What You Should Know About Revenue Bonds for the Series 7 Exam
You will need to become familiar with Revenue Bonds for the Series 7 Exam. Unlike tax-backed bonds, revenue bonds are issued to fund municipal facilities that’ll generate enough income to support the bonds. These bonds raise money for certain utilities, toll roads, airports, hospitals, student loans, and so on.
A municipality can also issue industrial development revenue bonds (IDRs) to finance the construction of a facility for a corporation that moves into that municipality. Remember that even though a municipality issues IDRs, they’re actually backed by lease payments made by a corporation. Because the corporation is backing the bonds, the credit rating of the bonds is derived from the credit rating of the corporation.
General characteristics of revenue bonds
They don’t need voter approval. Because revenue bonds fund a revenue-producing facility and therefore aren’t backed by taxes, they don’t require voter approval. The revenues that the facility generates should be sufficient to pay off the debt.
They require a feasibility study. Prior to issuing revenue bonds, the municipality hires consultants to prepare a feasibility study. The study basically answers the question, Does this make sense? The study includes estimates of revenues that the facility could generate, along with any economic, operating, or engineering aspects of the project that would be of interest to the municipality.
How to analyze revenue bonds
Always check out the specifics of the security. For instance, when gauging the safety of a revenue bond, you want to see whether it has a credit enhancement, which provides a certain degree of safety. You also want to look at call features. You can assume that if a bond is callable, it has a higher yield than a noncallable bond because the investor is taking more risk.
For Series 7 exam purposes (and if you ever sell one or more revenue bonds), you also need to be familiar with the revenue-bond-specific items. For instance, municipal revenue bonds involve covenants, wonderful little promises that protect investors by holding the issuer legally accountable.
Other factors that provide investors with a certain degree of comfort are that municipalities must provide financial reports and are subject to outside audits for all of their revenue bond issues.
Municipalities don’t want to default on their loans. That’s why issuers use the additional bonds test, which says that if the municipality is going to issue more bonds backed by the same project, it must prove that the revenues will cover the bonds. If it’s open-ended, additional bonds will have equal claims to the assets. If it’s closed-ended, any other bonds issued are subordinate to the original issue.
A catastrophe clause states that if a facility is destroyed due to a catastrophic event such as a flood, hurricane, tornado, or the like, the municipality will use the insurance that it purchased to call the bonds and pay back bondholders.
The flow of funds relates only to revenue bonds. The flow of funds tells you what a municipality does with the money collected from the revenue-producing facility that’s backing the bonds. Typically, the flow of funds is as follows:
Operation and maintenance
This item is normally the first that the municipality pays from revenues it receives. If the municipality doesn’t adequately maintain the facility and pay its employees, it’ll cease to run.
Usually the next item paid after operation and maintenance is the debt service (principal and interest on the bonds).
Debt service reserve
After paying the first two items, the municipality puts aside money into the debt service reserve to pay one year’s debt service.
Reserve maintenance fund
This fund helps supplement the general maintenance fund.
Renewal and replacement fund
This fund is for exactly what you’d expect — renewal projects (updating and modernizing) and replacement of equipment.
Municipalities can use this fund for several purposes, such as redeeming bonds, paying for improvements, and so on.
This system is called a net revenue pledge because the net revenues are used to pay the debt service. However, if the municipality pays the debt service before paying the operation and maintenance, it’s called a gross revenue pledge.
The debt service coverage ratio is an indication of the ability of a municipal issuer to meet the debt service payments on its bonds. The higher the debt service coverage ratio, the more likely the issuer is to be able to meet interest and principal payments on time.
The following question tests your debt service coverage ratio knowledge. Use the following formula to answer it.
A municipality generates $10,000,000 in revenues from a facility. It must pay off $6,000,000 in operating and maintenance expenses, $1,500,000 in principal, and $500,000 in interest. Under a net revenue pledge, what is the debt service coverage ratio?
(A) 1 to 1
(B) 1.5 to 1
(C) 2 to 1
(D) 4 to 1
The right answer is Choice (C). Because the question states that the municipality is using a net revenue pledge, you have to calculate the net revenue. First, using the earlier equation, figure the net revenue by subtracting the operation and maintenance expenses ($6,000,000) from the gross revenue ($10,000,000), which gives you $4,000,000.
Next, take the $4,000,000 and divide it by the combined principal and interest. The principal is $1,500,000 and the interest is $500,000, which gives you a total of $2,000,000. After dividing the $4,000,000 by $2,000,000, you come up with a ratio of 2 to 1, which means that the municipality brought in two times the amount of money needed to pay the debt service (principal and interest).
A debt service coverage ratio of 2 to 1 is considered adequate for a municipality to pay off its debt. A debt service coverage ratio of less than 2 to 1 may indicate that the municipality may have problems meeting its debt obligations.
Here’s how your equation should look: