Revenue bond financing

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Revenue bond financing is the process of borrowing money from investors in order to finance a revenue-generating public project based on a pledge to use future revenues from that project to repay the bondholders. Revenue bond financing is usually used by sub-national governments such as states, municipalities, and public authorities, or any similarly financially independent subdivisions of a government. Revenue bonds are typically secured only by the revenues generated by the project they are being used to finance--for example, if it were used to finance the construction of a toll road, then the fees collected from the drivers using the toll road might be pledged for use in repaying the investors of these bonds in the form of their principal and interest. One of the advantages of using revenue bonds is that they are aligned to the benefit principle - those who derive benefit from the project bear the burden of paying for the project, a concept also related to User fee financing. E.g., for water services, those who consume more gallons of water pay a higher service charge than those customers who consume fewer gallons of water. In this way, consumers pay fees that are proportional to the benefit they derived from the product or the service. Unlike General Obligation (GO) bonds, which pledge the government's full-faith and credit (i.e. the government's power to tax its jurisdiction), revenue bonds are generally only secured by the project, not by taxes or the taxing power of the state. Revenue bonds are usually issued in denominations of $5,000 and mature in around 20 to 30 years. Historically, in the U.S., a higher volume of revenue bonds were issued compared to General Obligation (GO) bonds. According to the Electronic Municipal Market Access (EMMA) [1], 72% of the total volume of new bonds issued between 2010 and 2014 were revenue bonds.

CONCEPT


Goals
Conceptual Example

A State government desires to build an a new bridge for automobiles across a river in order to disperse and improve the flow of traffic in the area. In order to pay for the bridge, the state plans to install toll booths on either side of the bridge, and to use revenues collected from drivers in order to pay bondholders, who will provide the financing for the project upfront in exchange for being repaid with interest over the subsequent twenty years. In order to pay for the bridge, the state pledges the toll revenues to the bondholders throughout the term of the bond--in other words, it cannot use the toll revenues for anything else until the bonds have been repaid. However, unlike in the case of a GO bond, if the toll road fails to produce the expected amount of revenues, the bondholders will fail to recover their investment, but the jurisdiction will not be forced to cut budgets or raise revenues elsewhere, as the toll revenues are the only source of funding pledged to the bondholders.

Specific Example

In April 2015, Barnard College in New York issued tax-exempt revenue bonds to receive $109,035,000 in bond proceeds[1]. Barnard College issued these bonds through a public authority - Dormitory Authority of the State of New York (DASNY). DASNY is New York State’s facilities finance and construction authority. These revenue bonds were issued to finance the construction of approximately 133,000 gross square foot of multi-purpose facility at the College and to provide for other campus-wide renovations and maintenance projects. Barnard College in turn has pledged revenues from the tuition and fees it charges to students for providing college education. It will use these revenues to make the interest and principal payments to the investors of these bonds. Barnard College will be able to provide better facilities to its existing students and attract more students because of expanded facilities. This in turn will benefit the local residents by providing an increased supply of college educated work force, increased local spending by students which will in turn improve the local economy. This example demonstrates how Barnard College was able to use the revenue bonds to finance capital projects.

Tradeoffs

Tradeoffs of implementing this policy may include:

  1. Higher interest rate payments due to higher investor risk: revenue bonds are usually repaid with revenues generated by the project that was financed using the bond proceeds. However, when it is difficult to accurately forecast the revenues that will be generated by a given project, there may be an increased perceived risk of the project failing to generate sufficient revenues to meet its debt repayment obligations, often making revenue bonds more riskier than General Obligation bonds and, hence, requiring the payment of a higher rate of interest from investors to compensate them for this risk.
  2. Higher cost of issuance: because it is hard to accurately forecast the demand and therefore the revenues from the project financed through revenue bonds, it is essential to conduct a feasibility studies. Feasibility studies are usually used to present investors with anticipated revenue streams and other assumptions used in forecasting the demand for and revenues from the project. These studies are usually conducted by independent experts to add credibility to the studies, adding to the cost of issuing revenue bonds.
  3. Greater restrictions on the use of bond proceeds: in the case of General Obligation bonds, the larger taxing power of the state is pledged to the repayment of the debt. This allows the issuer to be more flexible with the General Fund – it has the flexibility to move new sources of revenue to other funds based on its need and the timing of the receipt of the revenue and debt obligations due date. On the other hand, when a particular source of revenue is pledged for a revenue bond, it has no flexibility to use this revenue source for anything other than debt repayment until its obligations have been met.
  4. Greater compliance and pricing requirements: revenues bonds often include additional, legally-required investor protections that add to the complexity and cost of compliance. For example, a rate covenant may require the issuer of the bond to maintain rates and charges to satisfy the revenue -i.e. in order to generate adequate revenue to make debt service payments, rates and user fees may be increased based on a stipulated scale and time period. For example, a water authority may raise the water usage fees in order to comply with the rate covenant it promised to investors while issuing a revenue bond. When a rate covenant is included in the bond documents given to investors - the issuer is legally bound to adhere to the rate covenant. Other restrictions could be in the form of coverage--e.g., a ratio of pledged revenues that will be used for making debt service payments to the debt service that will come due annually or requirements for having casualty insurance on the asset that is being financed.
  5. Tradeoff between credit rating and future debt capacity :for example, an airport system pledges all its revenues for a revenue bond whose proceeds it’s using to finance the expansion of passenger facilities in an airport. Generally an airport system would have pledged its revenue from Passenger Facility Charges (PFC) to finance any project related to passenger facilities. PFC fees are used by public agencies that manage commercial airports to fund FAA-approved projects that enhance safety, security, or capacity; reduce noise; or increase air carrier competition. In this example, however the airport chose to pledge all of its revenues to this revenue bonds. By pledging all of the airport revenue sources it is limiting its overall debt capacity, compared to pledging just the revenues from PFC fees and limiting its capacity to issue additional PFC secured revenue bonds. However, this airport system could have used this if the underlying credit quality of its overall revenue is better than that of the PFCs. Hence, this airport system opted to maintain a higher credit rating by limiting its overall future debt capacity.


Compatibility Assessment

If answered yes, the following questions indicate superior conditions under which the policy is more likely to be appropriate:

  1. Does the project that is to be funded by the revenue bonds have a reliable, continuous source of revenue throughout the life of the bond and asset/project?
  2. Does the consultant or agency conducting the feasibly studies have sufficient sector expertise to produce accurate and credible assumptions and projections?
  3. Is the revenue that is to be pledged for the revenue bond not yet pledged for a prior bond--or, if it has been, will there be sufficient revenues remaining after paying the previous bond holders to pay the new bond holders?
  4. Are the revenues being pledged diversified enough to avoid defaulting on the bonds? (i.e., If the revenues are too narrowly-generated then any dramatic change in the revenue can have adverse effects on debt service payments to the bond holders)
  5. Is the credit quality and historical credit rating of the underlying revenue source favorable enough to attract investors without having to provide very high interest rates?
Design

The following questions should be considered when determining how to implement this policy:

  1. What is the total amount that will needed to be raised in order to complete the project?
  2. What share, if not all, of revenues will be used to pay off the bonds?
  3. What restrictions, if any, will apply to the use of revenues once all bonds have been repaid?
  4. What are the legal restrictions on issuing the revenue bonds such as rate covenants, Federal tax laws pertaining to Debt Service Reserve Fund etc?
  5. What is the life time of the asset relative to the maturity of the revenue bond that is being used to finance this asset or project?
  6. Is it reasonable to expect that this project or asset will pay for itself?
  7. What is the reasonable feasibility of the project that is being financed - are the projections for demand, completion of construction being based either on reasonable assumptions or prior experience of executing similar projects?
  8. Is the competition and its impact on the revenue generating capabilities of the project being financed, assessed?
  9. Is there an opportunity to make the revenue sources being pledged or appropriated broader rather than narrower?
  10. What is the underlying credit quality of the revenue that is being pledged for meeting debt obligations?
  11. What if any, are the prior claims to a revenue source that is being pledged for meeting debt obligations to investors?
  12. How many times does the current or the expected revenue cover the bonds debt obligations?

ADOPTION


PolicyGraphics
  • Has adoption of: Common. Revenue bond financing is a common method of financing capital projects among a high number of sub-national governments such as states, municipalities and public authorities.
Adopters

Notable entities who have implemented or adopted this policy include:


Revenue bond financing is used by various types of revenue backed projects. Usually government entities that are designated as enterprises or run like a business, use revenue bond financing. Therefore, the adopters of revenue bond financing include a large number of authorities, enterprises or business like units within the State and City governments across the US. Non-profits use conduit authorities to issue tax-exempt revenue bonds. Hence the adopters of revenue bond financing vary according to the use.

For example, a Department of Aviation within a City government can use airport revenue bonds to finance airport construction, expansion, renovation and so on. "The City is a political subdivision of the State of Colorado (the “State”). The Denver Municipal Airport System (the “Airport System”) is owned by the City and the power to operate, maintain and control the Airport System is vested in the Department. The City by ordinance has designated the Department as an “enterprise” within the meaning of the State constitution with the authority to issue its own revenue bonds or other financial obligations in the name of the City. Denver International Airport (the “Airport”) is the primary asset of the Airport System.” (Official Statement of City and County of Denver, Colorado, $171,360,000 Airport System Revenue Bonds, Series 2010A [2]). NYU, a private nonprofit university, could use the Dormitory Authority of the State of New York (DASNY) or more recently NYU Build, to issue tax-free bonds for construction or renovation of a research facility in an NYU building.

The list of adopters can be classified by the following types of major revenue bonds[2]. The example of adopters provided for each of the type of revenue bonds are only an indicative list and not an exhaustive list. Almost all States and Cities these types of revenue bonds.

• Airport revenue bonds fund the construction of airports. Landing fees, fuel fees, and lease payments secure these bonds. City of Denver (The Denver Municipal Airport System) • Industrial revenue bonds finance public projects such as factories, industrial parks, and stadiums. Fees, concessions, and lease payments provide the backing. Allegheny County (Allegheny County Industrial Development Authority) • Public power revenue bonds pay for power plants. The sale of electricity provides the revenues. State of Nebraska (Dawson Public Power District) • Hospital revenue bonds fund construction and renovation of hospitals and the buying of equipment. Hospital revenues, such as those from Medicare, are used to repay bondholders.County of Polk (The Hospital Facility Authority of Polk County) • Housing revenue bonds fund the construction of housing. They may cover single-family or multi-family housing units. Mortgage payments are the security. New Housing Authority bonds finance low-income housing. State of Michigan (Michigan State Housing Development Authority) • Student loan revenue bonds finance loans taken by college and university students.Commonwealth of Kentucky (Kentucky Higher Education Student Loan Corporation) • Transit revenue bonds pay for public transportation. Fares and government subsidies secure them. City of Chicago (Chicago Transit Authority) • Water revenue bonds finance water and sewer projects. Connection fees and usage fees provide the revenues. State of New York (Water Authority of Western Nassau County) • Highway revenue bonds are used to build revenue-producing facilities such as bridges and toll roads.State of Kansas (Department of Transportation) • Toll road bonds are a sub-type, the revenues of which come from tolls. Gas tax revenue bonds are another sub-type of highway revenue bonds. Gas taxes, license fees, and other non-toll sources secure them. City of Cape Coral, Florida • Special tax bonds are backed by excise taxes such as those on cigarettes and alcohol. They may also be backed by special assessments on those who will benefit directly from a particular project. • College and university revenue bonds finance the construction of centers of higher learning. Bondholder payments include dorm fees and tuition payments. State of New York (Dormitory Authority of the State of New York) • Double-barreled bonds receive backing from both revenue and the municipality's creditworthiness. They are a hybrid, and they may finance a variety of projects

STAKEHOLDERS


Issuers: public authorities at the State and City level like Chelan County Public Utility District, Michigan State Housing Development Authority issuing Single-Family Mortgage Revenue Bonds, Hospital Authority of Polk County, Oregon that issued tax-exempt revenue bonds for Dallas Retirement Village Project to expand its Continuing Care Retirement Community campus to add additional Independent Living Units (ILUs). Issuers are an important stakeholder. They are responsible to their communities in ensuring judicious use of the debt for projects that are truly important to the local economy and in distributing the burden of this debt among all those who benefit from the infrastructure that is financed by the debt, both in the present and in the future. Issuers are also responsible to their investors in ensuring they meet their debt obligations in a timely manner, make accurate representations of the project, its needs and its revenue generating capacity and in continuing to inform its investors of its activities and finances through the life of the debt, to the maximum extent possible.

Community: the community in a particular City or State are also important stakeholders. The community that pays taxes in that particular City or State, depending on their influence, may either support or oppose revenue bonds. Although revenue bonds do not require voter approval, if the community perceives that the revenue bond proceeds are not being used appropriately they may want to participate in the decision making process. Also, the community bears the debt burden since the taxes they pay maybe used to make the debt related payments to bondholders. The community also plays dual role of being the user or the customer and a bondholder.

Users/customers: since revenue bonds use revenue generated by the asset or the project, customers are important stakeholders. Customers will use the asset or the project if it’s important to them and has an impact on their lives. For example, if a particular freeway is congested solutions could include either congestion pricing or expanding the road. Instead if the government decided to build a new toll road that the motorists don’t use, it will be left with a huge debt burden, an infrastructure it did not really need and angry tax payers who will believe that the government squandered their tax dollars. The issuer will also have to provide a higher interest rate on the bonds that it initially estimated, to compensate its investors for the additional risk of materially lower toll revenues which were to be used to meet the debt obligations. Therefore, users or customers are crucial stakeholders and it is important to understand their needs.

Revenue bond holders / investors: investors are important stakeholders in a revenue bond financing. Investors provide the financing needed to build the project or the asset in exchange for interest and repayment of principal by the issuer.

Unions: since revenue bonds involve construction of infrastructure construction unions are stakeholders too. This would be a steady stream of work for the unions.

Revenue bond underwriters: revenue bonds encompass many major types of infrastructure and projects which are sometimes backed by complex financing structures like tax increment financing. This structure of financing may not be commonly understood by all investors and hence a lot of effort will have to be directed towards educating and marketing these revenue bonds among potential investors. Therefore, revenue bonds are usually underwritten through negotiated sales rather than competitive sales. Since competitive sales usually get the underwriters to bid for bonds, this method of sales is generally known to reduce the cost of issuance for the issuer and lower underwriting spreads for the underwriters. However, negotiated sales tend to have a higher cost of issuance to the issuer and generally a higher spread for the underwriter. Underwriters are important stakeholders since the municipal market does not engage with its investors directly and therefore in order to successfully raise the required financing for a project, underwriters are important to issuers in bringing investors on board.


Supporters

Below is a description of two broad categories of supporters:

  • Issuers: Generals Obligation (GO) bonds are subject to statutory debt limitations and voter approval. If a State had to finance the construction of a bridge to ease the traffic woes of the community but was subject to debt limitations and voter approval, it would limit the number of projects the state can carry out by the debt limit and expose the initiative to an additional layer of the politics if it required voter approval.
  • Unions: wherever unions can have a steady stream of work, for example with school districts, construction unions would favor labor agreements with the school district representatives. This will work to the advantage of the unions if they can agree on labor terms and conditions with the representatives. This would also cut out competition to a certain extent.
Opponents

Community, Revenue bondholders / investors. [4][5]

Below is a description of some broad categories of stakeholders that might oppose revenue bond financing in specific circumstances:

  • Voters / community: since revenue bonds do not need voter approval, voters may perceive that their governments are not being transparent enough with the revenue bond finances and its use. For example, in November 2015 in California, a Stockton-are farmer proposed an initiative. Under this initiative the state would require voter approval for any state projects using revenue bonds exceeding $2 billion. Small business owners and taxpayer organizations perceive large state funded projects using revenue bonds as adding to the State’s financial obligations without any input from the voters. California plans to construct a $15 billion tunnel under the Sacramento-San Joaquin River Delta. The Delta-are landowners are opposed to the diversion of their water through this tunnel and hence proposed this initiative. Again in California in November 2015, the community voted to institute a Citizens Bond Oversight Committee for school districts funding because they perceived that the state’s school districts financing through bonds were corrupt in that they were using Capital Appreciation Bonds irresponsibly, expenditures using bond proceeds were inappropriate, contracts for bond underwriting were questionable and improper construction, program management and project delivery. The construction unions did not favor the instituting of this committee since the committee would be opposed to negotiated labor terms and conditions between the school district representatives and the construction union since it would cut out competition and raise the costs of construction.
  • Revenue bondholders / investors: in some instances, investors may be opposed to revenue bond financing. Although defaults on revenue bonds are extremely rare, in cases where the issuers miscalculated the need for a project or the type of project they finance through revenue bonds may not be agreeable to investors. For example, as of August 2015 Moody’s maintained the rating of Ba1 (a notch below investment grade) on the outstanding $512 million PILOT Revenue Bonds, Series 2006; the $78 million PILOT Revenue Bonds, Series 2009; the $53 million Installment Purchase Bonds, Series 2006; and the $7 million Lease Revenue Bonds, Series 2006. This rating is a reflection of the underperformance – materially lower revenues due to lower attendance compared to the initial revenue forecasts. Although investors have to be compensated for this additional risk by higher interest rates, investors may perceive this issuer to have misrepresented the investment into this asset. Losing investor confidence could adversely affect the issuers future issuance and credit rating.

REFERENCES


Research
  1. Building a Better America: Tax Expenditure Reform and the Case of State and Local Government Bonds and Build America Bonds, The Georgetown Journal of Law & Public Policy, Blaine G. Sato, July 2013.
  2. Sports Stadiums as Public Works Projects: How to Stop Professional Teams From Exploiting Taxpayers, Virginia Sports & Entertainment Law Journal, Courtney Gesualdi, April 2014.
  3. Fixing Public Sector Finances:The Accounting and Reporting Lever, UCLA Law Review, James Naughton & Holger Spamann, March 2015.
  4. Capital Financing of Schools: A Comparison of Lease Purchase Revenue Bonds and General Obligation Bonds, Shama Gamkhar and Mona Koerner, June 2002.
  5. Competitive Versus Negotiated Municipal Revenue Bond Issues: An Investigation of Underpricing, Judy E. Maese, March 1985.
  6. The Behavior of the Interest Rate Differential Between Tax-exempt Revenue and General Obligation Bonds: A Test of Risk Preferences and Market Segmentation, David S. Kidwell and Timothy W.Koch, March 1982.
Resources
  1. Standard & Poor's Public Finance Criteria, 2007
  2. The Handbook of Municipal Bonds, Sylvan G.Feldsten, Frank J.Fabozzi
  3. The Fundamentals of Municipal Bonds, Securities Industry and Financial Markets Association
  4. http://www.bondbuyer.com/
  5. http://www.emma.msrb.org/ The Electronic Municipal Market Access system, or EMMA®, is the official repository for information on virtually all municipal securities. EMMA provides free public access to official disclosures, trade data, credit ratings, educational materials and other information about the municipal securities market. EMMA is an award-winning website, recognized by the National Federation of Municipal Analysts and the National Association of State Treasurers' State Debt Management Network. The Municipal Securities Rulemaking Board (MSRB) operates the EMMA website under authority granted by the U.S. Securities and Exchange Commission (SEC). The EMMA website was established to increase public access to disclosure and transparency information in the municipal securities market. EMMA provides investors, state and local governments and other market participants with key information about municipal securities, free of charge. The information on EMMA is presented in an easy to use format that is available to the general public.
Footnotes
  1. Electronic Municipal Market Access (EMMA).
  2. http://news.morningstar.com/classroom2/course.asp?docId=5394&page=4&CN=sample
  3. . http://unionwatch.org/california-bond-oversight-committees-crumble-against-union-power/
  4. http://www.latimes.com/local/political/la-me-pc-ballot-measure-new-obstacle-to-diverting-water-to-southern-california-20151030-story.html
  5. http://www.forbes.com/sites/mikeozanian/2015/08/18/citi-field-bonds-remain-junk-as-mets-fans-still-dont-believe/
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