Quick Answer
Revenue bonds are backed by income from a specific project, not by taxing power, and they don't require voter approval. A trust indenture sets protective covenants (rate, additional bonds test, non-competition) and a flow of funds; the net revenue pledge (O&M first) is the default unless the issue explicitly uses a gross pledge (bondholders first).
With general obligation (GO) bonds backed by taxing power, the next major category works entirely differently. Revenue bonds are backed by income from a specific project or facility, not by taxes.
What Backs a Revenue Bond?
- Backed by revenue from a specific project or facility (e.g., tolls, water fees, airport charges, hospital revenue)
- Do NOT require voter approval (unlike GO bonds)
- Are NOT backed by the taxing power of the issuer
- Typically secured by a trust indenture (bond resolution) that establishes covenants and a flow of funds
- Examples of revenue bond projects: toll roads, bridges, water/sewer systems, airports, hospitals, convention centers, parking garages
Exam Tip: Gotchas
- Revenue bonds do NOT require voter approval (general obligation bonds do). This is a frequently tested distinction.
- Revenue bonds are backed by project revenue, not taxing power. If the project fails, bondholders bear the loss.
Why Does a Revenue Bond Need a Feasibility Study?
- Before issuing revenue bonds, a feasibility study is conducted by an independent consultant
- The study analyzes whether the project will generate sufficient revenue to cover operating expenses and debt service
- Investors and rating agencies rely on the feasibility study to assess credit risk
- No equivalent requirement exists for GO bonds (they are backed by taxes, not project revenue)
What Are the Sources of Revenue?
- Revenue bonds are repaid from user fees, tolls, rents, charges, assessments, or other income streams generated by the financed facility
- The revenue source is specific to the project; if the project underperforms, bondholders may not be fully repaid
- Essentiality and exclusivity of the revenue source affect credit quality: essential services (water, sewer, electric) generate steadier revenue than discretionary facilities (convention centers, sports arenas)
- A revenue source with no competing alternative is more reliable than one that faces substitutes
Exam Tip: Gotchas
- Subordinate lien (junior lien) bonds sit behind senior-lien bonds in the flow of funds. They can be issued more easily than additional senior parity bonds but carry lower priority and more risk.
What Protective Covenants Does the Trust Indenture Include?
The trust indenture includes covenants that protect bondholders:
| Covenant | Purpose |
|---|---|
| Rate covenant | Issuer agrees to maintain user fees at levels sufficient to cover debt service (e.g., 1.25x coverage) |
| Insurance covenant | Issuer must maintain adequate insurance on the facility |
| Maintenance covenant | Issuer must keep the facility in good working condition |
| Additional bonds test (ABT) | Restricts issuing new parity bonds unless revenue coverage meets a specified threshold |
| Non-competition (anti-diversion) covenant | Issuer agrees not to build a competing facility that would divert revenue |
| Catastrophe clause | Provisions for early redemption if the facility is destroyed and cannot be rebuilt |
Exam Tip: Gotchas
- The rate covenant is the most important protective covenant. It ensures user fees stay high enough to cover debt service. Without it, an issuer could lower tolls or fees and leave bondholders short.
- The additional bonds test (ABT) protects existing bondholders from dilution. New parity bonds can only be issued if revenue coverage meets the threshold.
What Order Does the Flow of Funds Follow?
The flow of funds determines the priority in which revenue is applied. There are two types:
Net Revenue Pledge (most common; assumed unless stated otherwise)
- Gross revenue collected
- Operations and maintenance (O&M) paid first
- Debt service (interest and principal) paid next
- Debt service reserve fund
- Reserve maintenance fund
- Renewal and replacement fund
- Surplus fund (excess revenue)
Gross Revenue Pledge (more protective for bondholders)
- Gross revenue collected
- Debt service paid first (before O&M)
- Operations and maintenance
- Reserve funds
- Surplus fund
Think of it this way: Picture a toll road collecting $10 million in revenue. Under a gross pledge, bondholders get paid first from the full $10 million, and whatever is left covers road maintenance. Under a net pledge, the road gets repaired first, and bondholders get paid from what remains. Bondholders prefer gross because their money comes off the top.
Key distinction:
- Under a gross revenue pledge, bondholders have first claim on all revenue before any expenses. This is more protective for investors.
- Under a net revenue pledge, operations and maintenance (O&M) is paid first, then bondholders. The facility stays maintained, but bondholders take a back seat.
- The net revenue pledge is the default unless a gross pledge is explicitly stated.
Memory Aid: Gross = bondholders Go first. Net = bondholders are Next (after O&M).
Exam Tip: Gotchas
- Net revenue pledge pays O&M first, then bondholders. A gross revenue pledge pays bondholders first. Gross is better for bondholders.
- If the exam does not specify which pledge type, assume net revenue pledge.
How Is the Debt Service Coverage Ratio (DSCR) Calculated?
- Measures the project's ability to pay debt service
- DSCR = Net revenue / Annual debt service
- Standard adequate coverage for most revenue bonds is 2.0x
- Utility revenue bonds (water, sewer, electric) are the exception: a minimum DSCR as low as 1.25x is a common rate covenant requirement, because essential services generate very stable, predictable demand
- A DSCR below 1.0x means the project cannot cover debt service from operations
- Higher coverage ratios indicate greater ability to service the debt
Think of it this way: If a toll bridge earns $5 million after operating costs and owes $4 million in debt service, the DSCR is 1.25x. That extra $1 million is the safety cushion.
Exam Tip: Gotchas
- DSCR of 1.25x means a 25% cushion above debt service, not that 25% of revenue goes to debt service. The project generates $1.25 for every $1.00 owed.
- Utility revenue bonds require LOWER coverage (1.25x) than most other revenue bonds (2.0x). This is counterintuitive, but essential services need less of a cushion because demand is so stable.
Where Does Credit Information Come From?
- Rating agencies: Moody's, S&P, Fitch assign credit ratings based on the issuer's ability to pay
- Official statements: Primary source of credit information for new issues
- Electronic Municipal Market Access (EMMA): Ongoing source for continuing disclosure filings, trade data, and material event notices
- Revenue bond issuers typically must provide annual audited financial statements to bondholders (per the trust indenture and continuing disclosure agreements)
- Rating services evaluate: revenue coverage, management quality, economic conditions, legal protections, and debt structure
What Credit Enhancements Support Revenue Bonds?
| Enhancement | Description |
|---|---|
| Bond insurance | A third-party insurer (e.g., Assured Guaranty) guarantees timely payment of principal and interest; insured bonds carry the insurer's rating |
| Letter of credit (LOC) | A bank guarantees payment; often used for variable-rate demand obligations (VRDOs) |
| State aid intercept | State withholds aid payments to a delinquent local government and redirects them to bondholders |
Exam Tip: Gotchas
- Bond insurance raises the bond's rating to the insurer's rating, not the issuer's. If the insurer is rated AA and the issuer is rated A, the bond trades at AA.
- A letter of credit (LOC) is a bank guarantee, not an insurance policy. LOCs are common with variable-rate demand obligations (VRDOs).
What Should You Check on Exam Day?
- Revenue bonds do NOT require voter approval; GO bonds do
- Feasibility study replaces the credit analysis a GO bond gets from its tax base
- Net revenue pledge is the default (O&M paid first); a gross pledge pays bondholders first and must be explicitly stated
- DSCR = net revenue / annual debt service; 1.25x means a 25% cushion, not that 25% of revenue goes to debt service
- Bond insurance substitutes the insurer's rating for the issuer's; an LOC is a bank guarantee, not insurance