaranteed by agencies like municipalities where repayments are prompt and have very low default rates as municipals are authorized by the government to increase the tax amount that is receivable from the public to pay off the dues and debts associated with the repayments to the investors.read more which do not invest in income-generating projects but provide service to the entire community whereas projects funded by such bonds only charge those communities which pay for the service.The lower the tax bracket, the more favorable corporate bonds investment as the tax charges increase. Municipal bonds appear more attractive.

#2 – Higher Return

They provide a higher return than the general obligation bondsGeneral Obligation BondsGeneral Obligation Bonds are a type of bond that is supported or guaranteed by agencies like municipalities where repayments are prompt and have very low default rates as municipals are authorized by the government to increase the tax amount that is receivable from the public to pay off the dues and debts associated with the repayments to the investors.read more since they are secured by the revenue generated from the project, there is a greater risk of non-payment of the promised return, so the investor is compensated with a higher return as compared to general obligation bonds to attract them.

#3 – No Claim on Assets

BondholdersBondholdersA bondholder is an investor who buys or holds a government or corporate bond.read more do not have any claim on the assets of the projects. If the projects do not turn out to be successful, bondholders cannot repossess the toll roads or equipment.

#4 – Issues with Call Provision

These bonds are issued with a catastrophe call provision, which allows the issuer to call back the bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more if the revenue-producing facility is destroyed.

#5 – Insurance or Guarantee in Case of Default

Such bonds are exposed to credit, interest, call, and market risksMarket RisksMarket risk is the risk that an investor faces due to the decrease in the market value of a financial product that affects the whole market and is not limited to a particular economic commodity. It is often called systematic risk.read more similar to other classes of debt. To avoid defaulting on its obligation, the issuer often provides insurance on their bonds. In some cases, federal agencies also provide a guarantee.

Revenue Bonds Types

  • Industrial bonds finance public projects like parks, the stadium they will generate usage feed when booked for concerts, sports events, meetings.Airport bonds to fund construction of airports, landing fees, fuel fees, lease paymentsLease PaymentsLease payments are the payments where the lessee under the lease agreement has to pay monthly fixed rental for using the asset to the lessor. The ownership of such an asset is generally taken back by the owner after the lease term expiration.read more to secure the bonds.Public utility bonds which fund through the sale of electricity.Hospital bonds that fund hospital construction, renovation, equipment purchase.Highway bonds used to build revenue-producing facilities such as bridges and toll roads.Transportation bonds are issued to finance local public transportations such as buses, subway systems.Special tax bonds-generate funds by levyingLevyingA levy is a lawful process where the debtor’s property is seized when the debtor cannot pay the outstanding debts. It is different from liens, as a lien is only a claim against a property, whereas a levy is an actual property takeover to fulfill the obligation.read more a tax on a particular activity or asset, for e.g., the special tax may be levied on the sale of alcohol or tobacco.Sewerage projects where cash is generated from usage fees, assessment fees, connection feed is used for paying bonds.

Advantages

One of the advantages of investing in revenue bonds is that interest incomeInterest IncomeInterest Income is the amount of revenue generated by interest-yielding investments like certificates of deposit, savings accounts, or other investments & it is reported in the Company’s income statement. read more is usually exempt from federal, state, or local taxes. So, it is quite beneficial for investors with a high-income tax bracket. Due to this advantage, it is popular in high tax rate states. Consider an investor with a total portfolio of $500000. He considering alternative ways of investment out of which he chooses two option below:

  • Option 1 To purchase corporate bondsCorporate BondsCorporate Bonds are fixed-income securities issued by companies that promise periodic fixed payments. These fixed payments are broken down into two parts: the coupon and the notional or face value.read more which provide a total annual yield of 7%, i.e., $35000Option 2 To purchase tax-free municipal bondsMunicipal BondsA municipal bond is a debt security issued by a national, state, or local authority to finance capital expenditures on public projects related to the development and maintenance of infrastructures such as roads, railways, schools, hospitals, and airports.read more @yield of 5%, i.e., $25000 interest income per year.

If he chooses option 1, he is still liable to pay income tax of say 30%(applicable in that state), i.e., $10500, which reduces his interest income to $24500. However, in the latter case, he does not have to owe anything to tax authorities and can keep the full amount.

#1 – Municipal Bonds can be Considered Less Volatile

Short-duration bonds are less volatile, and their value does not frequently fluctuate as compared to bonds with longer duration. However, there is a trade-off between risk and reward where returns tend to lower for shorter maturity bonds.

#2 – Bondholders are Quite Emotionally Attached

When a bondholder buys a municipal bond which is used by the government or local authorities to finance hospital, school, or gymnasium in the locality, this helps to improve the lifestyle of an average person, so the bondholder does hold it until maturity

Disadvantages

#1 – Higher Default Risks

Because they are not backed by full faith and credit of the municipality, they are subject to higher default risksDefault RisksDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors.read more as compared to general obligation bonds

#2 – Inflation Puts Downward Pressure on the Return

The inflation rate dramatically impacts the returns generated from these bonds. However, variable-rate revenue bonds do offer some protection against inflation.

#3 – Tax Exemption Advantage can be Revoked

Pending tax legislation does impact the value of revenue bonds if the state or federal tax rate is reduced. In other words, these bonds provide maximum benefit to the high tax environment where a high tax bracket individual gets tax exemption advantage. As an exemption, these tax exemptionTax ExemptionTax-exempt refers to excluding an individual’s or corporation’s income, property or transaction from the tax liability imposed by the federal, local or state government. These exemptions either allow total relief from the taxes or provide reduced rates or charge tax on some items only.read more advantages provided to revenue bonds can be revoked by an IRS.

Conclusion

Revenue bonds make up the vast majority of municipal bonds. Investors willing to buy these bonds must know the varieties available, as well as how the project will produce the promised return on a consistent basis.

This has been a guide to What is Revenue Bonds & its Definition. Here we discuss the revenue bond types and characteristics along with the example, advantages, and disadvantages. You can learn more about from the following articles –

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