Municipal Revenue Bonds in a Fixed Income Portfolio

Rob Williams
Director of Income Planning, Schwab Center for Financial Research

With so much media focus on the financial stresses impacting state and local governments' general obligation bonds, it's easy to overlook a huge swathe of the municipal market—municipal revenue bonds—which make up close to 60% of the $3.7 trillion muni market.¹ Unlike GO bonds, which are backed by a specific tax source or by a full faith and credit from state and local government general revenues, municipal revenue bonds are paid from a specific revenue source, such as a hospital or sewer system.

In a slowly expanding economy, revenue bonds—in particular those backed by essential services users can't do without, such as water or sewer—can complement GO bonds for investors looking to diversify their muni portfolios.

Source: Barclays Global Family of Indices, Barclays US Municipal Bond Index, October 4, 2012. Chart shows the composition by sector of the Barclays US Municipal Bond Index. The pre-refunded and insured category includes state and local GO as well as revenue bonds. The source of payment for pre-refunded bonds is typically other bonds, often US Treasuries. Insured bonds are backed by a municipal bond insurance company.

The credit characteristics and qualities of bonds that fall into the "revenue" category vary more widely than those of GO bonds, so it's important to understand the details of the enterprise and revenue available to back a bond.

Start with essential services

We suggest that investors focus first on muni bonds backed by revenues from essential services—especially systems with mature service areas with a built-out population in communities with strong residential customer bases, access to job centers and above-average household income levels. By "essential services," we mean public enterprises with an effective monopoly on their service areas, where customers generally need those services even in a weak economy.

Good examples are water and sewer services, the bonds for which are backed by revenues from water and sewer utility charges. Demand for such services does not tend to vary widely based on economic conditions or tax collections. If you'd like help assessing these factors, you can read the latest rating agency report associated with an individual bond, talk with a Schwab Fixed Income Specialist or rely on professional management by using bond funds.

Water and sewer issuers make up about 7.4% of the index of large bond issues, as represented by the Barclays US Municipal Bond Index, and their ratings trend toward the upper end of credit quality. The chart below shows the breakdown by revenue type of the various components of the overall revenue bond market.

Distribution of Major Muni Index by Revenue Type

Source: Barclays Global Family of Indices, Barclays US Municipal Bond Index, as of October 2012. This chart shows the percentage of revenue bonds by category as part of the overall Barclays US Municipal Bond Index. The revenue bond portion totals 60% of the Barclays US Municipal Bond Index, as seen in the pie chart above. Bonds with ratings from Aaa to Baa (Moody's) are considered investment-grade. The ratings proceed from Aaa to Aa to A and then Baa in ranking from highest to lowest quality, in the view of Moody's, which adds qualifiers of 1 (higher) to 3 (lower) within each rating category.

Look at credit risk for revenue bonds

Other areas of the revenue bond market often involve more credit risk; however, that risk can vary widely. Start first with a clear sense of the business characteristics and revenue driver of the bonds you own.

A step below essential service revenue bonds, you'll generally find the following:

• Special-tax revenue bonds, which are secured by special taxes such as a dedicated sales tax. Sales taxes are driven by consumer activity, which can be highly dependent on the economic climate and spending. Many special-tax revenue bonds, however, have legal covenants that require available revenues to provide a certain level of coverage over debt service (such as 1.25x or 2.0x coverage) that provides some cushion if revenues fall. For more details on a particular bond, read the bond prospectus or most-recent rating agency report.
• Higher-education revenue bonds backed by the revenues of higher-education facilities. Credit quality for these bonds depends on student demand and the other resources available to the higher-education enterprise, which can vary. Some are rated very highly, even Aaa, while others may have more-speculative credit characteristics.
• Transportation revenue bonds backed by revenues from airports or transit systems. These bonds also vary in quality based on system maturity, management quality and business strength. Mass transportation systems or highly used airports, for example, may have stronger credit characteristics, a more predictable customer base and more flexibility to manage financial challenges than other less-developed or essential systems. 

Further along the credit quality spectrum lie more-speculative revenue sources, including:

• Hospital revenue bonds backed by revenues of not-for-profit hospitals. These can have less-stable credit characteristics, on average, compared with other sectors, depending on the size and financial strength of the hospital or system. Smaller health-care issuers, such as nursing homes, may have non-investment-grade (speculative) credit characteristics.
• Electric revenue bonds, which can be exposed to business risks, depending on the competition and the service area.

These more-speculative areas should only be explored by investors with higher tolerances for risk who are willing and able to dig deeper into credit quality. Lower-rated bonds generally have more-volatile credit quality, and although defaults are historically infrequent for rated bonds overall, we suggest focusing first on more highly rated bonds.

Despite the popular perception that agency bond ratings are unreliable, they've generally held true, on average, even during the current climate.

Risk-averse buyers should beware of—or outright avoid—revenue bonds with more-speculative credit qualities. The majority of muni defaults that have occurred since the beginning of the Great Recession have been in sectors with more-volatile credit characteristics. For example, bonds backed by taxes from new housing projects, or smaller, more-speculative enterprises that compete with other for-profit businesses or carry greater business risks, such as nursing homes or health-care facilities.

Defaults Historically Concentrated in Housing and Health Care

Source: Moody's Investor Services, "U.S. Municipal Bond Defaults and Recoveries, 1970-2011," March 7, 2012. Default counts include Moody's-rated issuers only. Defaults have historically have been higher for issuers with no bond ratings.

Yields on muni revenue bonds

Given the stress on state and local issuers, including the intensified focus on state and local credit quality, investor money has flowed steadily into the market for revenue bonds. In some sectors of the revenue bond market, yields have fallen relative to GO bonds. As a result, yields have fallen relative to historical levels. This is true for essential-service revenue bonds as well as more-speculative issuers, as muni investors search for diversification and yield. In historically more-stable sectors, such as essential-service utilities (water and sewer) bonds, yields have been similar to yields on GO bonds historically (as shown in the chart below.)

Yields Falling for Both Revenue and GO Bonds

Source: Bloomberg municipal curves, as of October 19, 2012. Generic US Muni General Obligation AA+, US Muni Utility AA and US Muni Healthcare AA curves.

The chart above also shows that higher yields can be found in sectors with greater business risk, such as healthcare. The yields for revenue bonds in these sectors may be higher, particularly for bonds with lower ratings, to compensate investors for the increased credit risk.

Yields in all sectors of the muni market have fallen, as many investors continue to look for relatively safe yield. But the benefits of diversification by revenue source as well as issuer can broaden the base of credit factors that might impact a diversified muni portfolio.

We suggest that muni bond investors consider a mix of state and high-quality GO bonds along with highly rated essential-service revenue bonds, in laddered portfolios invested to maturities as long as 12 years. Consider additional credit risk in more-speculative sectors or in longer maturities based only on your balance of income needs, risk tolerance and knowledge of those sectors.

Next steps

Because the market for municipal bonds backed by municipal revenues is large and varied, it defies easy generalization. But for diversification of the economic and political drivers of credit quality, consider essential-service municipal revenue bonds along with GO bonds as the core of your muni portfolio.