Local utilities, municipalities and state governments utilize different financing tools to obtain funding for their various endeavors; while GO bonds are one of the top financing tools, revenue bonds have always held the lead over GO bonds in U.S. municipal markets.

The majority of U.S. infrastructure is funded with revenue bonds, the second prominent type of municipal debt. In this article, we take a closer look at how revenue bonds can be a better investment option than GO bonds in the current economic and political context.

As the name suggests, essential service revenue bonds are primarily issued to fund projects for essential service utilities that provide critical services to maintain public health and safety, like water, wastewater and electricity. These bonds are typically issued by utilities or transportation agencies and play an integral part in infrastructure growth, leading to economic growth. The main sources of revenue for these bonds are connection fees and user consumption costs.

Since revenue bonds are utilized to fund critical services, they provide investors with the assurance of stable and sustainable revenue streams that are also better protected from economic downturns in city and state economies.

On the contrary, GO bonds are used to raise funds for projects that don’t necessarily provide a direct source of revenue, such as parks, bridges and roads. As a result, these bonds are backed by the taxing authority of the issuing state or local government and its full faith and credit. The GO bond issuer pledges its General Fund as a security for meeting its debt obligations. For many municipalities, this fund is primarily generated through property taxes.

Because GO bonds aren’t necessarily used to fund critical services at state or municipality levels, an economic downturn will have a profound impact on revenue streams backing GO bonds.

The table shows revenue bonds are the leader in municipal debt markets compared to GO bonds (debt issuance data in USD billions).

For more information, check out the basic difference between revenue and general obligation bonds.

You might also want to know how states dependent on taxing power from specific industries can struggle during economic downturns to repay their obligations.

As mentioned above, essential service revenue bonds are secured by revenue streams generated through projects and user fees. These revenue streams can be pledged either by gross revenue pledge or net revenue pledge.

Under the gross approach, bondholders are promised payment prior to any other expenditure, whereas under the net approach, the operational and maintenance expenditures are met prior to debt service. The net approach is more common for utilities because payment for operations and maintenance of systems ensures the continuity of critical services. Almost all the revenue bonds are required to keep proper ratios between revenues and all expenditures (including debt payments) – a parameter that determines the rates at which users must be charged to potentially increase revenue.

GO bonds are secured by the pledge of property taxes that can be limited or unlimited in nature. Under the limited approach, municipalities are constrained to raising taxes to a certain rate or dollar amount to meet debt service requirements. The unlimited approach gives municipalities the freedom to tax to any rate, as long as the money is being used to meet the debt service requirement.

In the case of revenue bonds, because net revenue pledges ensure the continuity of critical services for the population, from an investment perspective it makes more sense to remain invested in these bonds even in an uncertain economic environment, as consumers are not likely to completely discontinue the use of these services. However, investors should keep in mind that the local government keeps a close eye on utility rates and usage forecasts to make sure that revenue streams don’t fall short of meeting their obligations.

Make sure to check our Municipal Bond Glossary to familiarize with the muni market concepts.

Despite the benefits of net revenue pledged bonds, investors must analyze Annual Continuing Disclosures to determine the financial health of an issuer and their ability to meet bond covenants.

In revenue bonds, the focus of the analysis should be on the composition of the user base and the issuer’s ability to manage user fees.

1. The top 10 users of the services: The top users of services are typically mid-level to large businesses. It is critical for investors to keep an eye on the top users because if one of these users leave, it could be seen as a credit-negative event.
2. Revenue-to-expenditure ratio: Ratios like net revenues to total expenditure (including debt service) are used to determine the user fee hikes required to maintain bond covenants and the municipality’s ability to take on more debt. For example, in California, several municipalities had to increase their water rates because of lesser usage during drought.
3. Future preparedness: The management and city government’s preparedness to handle future population growth and funding sources to meet these needs.

Before you decide to invest, make sure that you know how your muni bond revenue source can be impacted. For instance, consider these 2 cases:

• Revenue bonds are backed by revenue streams from critical services provided by utilities, meaning these revenues are not part of a city’s general fund or commingled in any way. Also, each utility is treated like its own business, so there are bond covenants that have to be met.

• On the other hand, the vulnerability of tax-backed GO bonds was exposed during the recent financial crisis. As foreclosures reached an all-time high, property tax revenue was cut, leading to several municipality defaults.

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Where both essential service revenue bonds and GO bonds provide stable income and diversification for an investor portfolio at relative risk, it’s imperative to understand the complete structure of net revenue pledges, as they can be lucrative and safer options than GO bonds.

A simple comparison can be made with this statement: If an individual loses his job in an economic downturn, would he or she be more likely to pay his water and sewer bill, or make his property tax payment? Investors must understand the intricacies of both debts along with the understanding of the pledged revenues and credit characteristics of the issuer.

Be sure to visit our Market Activity section to explore recent muni bond trades.