Types

A municipal bond that does not rely on property (ad valorem) taxes is a revenue bond. There are various types of municipal revenue bonds, which are discussed in this section.

An industrial revenue bond (IRB), sometimes referred to as an industrial development bond (IDB), is issued to bring business to the municipality. The municipality issues a bond and uses the proceeds to build a corporate facility (e.g. office buildings, factories). A corporation leases the property from the municipality, and the lease payments are used to pay back the borrowed funds. Although it’s a municipal bond, the credit rating is based on the corporation. If the corporation goes bankrupt and stops making lease payments, the revenue available for the bond just dried up, leading to default.

IRBs can be subject to unique tax rules. First, federal taxes may apply to investors if a large portion of the bond is purchased by the corporation leasing the facility. Think about it - the corporation makes a lease payment to the municipality that is passed through to the bondholder (the corporation). Assuming the interest is tax-free, it would be quite a deal for the corporation! Government regulations prevent this from happening. Also, IRBs can be considered private activity bonds that are subject to alternative minimum taxes (AMT). Remember, municipal bonds that benefit a private (non-government) entity are typically considered private activity bonds.

Lease-back bonds, also known as lease rental bonds, involve the issuance of a bond to build or buy a building to be rented. Once the building is ready to rent, the lease payments from the renters are used to pay back the borrowed funds. These are very similar to IRBs, but lease-back bonds support developments that are rented to other municipal units. For example, a city builds a new facility for the police department, which then rents the facility from the city. The lease payments are used to pay back the borrowed funds.

Special tax bonds are issued to support any project the municipality prefers, then are paid off with non-ad valorem taxes. Typically paid off with “vice” excise taxes like liquor, tobacco, and marijuana, the capital raised does not have to be connected 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 pay back the borrowed funds. Because special tax bonds rely on taxes, they’re considered non-self-supporting revenue bonds. All other revenue bonds that are not dependent on taxes are self-supporting bonds.

A special assessment bond is issued to improve a small portion of a municipality. For example, a city could use borrowed funds to build a bike path and improve sidewalks in a specific neighborhood. Taxes that are assessed only to citizens and businesses in that local area would be used to pay off the bond. This is another example of a non-self-supporting revenue bond due to its dependence on taxes.

New Housing Authority (NHA) bonds, sometimes referred to as Public Housing Authority (PHA) bonds, support low-income housing units. The municipality issues an NHA bond and uses the funds to build or purchase a living facility (usually an apartment complex) for tenants. Citizens with low income qualify to rent a unit at affordable, subsidized rates. For example, a housing unit may require a $1,000 per month rent payment to supply the municipality with enough money to pay back borrowed funds. If the tenant can only afford $200 a month, the federal government pays the remaining balance ($800 in this example). NHA bonds are the safest type of municipal bond because of their federal backing and are typically rated AAA.

Moral obligation bonds are an interesting type of municipal bond that can be subject to a considerable amount of risk. These are bonds that come with a “moral obligation” to pay back borrowed funds, but not a legal obligation. In plain English, the bondholders have no legal right to the interest and principal they’re due. Municipalities typically make a promise to involve the state legislature if a moral obligation bond fails, which is known as legislative apportionment. To better understand moral obligation bonds, let’s talk about a real-world example.

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 idea was to bring a successful company (38 Studios) with up to 450 job opportunities to the state. The revenues from the business were designated to pay back the borrowed moral obligation funds. However, 38 Studios went bankrupt in 2012. After the bankruptcy, the bond’s potential default was to be decided by Rhode Island’s state legislature. The state had a tough choice to make: let the bond default or pay it off with state funds. Letting the bond default wouldn’t create any legal problems (they are moral, not legal obligations), but it would hurt the state’s credit rating, making it more expensive and difficult to borrow money in the future. The state decided to go the other way instead, which resulted in taxpayers paying a big portion of the bond funds.

Double-barreled bonds are a hybrid of general obligation and revenue. These bonds are primarily paid off with revenues from the project or facility, but property (ad valorem) taxes can be utilized if the revenues fall short. For example, a municipality could issue a double-barreled bond and use the capital to build a new hospital. If the hospital makes enough money, the revenue is the only source of money used to pay off the bond. If revenues fall short of debt service requirements, the municipality can use property taxes to make up the shortfall. Because property taxes ultimately back them, double-barreled bonds require voter approval to be issued and are subject to debt limits (like all G.O. bonds).

Build America Bonds (BABs) were created as a federal response to the Great Recession of 2008. In the middle of the greatest financial collapse since the Great Depression, lawmakers wanted to provide an incentive to municipalities to borrow money and primarily spend it on infrastructure (e.g. improving or building schools, roads, bridges, etc.). The goal was to get municipalities to improve their cities and offer job opportunities while in the middle of a recession. The incentive was based on taxes. BABs were fully taxable bonds (like corporate bonds), but the federal government subsidized the interest payments at a rate of 35%. For example, let’s assume a city issues a 10% BAB to improve its infrastructure. The municipality would pay a coupon of 6.5% (65% of 10%), while the federal government paid the remaining 3.5% (35% of 10%). BABs are no longer issued today, but plenty of them still exist in the secondary market.

Certificates of Participation (COPs) offer a non-traditional way for municipalities to raise money. Assume a municipality owns real estate it’s not currently using. They “give up” ownership of the real estate to a non-profit third party, then rent the real estate from the non-profit. A COP is then issued, which gives investors rights to the lease payments the city makes. The city makes a rent payment on the property they used to own, the non-profit third party collects the rent, then distributes the rent money to COP holders. When the COP matures, the property is returned to the municipality. If this sounds complicated, it is! COPs offer municipalities a creative way of borrowing funds without actually taking on debt (it’s just a lease payment). These bonds do not require voter approval and are not subject to debt limits, even if taxpayer money is being used to pay the lease.