What is a Revenue Bond?
How Does a Revenue Bond Work?
Let's assume ABC Town wants to build a new toll road, but it doesn't have the money to fund the construction. It could issue revenue bonds, and the tolls collected from the toll road would fund the interest and payments. If the revenue from the toll road is insufficient, ABC Town might not be able to make timely interest and principal payments. In many cases, revenue bond issuers can avoid or delay interest payments if a minimum amount of revenue is not generated from the project.
Revenue-bond holders generally have no claim to the project’s assets (i.e., they cannot repossess the toll road if it does not generate the promised interest and principal payments). Revenue bonds may also have catastrophe provisions, which allow the issuer to call the if the revenue-producing is destroyed. Thus, revenue bonds generally a higher than general to compensate for these added risks.
Revenue bonds usually have $1,000 or $5,000 face values. They usually pay interest semiannually, although some are zero-coupon bonds. Typical are one to 30 years. Many are serial bonds, and many are callable or putable, and some have unusual payment schedules. The issuer sets forth the terms of the debt in the indenture agreement.
Revenue bonds are typically issued the same way corporate bonds are: through an that presents a written to buyers and facilitates a competitive bidding process. After the bonds begin trading, dealers across the country earn spreads by acting as intermediaries between buyers and sellers. Although purchasing specific revenue bonds and other gives investors direct control over which bonds they hold and the location of the issuers (thus maximizing tax advantages), and trusts are the most common way to invest in revenue bonds and other .
, in general, rank between agency and corporate in risk and return. As with all debt, they are subject to credit, interest-rate, call, and . To mitigate , some issuers carry private insurance on their (investors can also purchase this insurance). In some cases, a federal agency might or insure a revenue issue. Some issuers also back their with a commercial bank letter of credit or funds.
Why Does a Revenue Bond Matter?
One of the largest advantages of investing in revenue bonds is that the interest is usually
exempt from federal and most state and local if the investor lives in the state or municipality issuing the debt (capital gains on are taxable, however). Although investors subject to the alternative minimum tax may be subject to , for the most part the exemption means that investors in high federal-tax brackets benefit from revenue bonds and other . This is why there is usually stronger demand for revenue bonds and other in high-tax states (although this demand in turn lowers the yields of these relative to those issued in low-tax states).
As with all , revenue prices rise when interest rates fall, and fall when interest rates rise. can cut significantly into a revenue 's modest returns (relative to corporate ), although variable-rate revenue do some protection against this.
Pending or suspected tax legislation can dramatically affect the value of revenue bonds. Remember, the higher the marginal tax rate, the more valuable a revenue bond's is. If a state or the federal government reduces tax rates, revenue bonds lose some of their advantage for high-tax-bracket individuals (and thus become less valuable). Another risk is that the may decide to tax income or revoke the exemption of a particular issue.