Types

A municipal bond that does not rely on property (ad valorem) taxes is a revenue bond. There are several types of municipal revenue bonds.

An industrial revenue bond (IRB), sometimes called an industrial development bond (IDB), is issued to attract business to a municipality. The municipality issues the bond and uses the proceeds to build a corporate facility (e.g., office buildings, factories). The corporation then leases the facility from the municipality, and the lease payments are used to repay the borrowed funds.

Although an IRB is a municipal bond, its credit quality is tied to the corporation. If the corporation goes bankrupt and stops making lease payments, the revenue supporting the bond can disappear, which can lead to default.

IRBs can also be subject to special tax rules:

• Federal taxes may apply to investors if a large portion of the bond is purchased by the corporation leasing the facility. The concern is that the corporation could effectively “pay itself” tax-free interest through the lease-payment structure. Regulations are designed to prevent this.
• IRBs can be considered private activity bonds that are subject to alternative minimum taxes (AMT). In general, municipal bonds that primarily benefit a private (non-government) entity are treated as private activity bonds.

Lease-back bonds, also called lease rental bonds, are issued to build or purchase a building that will be rented out. Once the building is available for use, lease payments from the renter are used to repay the borrowed funds.

Lease-back bonds are similar to IRBs, but they typically support facilities rented to other municipal units. For example, a city might build a new police facility, and the police department then leases the facility from the city. Those lease payments are used to repay the bond.

Special tax bonds are issued to fund projects the municipality chooses and are repaid with non-ad valorem taxes. They’re commonly repaid with “vice” excise taxes such as liquor, tobacco, and marijuana taxes. The project being funded does not have to be related to the good being taxed.

For example, the state of Colorado allocates a large portion of taxes on marijuana to the education system. Colorado could issue a special tax bond to build or improve schools across the state and use marijuana taxes to repay the borrowed funds.

Because special tax bonds rely on taxes, they’re considered non-self-supporting revenue bonds. Revenue bonds that are not dependent on taxes are considered self-supporting bonds.

A special assessment bond is issued to fund improvements in a specific, limited area of a municipality. For example, a city might borrow funds to build a bike path and improve sidewalks in one neighborhood. Taxes assessed only on the citizens and businesses in that local area are used to repay the bond. Because repayment depends on taxes, this is another example of a non-self-supporting revenue bond.

New Housing Authority (NHA) bonds, sometimes called Public Housing Authority (PHA) bonds, fund low-income housing. The municipality issues an NHA bond and uses the proceeds to build or purchase a housing facility (often an apartment complex). Qualified low-income tenants rent units at affordable, subsidized rates.

Here’s the basic idea: the facility might need $1,000 per month in rent per unit to generate enough revenue to repay the borrowed funds. If a tenant can only afford $200 per month, the federal government pays the remaining $800. NHA bonds are considered the safest type of municipal bond because of this federal backing and are typically rated AAA.

Moral obligation bonds can involve significant risk. These bonds carry a “moral obligation” to repay borrowed funds, but not a legal obligation. That means bondholders do not have a legal claim to the interest and principal they’re owed.

Municipalities often state that if a moral obligation bond runs into trouble, they will ask the state legislature to consider providing funds. This process is called legislative apportionment.

A real-world example helps show how this works:

In 2010, Rhode Island’s Department of Economic Development issued a $75 million moral obligation bond to pay Curt Schilling (retired Red Sox pitcher; the “bloody sock” guy) to bring his video game company to the state. The plan was to attract a successful company (38 Studios) and create up to 450 jobs. Revenues from the business were expected to repay the moral obligation bond.

However, 38 Studios went bankrupt in 2012. After the bankruptcy, whether the bond would be repaid depended on action by Rhode Island’s state legislature. The state could allow the bond to default (with no legal requirement to pay), but doing so could damage the state’s credit rating and make future borrowing more expensive. Rhode Island chose to pay a large portion of the bond with state funds, meaning taxpayers covered much of the cost.

Double-barreled bonds combine features of general obligation and revenue bonds. They are primarily repaid with revenues from the project or facility, but property (ad valorem) taxes can be used if revenues fall short.

For example, a municipality might issue a double-barreled bond to build a hospital. If the hospital generates enough revenue, that revenue is used to repay the bond. If revenues don’t meet the bond’s debt service requirements, the municipality can use property taxes to cover the shortfall.

Because property taxes ultimately back these bonds, double-barreled bonds require voter approval and are subject to debt limits (like all G.O. bonds).

Build America Bonds (BABs) were created in response to the Great Recession of 2008. Lawmakers wanted to encourage municipalities to borrow money - primarily for infrastructure projects (e.g., schools, roads, bridges) - to support improvements and job creation during the recession.

The incentive was tax-based. BABs were fully taxable bonds (like corporate bonds), but the federal government subsidized 35% of the interest payments. For example, if a city issued a 10% BAB, the municipality would effectively pay 6.5% (65% of 10%), while the federal government would pay the remaining 3.5% (35% of 10%). BABs are no longer issued, but many still trade in the secondary market.

Certificates of Participation (COPs) are a non-traditional way for municipalities to raise money. Suppose a municipality owns real estate it isn’t currently using. It transfers ownership of the property to a non-profit third party and then leases the property back.

A COP is then issued to investors, giving them rights to the lease payments the municipality makes. The municipality pays rent to the non-profit, the non-profit collects the rent, and then distributes that rent to COP holders. When the COP matures, the property is returned to the municipality.

COPs allow municipalities to raise funds without issuing traditional debt (the obligation is structured as lease payments). COPs do not require voter approval and are not subject to debt limits, even if taxpayer money is ultimately used to make the lease payments.