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 don’t require voter approval and aren’t subject to debt limits, they can still face obstacles before issuance. Municipalities often hire outside consultants to create feasibility studies. A feasibility study evaluates whether the project or facility is likely to generate enough revenue to repay borrowed funds and avoid default.

Using an independent third party (usually a consulting or marketing firm) matters because the municipality may have internal supporters of the project who aren’t focused on profitability. For example, a prominent official (like the mayor) might strongly favor a project even if it has little chance of generating sufficient revenue. The feasibility study is meant to give an unbiased view of the project’s viability.

The topics typically covered in a feasibility study include:

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

Let’s assume a city is considering issuing a revenue bond to build an aquarium. Before building it, the city needs to understand whether the aquarium can realistically support the bond.

• Cost of facility: How much will it cost to get the project up and running? If the project is too expensive, it may be difficult to justify or support.
• Demand: Will enough people want to visit? If residents (and tourists) aren’t interested, ticket sales may fall short and the bond could default.
• Competition: Is there already an aquarium nearby (or in the same city)? If so, competition could reduce revenue for both.
• Economic impact: Will the aquarium meaningfully benefit the local economy, or is the impact likely to be minimal?
• Management structure: Who will operate the aquarium, and do they have the experience to run it effectively?

These are the kinds of questions a feasibility study should answer. Investors can also use the study’s information to judge whether the bond is worth buying.

Sidenote

Case study: Jacksonville Aquarium

In 2015, a feasibility study was commissioned to evaluate building an aquarium in downtown Jacksonville, FL.

These are the highlights from the study:

• Cost of the feasibility study: $50,000
• Total cost of aquarium: $100,000,000
  • Cost of facility: $85,000,000
  • Cost of animals and staff: $15,000,000
• Projected number of visitors: 1,300,000
• Recommended ticket price: $21.95
• Projected gross ticket sales: $1,000,000,000

While the feasibility study was considered a success for those in favor of building the aquarium, no concrete plans have materialized.

If the feasibility study looks promising and the municipality 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 it’s worth reviewing the calculation here:

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

DSCR helps investors assess whether the revenue bond is at risk of default.

For example, assume the aquarium has $5 million in net operating income and $2.5 million in debt service requirements.

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

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

A DSCR of 2:1 means the aquarium is generating twice the income needed to cover its debt payments. Issuers generally want DSCR to be comfortably above 1. If DSCR falls below 1, the facility or project is bringing in less money than needed to pay bondholders.

Another way to analyze a municipal revenue bond is by reviewing its covenants. Virtually all are issued with a trust indenture, sometimes called a bond resolution. This document lists promises (covenants) the issuer makes to bondholders.

A simple way to think about it: it’s like lending money to a friend who writes down specific promises related to repayment (for example, “I’ll stay employed” or “I’ll avoid gambling”). In a revenue bond, the trust indenture spells out similar commitments designed to protect bondholders.

Let’s look at common covenants included in municipal bond trust indentures.

Insurance covenant

Unexpected events can happen, so municipalities typically obtain insurance for facilities they build. Insurance can reduce the financial impact of accidents or other unforeseen circumstances. The more unexpected expenses the facility faces, the greater the risk of default.

Catastrophe covenant

This covenant goes a step beyond the insurance covenant. If an “act of God” (e.g., tornado, hurricane, earthquake, etc.) destroys the facility, the issuer pledges to use the 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 that follow recognized accounting standards. The municipality may also obligate itself to publicly release periodic financial reports.

Rate covenant

The facility’s rates (prices or fees) must be high enough to cover:

• Debt service (payments to bondholders)
• Operations and maintenance

At the same time, basic economics still applies: if rates are too high, fewer people may use the facility. The key promise is that the issuer will maintain an adequate pricing system so the facility can pay its bills.

Maintenance covenant

A facility that isn’t properly maintained tends to lose customers and revenue. With this covenant, the issuer promises to maintain the facility appropriately.

Additional bonds covenant

This covenant addresses what happens if the municipality wants to issue additional bonds backed by the same facility.

It can be structured as an open-end indenture or a closed-end indenture, and the structure affects existing bondholders’ exposure to credit risk.

For example, assume the city has an outstanding revenue bond for the aquarium and wants to borrow more money to expand the facility. If the issuer takes on significant new debt but the expansion doesn’t attract enough new visitors, the increased debt burden could contribute to default.

• If there’s an open-end indenture, the issuer may issue new senior-level bonds if it passes an earnings test. In other words, the issuer must show it can support the additional debt. If it passes the test, it can issue:

  • New senior-level bonds (same liquidation priority as the original bonds), or
  • Junior bonds

  If it fails the test, it may only issue junior (subordinated) bonds, which have lower priority in 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 describes how the issuer uses the revenue it receives. In particular, you’ll want to know whether the bond is structured under a gross revenue pledge or a net revenue pledge.

When revenue is received from the facility or project, the issuer deposits it into the revenue fund. From there, the money is applied in one of two orders:

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

The difference is the order of priority. Under a gross revenue pledge, bondholders are paid first. Under a net revenue pledge, operations and maintenance are paid first.

Some test takers remember this by thinking the facility may get “gross” if it prioritizes paying bondholders over maintaining the facility (as it does with a gross revenue pledge).

This payment priority also changes how DSCR is calculated under each type of pledge.

Under a gross revenue pledge, debt service is paid before operations and maintenance (O&M). Since nothing has been subtracted from revenue yet at the point debt service is paid, DSCR is calculated using gross revenue, without deducting O&M:

$\text{DSCR}=\frac{\text{gross revenue}}{\text{debt service requirements}}$

Under a net revenue pledge, O&M is paid before debt service. That means O&M must already be subtracted from gross revenue before you arrive at the revenue available to cover debt service:

$\text{DSCR}=\frac{\text{gross revenue}-\text{O\&M}}{\text{debt service requirements}}$

For example, assume the aquarium generates $6,000,000 in gross revenue, spends $1,000,000 on O&M, and owes $2,500,000 in debt service:

• Gross revenue pledge: DSCR = $6,000,000 ÷ $2,500,000 = 2.4:1
• Net revenue pledge: net revenue = $6,000,000 − $1,000,000 = $5,000,000, so DSCR = $5,000,000 ÷ $2,500,000 = 2:1

Notice the net revenue pledge produces a lower DSCR here, since O&M has already been subtracted from revenue before dividing by debt service.

Sinking fund covenant

A sinking fund requirement is very similar to a call feature. Both can result in bonds being redeemed before maturity, which is an added risk to bond investors. If interest rates have declined, investors may face reinvestment risk when reinvesting the proceeds.

There are important differences between the two. Unlike call features, sinking fund requirements are mandatory and typically don’t redeem the entire issue.*

For example, a municipality might impose a sinking fund requiring 5% of its outstanding bonds to be redeemed each year. The issuer is typically allowed to redeem randomly selected bonds at a predetermined price (usually par). If the market price is lower, the issuer can instead buy back bonds in the market to meet the sinking fund requirement.

*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 often viewed as an added risk for investors, it can also signal creditworthiness. Assume a municipality issues a $100 million bond. If no sinking fund exists, the issuer must repay the entire $100 million principal at maturity (along with the final interest payment). That large lump-sum repayment can be a major burden for a cash-strapped municipality and could contribute to default. A sinking fund reduces this risk by requiring the issuer to pay down portions of the debt over time.

Covenant summary

The protective covenants listed above are common in trust indentures, although each issuer ultimately decides how to structure its bonds. Often, the protections included in a bond issue depend on investor demand. For example, a municipality may find it difficult to sell a revenue bond without a sinking fund covenant.

Even when covenants exist, bondholders generally can’t directly verify whether the issuer is following them. To provide oversight, the issuer hires a trustee to monitor compliance. 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 an individual. This creates an unusual relationship: the issuer hires the trustee to oversee the issuer’s actions and, if necessary, take legal action against the issuer. As a result, the trust indenture is ultimately an agreement between the issuer and the trustee (who acts on behalf of bondholders).

Sidenote

Trust Indenture Act of 1939

Now that you know what a trust indenture is, you should be aware of the law that requires them. The Trust Indenture Act of 1939, enforced by the SEC, requires non-exempt issuers of debt securities to create trust indentures. The law applies to non-exempt issues of $50 million or more.

Although we’ve discussed trust indentures and covenants using a municipal security as the example, corporate debt securities are required by law to have trust indentures (if the offering is $50 million or more).

You’ll learn about exempt issuers and securities later in this material, but for now you can assume a non-exempt issuer is a corporation.

Municipalities (and other government entities) are exempt from the Trust Indenture Act. So why discuss trust indentures with revenue bonds? Although municipalities aren’t required by law to use them, it’s difficult to sell a revenue bond without one. Investors typically demand a trust indenture to help protect their interests.