Analysis of Revenue Bonds
With GO bond analysis covered, let's turn to revenue bonds. Unlike GO bonds, revenue bonds are repaid from a specific revenue source tied to the project being financed. This means the analysis shifts from taxing power to project viability and bondholder protections.
Feasibility Studies
Before issuing revenue bonds, a feasibility study determines whether the project will generate enough revenue to cover debt service.
- Prepared by an independent consulting engineer or financial consultant
- Evaluates projected revenues, operating costs, demographic trends, and competitive factors
- A favorable feasibility study is critical to obtaining a strong credit rating
Sources of Revenue
Revenue bonds are repaid from a specific revenue source tied to the financed project:
| Bond Type | Revenue Source |
|---|---|
| Highway/bridge bonds | Tolls |
| Water/sewer bonds | User fees |
| Lease revenue bonds | Lease payments |
| Hospital bonds | Patient revenues |
| Higher education bonds | Tuition and fees |
Two factors that affect revenue quality:
- Exclusivity - is the revenue source dedicated solely to this bond issue?
- Essentiality - essential services (water, sewer, electric) have more reliable, predictable revenue than non-essential projects
Protective Covenants
The bond indenture contains covenants that protect bondholders. These are the most testable:
| Covenant | What It Does |
|---|---|
| Rate covenant (rate maintenance) | Issuer pledges to maintain user rates sufficient to cover debt service and operating expenses |
| Insurance covenant | Issuer must maintain adequate insurance on the facility |
| Maintenance covenant | Issuer must keep the facility in good working order |
| Additional bonds test | Limits issuance of new parity bonds unless coverage tests are met |
| Catastrophe covenant | If the facility is destroyed, bond proceeds may be used for redemption |
| Non-competition clause | Issuer pledges not to build or finance a competing facility |
Financial Reports and Continuing Disclosure
- Revenue bond issuers typically provide annual audited financial statements
- SEC Rule 15c2-12 requires ongoing reporting of financial and operating data (continuing disclosure)
- Investors and analysts review these reports to track revenue trends and coverage ratios
Restrictions on Additional Bonds
- The additional bonds test typically requires existing revenues to cover existing debt service at a specified ratio (e.g., 1.25x) before new parity bonds can be issued
- Subordinate lien bonds (junior lien) may be issued more easily but have lower priority in the flow of funds
Exam Tip: Gotchas
- The additional bonds test must be satisfied BEFORE new parity bonds can be issued. The exam may describe a scenario where an issuer wants to issue new bonds with equal claim on revenues. Look for whether the coverage ratio has been met.
Flow of Funds
The flow of funds determines the order in which revenue is distributed. There are two structures:
Gross Revenue Pledge (Gross Lien)
- Revenue collected
- Debt service fund (bondholders paid FIRST)
- Operations and maintenance (O&M) fund
- Reserve maintenance fund
- Renewal and replacement fund
- Surplus fund
Net Revenue Pledge (Net Lien)
- Revenue collected
- Operations and maintenance (O&M) fund (O&M paid FIRST)
- Debt service fund (bondholders paid from remaining revenue)
- Reserve maintenance fund
- Renewal and replacement fund
- Surplus fund
Key distinction:
- Gross pledge → bondholders are paid before O&M expenses → stronger bondholder protection
- Net pledge → O&M is paid first, then bondholders receive payment from net revenues (gross revenues minus O&M)
- The net pledge is more common in practice, even though the gross pledge is more protective for bondholders
Memory Aid: Gross = debt service is Given priority (bondholders paid first). Net = Not until O&M is paid (bondholders paid from what's left).
Exam Tip: Gotchas
- The key difference between gross and net revenue pledge is the ORDER of debt service vs. O&M. Under a gross pledge, bondholders are paid FIRST (before operating expenses). Under a net pledge, operating expenses come first. The exam will describe a flow of funds and ask which type it is.
Debt Service Coverage Ratio (DSCR)
The debt service coverage ratio measures whether revenue is sufficient to cover debt payments.
Formula: DSCR = net revenue / annual debt service
Where net revenue = gross revenue - O&M expenses (under a net pledge)
Think of it this way: A DSCR of 2.0x means the project earns twice what it needs to make its bond payments. The higher the ratio, the bigger the safety cushion for bondholders.
| DSCR | Meaning |
|---|---|
| Below 1.0x | Revenue cannot cover debt service (serious problem) |
| 1.0x | Break-even - revenue exactly covers debt service |
| 1.25x (5:4) | Adequate for utility revenue bonds (water, sewer, electric) |
| 2.0x | Standard adequate coverage for most other revenue bonds |
Exam Tip: Gotchas
- Utility revenue bonds require LOWER debt service coverage than other revenue bonds (1.25x vs. 2.0x). This seems counterintuitive, but essential services have extremely stable, predictable demand, so less of a coverage cushion is needed.
Credit Information and Rating Services
| Source | What It Provides |
|---|---|
| Moody's, S&P, Fitch | Credit ratings for municipal bonds |
| EMMA (Electronic Municipal Market Access) | Free access to official statements, continuing disclosures, and trade data |
| The Bond Buyer | Market data and indexes (covered in a later section) |
| Official statements | Primary disclosure document for new muni issues (analogous to a prospectus) |
Credit Enhancements
Credit enhancements improve a bond's credit quality beyond the issuer's own rating:
| Enhancement | How It Works |
|---|---|
| Bond insurance | Third-party guarantee of timely payment; bond takes on the insurer's rating (if higher) |
| Letter of credit (LOC) | Bank guarantees payment if the issuer defaults; common for variable-rate demand obligations (VRDOs) |
| State credit enhancement | Some states provide guarantees or intercept mechanisms for local issuers |
| Escrow of government securities | Pre-refunded bonds backed by U.S. Treasuries in escrow are effectively AAA |
| Federal guarantees | Certain housing and education bonds may carry federal backing |
- Bond insurance raises the bond's rating to the insurer's rating, potentially reducing borrowing costs
- After insurance, the investor bears the credit risk of the insurer, not the original issuer
Exam Tip: Gotchas
- Bond insurance shifts credit risk to the insurer, not the issuer. After insurance, the bond's credit quality depends on the insurer's financial strength. If the exam asks about credit risk on an insured bond, the answer is the insurer's rating.