What is a Revenue Bond?
A revenue bond is a type of municipal bond in which the repayment of the obligation is primarily guaranteed by the operating revenues of an entity. These bonds are primarily utilized by government entities to subsidize infrastructure projects. The most common projects include the construction of airports, roads, bridges, and sewer facilities.
Note that revenue bonds are different from another type of municipal bonds called general obligation (GO) bonds. The repayment of general obligation bonds is secured by all the revenues generated by an entity, including their tax revenues. The repayment of revenue bonds is guaranteed only by revenues obtained by the projects that were subsidized using the bonds. Tax revenues are not used at all.
Characteristics of Revenue Bonds
1. Longer time to maturity
Since revenue bonds are used for long-term projects, the bonds feature long maturities. Generally, the maturity dates of the bonds often range from 20 to 30 years. In addition, they come with a face value of $1,000 or $5,000. Both the interest and principal payments are made from the operating revenues of a project. However, if a project does not produce enough revenues to make the payments, the payments can be deferred to a later date.
2. Higher returns than general obligation bonds
At the same time, revenue bonds usually provide higher returns to investors compared to general obligation bonds. The higher returns can be justified for several reasons. First, there is a greater probability of non-repayment because they are only secured by the revenue streams generated by a project.
Also, these bonds do not provide investors with a claim to the assets of a project if a project does not generate the expected revenues. Finally, the bonds frequently include provisions that the issuers may call the issued bonds if the project’s assets are destroyed in catastrophic events.
Example of Revenue Bonds
John invests in fixed-income securities. He identifies that the local municipality aims to raise $5 million by issuing revenue bonds to subsidize the construction of the new toll bridge.
John analyzes the project and determines that the new bridge will twice reduce the travel time between the two adjacent cities. Therefore, he is confident that the toll bridge will generate sufficient revenue streams and decides to buy the bonds.
The bonds come with a face value of $1,000, a maturity of 30 years, and an interest rate is 2.5%. The interest and principal repayments are secured by revenues that will be generated by tolls when the construction is completed.
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