Analysis

Revenue bonds require a different type of analysis than G.O. bonds. Previously, we discussed how population demographics, economic diversity, and municipal finances are important considerations for G.O. bonds. Revenue bonds are backed by income from projects or facilities built with borrowed funds, not property taxes.

While revenue bonds generally do not require voter approval and are not subject to debt limits, they still face some obstacles prior to issuance. Municipalities hire outside consultants to create feasibility studies to determine if the project or facility will make enough revenue to pay back borrowed funds and avoid default. It’s important for an independent third party (usually a consulting or marketing firm) to evaluate the proposed project or facility. It’s possible an important person working for the municipality (like the Mayor) is a big fan of the proposed endeavor, even if it doesn’t have a chance of making money. The feasibility study should provide the municipality with an unbiased opinion on the viability of the project or facility. The topics typically covered in a feasibility study include:

• Cost of facility
• Demand
• Competition
• Economic impact
• Management structure

Let’s assume a city wants to consider issuing a revenue bond to build an aquarium. It’s important to research the aquarium’s potential for success before it’s built. How much will the project or facility cost to get up and running? If it’s too costly a project, it won’t likely garner enough support. What about the demand for the aquarium? If most of the municipality’s residents aren’t interested in aquatic life, not enough tickets will be sold and the bond will default. What if the city already has an aquarium? If so, the competition would make it difficult for either aquarium to survive. What if the economic impact is small or non-existent? Should the municipality prioritize another project? Who will manage and run the aquarium? These are all valid questions the feasibility study should answer. The information in the study can be used by investors to determine if the bond is worthy of investment.

If the feasibility study seems promising and the municipality subsequently issues the bond, investors will then pay close attention to the facility or project’s debt service coverage ratio (DSCR). This was already covered in the common stock chapter, but let’s remind ourselves of the calculation:

$\text{DSCR}=\frac{\text{net operating income}}{\text{debt\hspace{0.33em}service requirements}}$

The DSCR is an important piece of information that may alarm investors if the revenue bond is at risk of default. For example, let’s assume the aquarium has $5 million in net operating income and $2.5 million in debt service requirements.

$\text{DSCR}=\frac{\text{\$5,000,000}}{\text{\$2,500,000}}$

$\text{DSCR}=\text{2:1}$

The aquarium is making twice the amount of money it needs to stay “above water” and avoid default. Issuers always want the DSCR to be comfortably above 1. If it falls below 1, the facility or project is bringing in less money than needed to pay back bondholders.

Another way to analyze this type of municipal revenue bond is by analyzing its covenants. Virtually all are issued with a trust indenture, sometimes referred to as a bond resolution. This document contains a list of promises (covenants) made by the issuer to its bondholders. This would be similar to lending money to a friend, and they write up a list of promises related to paying you back (e.g. I promise to stay employed, I promise to avoid gambling, etc). Let’s explore common covenants included in municipal bond trust indentures.

Insurance covenant

The unexpected can always happen, so it’s important municipalities obtain insurance for facilities they build. This will prevent significant costs related to accidents or other unforeseen circumstances. The more unexpected expenses, the more likely a default will materialize.

Catastrophe covenant

This promise takes things one step further than the insurance covenant. If an “act of God” (e.g. tornado, hurricane, earthquake, etc) occurs and leaves the facility in shambles, the issuer pledges to use their insurance payout to call the outstanding bonds. This is sometimes referred to as a catastrophe call.

Books and records covenant

The issuer promises to keep accurate books and records compliant with recognized accounting standards. Additionally, the municipality may obligate itself to publicly release periodic financial reports.

Rate covenant

The rate assessed by the facility must be high enough to cover debt service (paying back bondholders) and operations/maintenance. Of course, a bit of economics will come into play; if rates are too high, not enough people will pay to use the facility. Bottom line - the issuer promises to maintain an adequate pricing system to ensure the “bills will be paid.”

Maintenance covenant

Would you go to an aquarium that wasn’t properly maintained or kept clean? Probably not. With this covenant, the issuer promises to take care of the facility properly.

Additional bonds covenant

What if the municipality wanted to issue additional bonds against the same facility? This covenant exists as an open-end indenture or closed-end indenture, which results in two different outcomes based upon the dynamics of the future offering. For example, assume there’s a revenue bond outstanding for our city aquarium that the issuer is currently paying off, and the municipality wants to borrow additional funds from investors to expand the facility. The additional bonds covenant determines how the issuer (the municipality) must operate if it issues another bond. This will increase the current bondholders’ exposure to credit risk. What if the issuer takes on a significant amount of new debt to expand the zoo, but the expansion doesn’t attract new visitors? It could result in default.

If there’s an open-end indenture, the issuer may issue new senior-level bonds if they pass an earnings test. Basically, the issuer must demonstrate they’ll be able to pay off the newly borrowed funds. If they pass the test, they can issue new senior level bonds (same liquidation priority as the original bonds) or junior bonds. If they fail the test, they may only issue junior (subordinated) bonds that are lower priority in the event of a default and liquidation. If there’s a closed-end indenture, the issuer may only issue new junior-level bonds with lower liquidation priority.

Another important aspect of revenue bonds is the flow of funds, which determines how the issuer utilizes the revenue it receives. In particular, it’s important to know if the issuer will structure the bond under a gross revenue pledge or net revenue pledge. When revenue is received from the facility or project, the issuer places those funds into the revenue fund. From there, revenue is spent in one of two ways:

Gross revenue pledge

1. Debt service
2. Operations and maintenance
3. Reserve and renewal funds

Net revenue pledge

1. Operations and maintenance
2. Debt service
3. Reserve and renewal funds

Do you spot the difference? In a gross revenue pledge, bondholders are paid first (debt service), then operations and maintenance are paid for. It’s the exact opposite for net revenue pledges, where operations and maintenance are first priority. Some test takers remember the facility may get “gross” if they prioritize paying bondholders over maintaining the facility (as they do with gross revenue pledges).

Sinking fund covenant

A sinking fund requirement is very similar to a call feature. Both result in the issuer redeeming bonds prior to maturity and are considered added risks to bond investors. Remember, reinvesting pre-maturity bond proceeds can result in reinvestment risk if interest rates have declined.

There are some important differences between the two. Unlike call features, sinking fund requirements are mandatory and don’t result in the entire issue being redeemed*. For example, a municipality self-imposes a sinking fund requiring 5% of its outstanding bonds to be redeemed annually. The issuer is typically allowed to redeem the randomly-selected bonds at a predetermined price (usually par). If the market price is lower, the issuer can opt to buy back bonds in the market to meet their sinking fund requirements.

*When a call feature is executed by an issuer, it’s common for all the outstanding bonds to be redeemed at once. Conversely, a sinking fund requirement typically only results in a small portion of the outstanding bonds being redeemed.

While a sinking fund covenant is viewed as an added risk for investors, it could also demonstrate the issuer’s creditworthiness. Assume a municipality issues a $100 million bond. If no sinking fund exists, one final interest payment plus the $100 million principal must be repaid once the bond matures. This could create a huge burden for a cash-strapped municipality, possibly resulting in default. A sinking fund requires the issuer to pay off portions of the debt along the way, reducing the amount that must be paid at maturity.

Covenant summary

The protective covenants listed above are common in trust indentures, although each issuer will ultimately decide how to structure their bonds. Oftentimes, the protections afforded to a bond issue is determined by investor demand. For example, a municipality may find it difficult to issue a revenue bond without a sinking fund covenant. Even when instituted, it’s virtually impossible for bondholders to know if these promises are being fulfilled. To prove they’ll follow through with their pledges, the issuer hires a trustee to oversee their actions. If the issuer breaks a promise, the trustee will sue the issuer on behalf of the bondholders.

The trustee is typically a commercial bank or trust company, not a single person. It’s a bizarre relationship, but the issuer hires the trustee to keep them in line and potentially sue them if they slip up. Therefore, the trust indenture is ultimately an agreement between the issuer and the trustee (who acts on behalf of the bondholders).