Municipal bonds generally can be classified into two camps—general obligation bonds and revenue bonds. General obligation, or GO, bonds are backed by the general revenue of the issuing municipality, while revenue bonds are supported by a specific revenue source, such as income from a toll road, hospital, or higher-education system. We recently focused on general obligation bonds, but here we’ll discuss revenue bonds and what to look for when investing in them.
Revenue municipal bonds, or revenue bonds, account for nearly two-thirds of all investment-grade munis outstanding, but they tend to get less attention than their more popular counterpart, general obligation bonds. Credit quality varies with revenue bonds, but they can be an attractive option for muni investors looking to round out a diversified portfolio or to add investments that may have higher yields, if they’re willing to accept additional risks.
Broadly, municipal bonds, including both GO and revenue bonds, are sold by local and state governments to help fund public projects or municipal government operations, like building new schools or repairing city sewer systems. Their interest payments are usually exempt from federal income taxes, and may be exempt from state income taxes if the bond issuer is located in the investor’s home state. For these reasons munis are often attractive to income-oriented investors looking to reduce income tax bills.
Composition of the municipal bond market
Source: Bloomberg Barclays Municipal Bond Index, as of 12/01/2020.
"Other revenue bonds” include the industry development revenue (IDR)/pollution control revenue (PCR), housing, and resource recovery indexes.
There are many types of revenue bonds
A common mistake investors make is to lump all revenue bonds in the same category. Given the size and diversity of the revenue bond market, investors can benefit from identifying the right type of revenue bonds for their needs and focusing a portion of their municipal bond portfolio there.
Most revenue bonds are backed by a “net” or “gross” pledge on the enterprise’s revenue. A gross pledge is a stronger pledge, because it is a pledge on revenues before operating or other expenses. A net pledge is a pledge of revenues after the enterprise pays for operating and other expenses. Below we delve deeper and take a look at the different categories of revenue bonds and the different business risks that each may face.
Bonds with usually less business risk:
1. Water and sewer/public power electric utilities bonds: Water and sewer revenue bonds are issued to finance the construction and improvement of sanitation or water utility facilities. Revenues to meet debt service are derived from various rates and fees, which most often are based on usage and connections.
Public power electric utilities acquire or generate electric power and provide it to their constituents. Some utility districts are publicly owned or operated and issue equity or taxable debt. However, utilities that are owned and/or operated by a municipality or state agency may issue tax-exempt debt.
What matters most: Water and sewer revenue bonds are considered to be tied to “essential services” and are viewed as more conservative municipal bonds.
Public power electric utilities bonds tend to be more complex, but can also be considered “essential services.” They tend to face more public and regulatory scrutiny because electric generation is one of the largest contributors to CO2 emissions. Debate over the impact of CO2 emissions on the environment and technological advancements are unique issues facing this sector.
2. Special tax revenue bonds: A special tax revenue bond is a bond that is repaid by levying a tax on a particular activity or asset. For example, a special tax may be levied on the sale of alcohol or tobacco to help fund a new cancer research facility.
What matters most: The credit quality of these bonds depends on what is being taxed, the social or economic trends that will affect the usage of that activity or asset, and the legal protections regarding comingling of funds with general government funds. For example, if the special tax is levied on the sale of tobacco, then the trend in the usage of tobacco products is a relevant concern.
These types of bonds can be very strong or weak depending on coverage and legal protections. Investors should pay special consideration to the credit rating of the sponsoring enterprise, because it could affect the credit rating of the special tax revenue bond.
Bonds with usually more business risk:
3. Transportation revenue bonds: Transportation revenue bonds are issued to finance local public transportation projects, such as buses, subway systems, toll roads and airport systems. The bonds may be repaid through the revenue earned by the transportation system. However, some transportation revenue bonds are repaid through taxes generated in the area the system serves or another pledge.
What matters most: At the simplest level, the credit quality of a transportation revenue bond depends on the essentiality of the service its issuer provides to the population it serves and the credit pledge. The credit quality of a transportation revenue bond may vary widely, with more-essential systems generally having greater flexibility to raise rates if needed. Transportation revenue bonds backed by a broader pledge, compared to just fare box revenues, also tend to receive higher credit ratings on average. Further spread of COVID-19 may stress the transportation sector to a greater degree than other sectors because the transportation sector tends to rely on large groups of individuals. We would be cautious of transportation issuers that are backed by farebox revenues in areas where there are large case counts.
4. Education revenue bonds: Education revenue bonds are issued to finance the construction or improvement of higher-education facilities, like public and private colleges, or help with ongoing operations. Revenue is partly derived from students’ tuition payments or from the institution itself.
What matters most: The characteristics of the university system are a key factor in determining the credit quality of the issuer. The higher-education sector can essentially be split into private and public colleges and universities. Publics tend to be large and benefit from economies of scale and are less dependent on student tuition. For more conservative bonds, look for educational facilities that have a strong reputation and will continue to attract a large student population. We are cautious on lower-rated private institutions due the many questions regarding what the future of higher education will look like in a post-COVID world.
5. Hospital and health care revenue bonds: Hospital bonds are issued to finance the construction or expansion of hospitals or health care facilities. They generate a large share of their revenues through reimbursements for services from either commercial insurers, commercially insured patients, patients insured through public entities such as Medicare and Medicaid, or self-pay from patients lacking insurance.
What matters most: Compared to other sectors of the municipal market, hospitals and health care providers tend to have more business risk, and, with the exception of larger, more established systems, tend to be lower-rated. In our opinion, tread cautiously here. Though municipal defaults are historically a rarity, when they do occur, a large portion occur within hospital and health care revenue bonds. In fact, nearly 30% of all munis that are in default are in the hospital and retirement sector.1 Coupled with rising health care costs, political issues facing the health care industry, and COVID related issues, it is very important to fully understand what you are buying with a hospital or health care facility bond.
6. Lease revenue bonds: Lease revenue bonds are a unique structure in the muni market. Instead of issuing long-term debt, like general obligation bonds do, to finance improvements on a public facility, the municipality may enter into an arrangement that uses lease revenue bonds. Often a trust, not the municipality, issues bonds and generates revenues to pay the bonds back by leasing the facility to the municipality. The municipality will generally appropriate money during each budget session to meet the lease payment.
Analysis: The unique structure of a lease revenue bond makes the essentiality of the facility being leased and the legal protections on appropriating funds very important. Bonds backed by structures with lower essentiality and limited protections for appropriating funds will usually be lower-rated and have higher yields. Our opinion is to be cautious of bonds backed by lease revenues, as these bonds should be viewed more like general government bonds, not revenue bonds.
Yields for revenue bonds vary
Given the complexity of the revenue bond market, it may not come as a surprise that yields and spreads vary. A spread is the additional yield a bond pays above a very highly rated benchmark. Bonds with more business risk and that likely face greater risks from COVID-19, like the hospital and transportation sectors, have higher spreads on average. However, sectors with less business risk, like water & sewer, have much lower spreads. Currently, spreads for all sectors are tight relative to their longer-term averages. In our view, given the low level of spreads, we think it’s prudent to be cautious with revenue sectors that tend to exhibit greater risks.
Spreads for all sectors are well below their longer-term averages
Source: Components of the Bloomberg Municipal Bond Index, as of 11/29/2021.
Differences in spreads may be due to differences in duration, credit qualities, maturities, coupon structure, or other factors.
What to do now
Consider allocating up to 100% of your muni bond portfolio in higher-rated bonds—those rated AA-/Aa3 or above. Start with highly rated general obligation and essential-service revenue bonds. More speculative investors looking for higher interest income could consider no more than 30% in lower-rated issuers—those rated BBB-/Baa3 to A+/A1. As one would expect, a lower-rated bond has a much greater chance of default than one with higher ratings. If investing in mutual funds or ETFs, you can find the ratings distribution and breakdown of GO and revenue bonds on the “Portfolio” tab on Schwab.com. For help selecting the right municipal investments given your needs, consider reaching out to a fixed income specialist.
1Source: Municipal Market Analytics, as of 11/24/2021. Based on par value. Excludes Puerto Rico-related issuers.