Analyzing Revenue Bonds Using Market Indicators

Instructor: LeRoy Rands

Bill has taught college undergraduate and MBA classes in finance, economics & management, 40 years of finance experience and has a MBA degree.

Revenue municipal bonds are the second biggest source of funding for governmental entities. However, revenue bonds are unique in that the bonds are used to fund a project that will generate the revenue to pay off the bonds.

Revenue Bonds

Mark works for ABC Financial as a bond analyst with a specialty of evaluating new revenue bond offerings. He knows what he needs to look at to ensure that a revenue bond makes sense.

Revenue bonds are a unique form of municipal bonds, because instead of relying on the tax and revenue sources of the issuer, the revenue bond is issued to finance a specific project that will generate its own revenue stream to finance and repay the bonds. Some types of revenue bond projects include:

  • toll roads and bridges
  • mass transit systems
  • sports arenas
  • sewer plants
  • public hospitals
  • facilities to process (and recycle) trash

Mark has received a new revenue bond offering that ABC Financial is thinking of underwriting, for a new light-rail transit system for the capital city of the State of Splendid. The revenue bond is for $240 million and Mark needs to make sure that the economics underlying the bond make sense.

Features of Revenue Bond Projects

Because of the unique nature of revenue bonds, Mark has to take a unique approach to analyzing these projects in order to give a recommendation to his clients and customers. These revenue producing projects are like their own business, and must be investigated like any other new business to determine whether the project makes sense and will generate the revenues to repay the financing.

Some of the features of revenue bonds include:

  1. No voter approval is needed, since the bond will not be repaid from tax revenues but from revenues from the project funding.
  2. A feasibility study must be done showing that the project makes sense and the economic, operational and engineering factors have been considered. This will also include projections of the revenues and bond repayment schedule.
  3. Projects financed by revenue bonds must provide regular financial statements to investors and have their statement audited by an outside audit/accounting firm.
  4. Revenue bonds can be issued to be paid off at maturity or they could be serial bonds, which are paid off in stages over the life of the bond.
  5. Revenue bonds could also be gross bonds, which means that interest and principal is paid before any operating expenses of the project, or net bonds, meaning that interest and principal is paid from funds remaining after operating expenses are covered.

Analyzing Revenue Bond Attractiveness

Mark has to look at many things on Splendid's bond offering before he can recommend it to ABC Financial's underwriting syndicate and all their customers. In general, he must be able to determine whether the project makes sense and will generate the projected revenues.

  1. Mark needs to look at the credit standing and credit worthiness of Splendid. Although the bond will be repaid from the revenues of the project, Splendid's ability to do the project will be reflected in its credit history.
  2. He also needs to consider the coupon or interest rate Splendid is offering for the bonds.
  3. Because revenue bonds are more risky than general obligation bonds, are there any credit enhancements in the new bond issue that will make it safer for the investment public?
  4. Are the projected revenues feasible? How has the issuer documented the projections? Obviously, the projections for the light-rail system ridership must be realistic and in line with systems they are replacing, like buses. If Splendid is depending on all commuters leaving their cars at home, this might not be a reasonable projection.
  5. Mark needs to look at the covenants in the bond. These are promises by the issuer of the level of financial and operating performance. For instance, a prominent covenant is a minimum debt service coverage ratio.
  6. The project must have adequate insurance to cover all potential problems.
  7. The feasibility study must be analyzed and documented carefully.
  8. Mark needs to look for the catastrophe clause, which would ensure that insurance on catastrophic losses is available to repay the bonds in case the project is destroyed or shut down by a crisis.

Mark and his staff have spent considerable time on the Splendid bond offering. He has decided the revenue projections are reasonable and that enough engineering work has been done that the light-rail cars and tracks can be obtained and installed within the budgeted numbers. He feels comfortable recommending to ABC Financial and their underwriting partners to go ahead with the offering.

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