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Understanding Municipal Revenue Bonds

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 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

​​​​​The municipal bond market is made up of approximately 28% general obligation bonds, 67% revenue bonds, and 5% other bonds.

Source: Bloomberg Barclays Municipal Bond Index, as of 09/04/2019. “Other” includes the insured and pre-refunded indexes. “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, astute 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 bondsWater 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. On average, debt service coverage for water and sewer utilities is expected to strengthen in 2019, according to Moody’s Investors Service, putting issuers in a more sound position to meet payments on 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 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, due to the ratings agencies’ interpretation of a ruling resulting from Puerto Rico’s debt restructuring.

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 are repaid through the revenue earned by the transportation system.

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. The credit quality of a transportation revenue bond may vary widely, with more-essential systems generally having greater flexibility to raise rates if needed. The need for increased infrastructure investment could pose a challenge for some issuers in this sector. For a municipality that is highly dependent upon public transportation, these bonds will demand a higher rating and may be a good complement to general obligation issues.

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 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. For more conservative bonds, look for educational facilities that have a strong reputation and will continue to attract a large student population. In our opinion, higher education generally has a very stable business model and can offer more conservative income. However, Moody’s has a negative outlook on the sector due to weak net tuition revenue growth and rising labor costs. Moody’s believes that public universities will face more financial difficulties relative to private universities. Though usually a very conservative bond, tread cautiously with educational facilities that are highly dependent upon student aid or grants, as may face difficulty if there are government cutbacks.

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, 20% of all munis that are in default are in the hospital and retirement sector1 Coupled with rising health care costs and political issues facing the health care industry, 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.

What matters most: 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.

Selected characteristics of revenue bond indexes

Index

Average yield to worst (%)

Average credit quality

Average duration (years)

YTD total return (%)

GO Bond Index

1.57

AA1/AA2

4.91

7.1

Revenue Bond Index

1.78

AA3/A1

5.1

7.9

Education

1.64

AA2/AA3

5.4

8.1

Electric

1.61

AA3/A1

4.6

6.9

Hospital

2.08

A1/A2

5.2

8.6

Leasing

1.77

A1/A2

5.3

8.4

Special Tax

1.65

AA1/AA2

5.2

7.8

Transportation

1.75

A1/A2

5.1

7.8

Water & Sewer

1.57

AA1/AA2

4.9

7.3

Source: Based on the sub-indexes in the Bloomberg Barclays Index, as of 09/05/2019. Revenue bonds are sorted alphabetically. Does not include resource recovery, IDR/PCR, or housing. For illustration only. Past performance is no guarantee of future results.

 

What to do now

Consider allocating up to 100% of your muni bond portfolio in higher-rated bondsthose 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 issuersthose 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.

 

1 Source: Municipal Market Analytics, as of 8/30/2019.

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Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

Tax-exempt bonds are not necessarily suitable for all investors. Information related to a security's tax-exempt status (federal and in-state) is obtained from third parties, and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the alternative minimum tax. Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

The Bloomberg Barclays U.S. Municipal Bond Index covers the USD-denominated long-term tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds and pre-refunded bonds.

The Bloomberg Barclays U.S. Municipal Bond: GO Bond Index is the GO bond component of the of the Bloomberg Barclays U.S. Municipal Bond Index.

The Bloomberg Barclays U.S. Municipal Bond: Revenue Bond Index is the revenue bond component of the of the Bloomberg Barclays U.S. Municipal Bond Index.

The Bloomberg Barclays U.S. Municipal Bond: Electric Index is the electric component of the of the Bloomberg Barclays U.S. Municipal Bond: Revenue Bond Index.

The Bloomberg Barclays U.S. Municipal Bond: Electric Index is the electric component of the of the Bloomberg Barclays U.S. Municipal Bond: Revenue Bond Index.

The Bloomberg Barclays U.S. Municipal Bond: Hospital Index is the hospital component of the of the Bloomberg Barclays U.S. Municipal Bond: Revenue Bond Index.

The Bloomberg Barclays U.S. Municipal Bond: Housing Index is the housing component of the of the Bloomberg Barclays U.S. Municipal Bond: Revenue Bond Index.

The Bloomberg Barclays U.S. Municipal Bond: IDR/PCR Index is the IDR/PCR component of the of the Bloomberg Barclays U.S. Municipal Bond: Revenue Bond Index.

The Bloomberg Barclays U.S. Municipal Bond: Transportation Index is the transportation component of the of the Bloomberg Barclays U.S. Municipal Bond: Revenue Bond Index.

The Bloomberg Barclays U.S. Municipal Bond: Education Index is the education component of the of the Bloomberg Barclays U.S. Municipal Bond: Revenue Bond Index.

The Bloomberg Barclays U.S. Municipal Bond: Water & Sewer Index is the water & sewer component of the of the Bloomberg Barclays U.S. Municipal Bond: Revenue Bond Index. 

The Bloomberg Barclays U.S. Municipal Bond: Resource Recovery Index is the resource recovery component of the of the Bloomberg Barclays U.S. Municipal Bond: Revenue Bond Index.

The Bloomberg Barclays U.S. Municipal Bond: Leasing Index is the leasing component of the of the Bloomberg Barclays U.S. Municipal Bond: Revenue Bond Index.

The Bloomberg Barclays U.S. Municipal Bond: Special Tax Index is the special tax component of the of the Bloomberg Barclays U.S. Municipal Bond: Revenue Bond Index.

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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