Revenue Bonds
Revenue Bonds
Revenue bonds are backed not by the issuer's taxing power, but solely by revenues from a specific project or enterprise. If that project fails to generate expected revenues, bondholders may not be repaid. This higher risk is compensated by higher yields.
Key takeaways
- Revenue bonds are secured only by revenues from a specific project or system (tolls, fees, patient charges, electricity sales)
- They are used for self-supporting enterprises: airports, water systems, power plants, parking facilities, hospitals
- Default risk is higher than general obligation bonds because the issuer is not using its tax power as a backstop
- Yields are higher to compensate for additional risk — typically 50 to 150 basis points above comparable-maturity GO bonds
- Revenue bonds require deeper credit analysis: you must understand the project's cash flows, demand assumptions, and operating environment
The revenue-backed structure
A revenue bond is a promissory note secured by a stream of future cash flows. A municipality might issue a $200 million revenue bond to build a new airport terminal. The bonds are not backed by the city's tax base; they are backed solely by the airport's future operations — passenger fees, airline concessions, parking revenue, rental car fees, and other airport revenues.
If the airport generates sufficient revenue, bondholders are paid in full. If the airport struggles (due to economic downturn, changed travel patterns, or management problems), bondholders may suffer losses. The city is not obligated to use tax money to cover a shortfall; the airport must stand on its own.
This distinction is legally important. A general obligation bond is an obligation of the city. A revenue bond is an obligation of the airport enterprise only. In a bankruptcy scenario, GO bondholders have a claim on all city assets and revenues; revenue bondholders have a claim only on the airport's assets and revenues.
Typical issuances and use cases
Revenue bonds finance self-supporting enterprises that generate user fees or charges:
Transportation: Toll roads, bridges, tunnels, airports, seaports, and public transit systems. A toll road bond is repaid from tolls collected. An airport bond is repaid from terminal fees and concessions.
Utilities: Water systems, wastewater plants, electric power plants, and natural gas systems. A water revenue bond is backed by customer water bills. An electric utility revenue bond is backed by electricity sales.
Healthcare: Hospitals and health systems issue revenue bonds backed by patient revenues, insurance payments, and Medicaid/Medicare reimbursements.
Housing: Colleges and universities issue revenue bonds for dormitories backed by student housing fees. Housing authorities issue bonds backed by rental payments.
Development and industry: Development corporations issue bonds to finance industrial parks, factory facilities, or technology parks, backed by lease payments from tenant companies.
In 2022, revenue bonds exceeded GO bonds in total issuance by a substantial margin — roughly 60% of all municipal bonds were revenue-backed. Water and wastewater systems were the largest category, followed by transportation and utilities.
Credit analysis: assessing the project
Evaluating a revenue bond requires different due diligence than a GO bond. You cannot rely on the issuer's broad financial strength; you must assess the specific project's viability.
Demand assumptions: Will the project generate enough customers or users? For a toll road, what is the traffic forecast? Is it based on realistic economic assumptions? A new toll road in a declining area might attract far fewer users than projected, threatening repayment. Demand forecasts are notoriously optimistic; compare them to actual experience where possible.
Pricing power: Can the revenue source adjust its rates if costs rise? A water utility has some ability to raise rates, but is constrained by regulation and customer resistance. An airport can raise landing fees within limits set by airline agreements. Some projects have fixed pricing (e.g., a parking structure with fixed rates) and cannot adjust to inflation.
Operating costs: What are the operating expenses, maintenance costs, and staff costs? Are they realistic? Many projects are underfunded for long-term maintenance, creating future cash shortfalls.
Competition: Is the project insulated from competition, or exposed to it? A toll road with no parallel free highway is safer than one competing with a free route. A water utility has a natural monopoly; an airport competes with others for airline service.
Market trends: Is the underlying market growing, stable, or declining? Hospital revenue bonds are safer in growing markets; riskier where population is declining. Electric utility revenue bonds face headwinds from distributed solar and wind generation.
Debt service coverage: What is the ratio of operating revenues to bond payments? A ratio of 1.5x or higher (meaning the project generates 1.5 times the annual debt service) is reassuring. A ratio of 1.0x to 1.2x is concerning; there is little margin for error.
Examples: successes and cautionary tales
Transportation success: The San Francisco Bay Bridge retrofit, financed partially by revenue bonds backed by bridge tolls, has succeeded because the bridge is heavily used and tolls were systematically raised to cover costs. This was a relatively low-risk project.
Cautionary tale — the Indiana Toll Road: In 2006, Indiana leased the Indiana Toll Road (a toll highway) to a private operator via a 75-year concession for $3.85 billion. The operator issued toll revenue bonds to finance the concession payment. But toll revenues fell short of projections, especially after the 2008 financial crisis. The operator defaulted on bonds, leading to losses for bondholders and a protracted legal and restructuring process.
Healthcare risk: Hospital revenue bonds depend on patient revenue, insurance payments, and government reimbursement rates. During the COVID-19 pandemic, many hospitals faced census declines and financial stress. Hospital revenue bonds that seemed safe in 2019 faced repricing in 2020.
These examples illustrate that revenue bonds are not "bad" — many perform excellently — but they require active credit monitoring and realistic demand assumptions.
Comparison to GO bonds
For a given issuer, a revenue bond yields more than a GO bond of the same maturity. Why? Because the investor is taking more risk. A GO bond has the city's full taxing power as a backup; a revenue bond does not.
Typical yield comparison (hypothetical, May 2024):
- City GO bond, 10-year, A-rated: 3.8%
- Same city's water utility revenue bond, 10-year, A-rated: 4.2% to 4.5%
The 40 to 70 basis points extra compensates for the higher credit risk. For a high-income investor, this extra yield might justify the risk — if the revenue bond analysis is thorough and the issuer's finances are sound.
Conversely, if the revenue bond yield is only 20 basis points higher than the GO bond, there may not be enough extra yield to justify the added risk and the need for deeper analysis.
Subordinated and other structures
Many revenue bond issuances include multiple classes or "tranches" of debt. Senior lien bonds have first claim on revenues; subordinated bonds have second claim. Junior bonds are paid only after senior and subordinated obligations are met.
This structure allows the issuer to sell bonds to different investor bases at different yields. An investor in senior lien bonds accepts a lower yield (perhaps 3.8% on a water utility bond) because of first priority. An investor willing to accept subordination might buy junior bonds at 5.5%.
The waterfall of payments is crucial: if revenues are tight, junior holders may not be paid in full, while senior holders are protected. Investors must know their place in the capital structure.
Callable bonds and refinancing risk
Many municipal revenue bonds are callable — the issuer can repay the bond early if rates fall and they can refinance at lower rates. This benefits the issuer but hurts the bondholder: you get your principal back when rates are low and yields are rising, forcing reinvestment at lower rates.
Revenue bonds are more likely to be called than GO bonds in many instances, because the cash flow stability of a well-performing project makes prepayment feasible. This is another reason to favor mutual funds or laddered individual bonds over concentrating in callable revenue bonds.
Flowchart for revenue bond assessment
Next
Revenue bonds are a natural step once you understand general obligation bonds. But some bonds fall into a middle category: they have characteristics of both GO and revenue bonds, or they are backed by revenues but with restrictions. In the next article, we'll explore one of the most important concepts: the tax-exempt status that drives muni returns, and how to calculate whether a muni is actually the right choice for your situation.