Revenue Bonds
A revenue bond is an obligation issued to finance a revenue-producing enterprise. Both the principal and interest of such bonds are paid exclusively from the earnings of the enterprise. As a general rule, such issues do not have any claim on the general credit or taxing power of the governmental unit that issues them. A system of sinking funds and operating controls typically is established to assure investors that the financial affairs of the project will be maintained in good order and all commitments honored.
In general, revenue bond financing is best suited to projects that (1) can operate on a service charge or user-fee basis; (2) have the potential to be self-supporting, previously demonstrated under public or private operation; and (3) can produce sufficient revenue without jeopardizing other important economic or social objectives of the community. Problems of social equity may arise when traditionally tax-supported functions are placed on a service charge basis. Facilities supported by service charges also frequently produce benefits to individuals who do not pay for them--for example, an enhancement in land values that may accrue to speculative holders of unimproved real estate.
Two principal reasons for the issuance of revenue bonds, rather than general obligation bonds are:
(1) Revenue bonds are based on the concept that only the users of a facility financed by the sale of bonds should pay for that facility.
(2) Revenue bonds are not ordinarily subject to statutory or constitutional debt limitations. Revenue bonds do constitute an obligation of the issuing jurisdiction. However, the obligations extend only to the payment of the bonds from a special source of revenue.
Historical Background
Revenue bonds were used in England over 200 years ago to finance toll bridges, turnpikes, and canals. The first revenue bond law in the United States was not enacted until 1897, when provision was made in the state of Washington for the issuance of $350,000 in bonds by the city of Spokane, secured solely by a pledge of revenue of its waterworks systems. Spokane adopted this then novel borrowing mechanism for the same reason that influenced subsequent expansion of its use--state restrictions on general borrowing and taxing powers of municipalities that limit the use of general obligation bonds.
The concept of a commission or authority (i.e., a municipal corpora-tion formed for the purpose of constructing and operating certain facilities that may or may not be confined within a given municipality) became a part of the revenue bonding process in this country from its earliest applications. Water districts, without power to tax but with the right to sell revenue bonds, date back to 1899 in Maine.
The creation of the Port of New York Authority in 1921 directed widespread attention to the possibilities of this method of borrowing. The depression of the early thirties, however, was most instrumental in the significant expansion of revenue bonding to provide needed capital funds to hard-pressed municipalities. During this period, the federal government sought to promote local public works, particularly those of a self-liquidating nature, through grants and loans to shore up the declining general borrowing power of state and local governments.
Following World War II, revenue bonds came to represent at least a third and at times as much as 45 percent of all tax-exempt bonds issued in a given year. By the mid-fifties, almost all states had some sort of enabling legislation for revenue bonds. An estimated $9.5 billion in revenue bonds were outstanding. The list of varied and diverse projects financed by revenue bonds included: water, sewer, electric, and gas systems; bridges, tunnels, turnpikes, parkways, and expressways; dock and harbor facilities; airports, parking facilities, mass transit; stadiums, arenas, and auditoriums; hospitals, sanitariums, and college dormitories; public housing projects; swimming pools, golf courses, and other public recreation facilities; hydroelectric power projects; and even municipal cemeteries.
From the point of view of the administrator, revenue bonded projects often enable the bypassing of both the requirement for voter authorization and the debt limits of the issuing jurisdiction. In addition, it often is possible to finance construction without raising taxes, even though in some cases the bonds of the authority carry a contingent guarantee from the local government served.
Revenue bond financing and the use of special districts, however, have raised a number of philosophical questions. Widespread use of special districts has severely inhibited the creation of multipurpose agencies and metro-governments that might be more effective in the solution of complex urban service delivery problems. Economists argue that special districts, through their revenue bonding powers, have distorted the municipal bond market by offering the investor a higher yield than general obligation bonds can produce.
On the whole, revenue bonds have had a good credit rating. Defaults that have occurred can be traced to mistakes in planning and management such as:
o Failure to adhere to appropriate state enabling legislation.
o Underestimation of operating costs or overestimation of anticipated revenues.
o Excessive expenditures for property acquisition.
o Failure to segregate and safeguard project revenues in accordance with the covenants of the bond ordinance or resolution.
o Insufficient care in engineering studies.
o Failure to allow sufficient time for project completion before bond payments begin to come due.
Appropriate Uses of Revenue Bonds
Revenue bonds should not be issued to pursue speculative projects or merely to evade sound and reasonable debt limits. When a jurisdiction has an adequate borrowing capacity at its disposal, the primary consideration should be which type of bonds can be sold at the lowest cost. In general, the types of projects suitable for revenue bond financing include:
(1) those that can be readily operated on a service charge or user-fee basis;
(2) those for which experience, either under public or private operation, has demonstrated the potentialities for self-support;
(3) those that can produce sufficient revenue without jeopardizing other important economic or social objectives of the community.
Problems of equity may arise when traditionally tax-supported functions are placed on a service charge basis. Facilities supported by service charges also frequently produce benefits to individuals who do not pay for them; for example, an enhancement in land values that may accrue to the speculative holder of unimproved real estate.
General characteristics of revenue bond laws include the following:
o Identification of the governmental units authorized to borrow and types of utilities to which the enabling legislation applies.
o General grant of power to acquire, construct, improve, or extend the particular improvements, to issue revenue bonds, and to pledge revenues to the payment of these bonds.
o Requirements that the issuing body establish sufficient charges or rates to operate and maintain the project and to meet principal and interest requirements.
o Guarantees that revenue bonds have all the qualities of negotiable instruments under the appropriate laws of the state.
o Provisions governing the authorization and sale of revenue bonds (including regulations relating to public referenda).
o Provisions designed to secure the successful operation of the project.
Bonds should be planned as to their terms, conditions, and safeguards with two objectives in mind: to suit the nature of the project and to attract the investor. Principles to be observed in planning bonds may be outlined as follows:
(1) Bonds should be scheduled for retirement well within the useful life of the project, that is, the rate of amortization of the bonds should at least equal an adequate rate of depreciation on the facility.
(2) The retirement of bonds, however, should be distributed in such a way as to allow a comfortable margin of revenue coverage for debt service without the need to charge abnormal rates or fees.
(3) The amount of combined annual interest and amortization should follow an even or possible slightly rising trend in order to coincide with the prospective pattern of revenues, that is, through the use of serial bonds, the maturity pattern should be established to reflect the anticipated income pattern.
(4) The first payment on principal should be deferred until the operations of the facility have become well established.
(5) Assurances must be evident to the investor from the outset (through the willingness of the issuer to grant reasonable covenants) that: (a) the project will receive businesslike management, (b) bond funds will be properly expended, (c) construction will be carefully inspected, (d) the plant and equipment will be properly maintained after the project is operational, (e) the rate structure or fee schedule is designed to keep the project self-supporting, and (f) adequate financial safeguards are met to assure the maintenance of adequate working capital and reserves.
In a number of states, revenue bond issues can be established through negotiated sales. Therefore, financial advisors may be drawn from the special experience of bond house personnel or from associated financial consulting organizations. Avoiding the use of qualified fiscal and legal advisors is a false economy and will usually result in higher interest costs many times over the fee for expert advice.
Revenue bonds may be issued as serial maturities, terms bonds, or serial and balloon maturities. In almost all cases, revenue bonds are callable prior to maturity through the utilization of surplus funds or a mandatory sinking fund. This callable provision may apply to all or a portion of the outstanding bonds. Serial maturities usually are called in inverse numerical order, while term bonds are called by lot in most instances.
Sources of Revenue
Sources of revenue in support of these bonds can be classified in five general categories:
(1) User charges are one of the oldest and most common sources of revenue. In financing utility systems, many localities issue bonds payable solely from such revenues. When municipalities guarantee debt service payments in the event these revenues are insufficient, the bonds are sometimes referred to as a "double barreled" security.
(2) Turnpikes and other transportation facilities often are financed by bonds payable from the tolls and fees collected and from the marginal income of concessions (e.g., automobile service facilities and restaurants along turnpikes, space lessees and parking lots at airports, etc.).
(3) Special taxes are those derived from an additional levy on such items as tobacco, alcoholic beverages, and other goods and services considered semi-luxuries.
(4) Under a lease-back arrangement, bonds are usually issued by an authority to finance construction of a given facility, which is then leased to the state, school district, or city at a rental level calculated to be sufficient to pay interest and retire the indebtedness. Funds for the rental payments are obtained by the lessee from various sources, including legislative appropriations, special taxes, and direct taxes.
(5) Since 1936, local governments (mostly in the South) have issued industrial revenue bonds to finance (a) the construction of factories or other business facilities that are then leased to private business, or (b) the purchase of factories or other facilities from private businesses that are then leased back to the sellers.
The use of public credit to "buy" the location of new businesses in a community has been strongly opposed by many financial organizations, including the Investment Bankers Association. However, legislatures in a growing number of states have authorized this type of debt as a means of enticing new industry.
In their haste to find a lessee of the property, public officials may not take the necessary precautions to investigate the financial stability of the enterprise or to safeguard the investment by insisting that the lease extend over the life of the bonds. As a consequence, the community or state runs the risk of having a contingent liability become an actual one, or of finding itself saddled with debt for special facilities for which another lessee cannot be found.
In some instances, a group of citizens may form a nonprofit corporation, issue corporate bonds, construct or otherwise acquire the project, lease the project to a private firm (or possibly to the local government if the intent is to circumvent existing debt limitations), and pay the bond debt service from the rentals received under the lease. If the IRS determines that the corporation is truly nonprofit, then the interest on the bonds may be free from federal income taxation.
Covenants on Revenue Bonds
Certain covenants are spelled out in all bond resolutions or trust indentures for the protection of the investors. Among other things, these covenants establish appropriate and clearly defined fiscal policies that, in turn, are protected against political tampering. It has been said that "covenants which protect the bondholder have equal protection to the bond issuer." Failure to incorporate the following provisions into the basic bond instruments generally result in higher interest rates.
Rate Covenant pledges the issuing body to fix rates, with revisions when necessary, sufficient to meet operation and maintenance charges, as well as annual debt service requirements, and to provide for certain reserves. Rates must be maintained sufficient to provide some minimum margin of safety over the charges incurred in the previous period. For example, for toll facilities, the covenant has been approximately 120 percent of the foregoing charges.
Maintenance and Insurance. The issuing body must covenant to maintain the properties in good repair and working condition at all times. Insurance must be carried on the facility corresponding in amount and in kind to that which is normally carried under private enterprise.
Records and Financial Reports must be kept and provided for audit annually by independent certified public accountants. Revenues must be deposited in a special fund and kept separate from all other funds of the jurisdiction.
Consulting Engineer must be placed on a retainer, when certain types of projects are undertaken, to perform certain "watchdog" duties over the operations of the facility. This practice is common with sewer and water systems and toll roads (at the state level).
Nondiscrimination Covenant guarantees that neither preferential treatment nor discrimination shall be applied to any groups in the matter of payment of rates for services, that is, charges will be equitable to all users.
Application of Revenues. A series of covenants usually are included relating to the disposition of funds according to specified priorities. A typical arrangement would be: (1) operations and maintenance; (2) interest and principal on bonds; (3) renewal and replacement fund; (4) working capital fund; (5) interest on future bonds, tax equivalent, or other return to the municipality.
Distribution of Revenues
The order in which revenues generated by self-supporting projects shall be applied, sometimes referred to as the "flow of funds," is set forth in the bond resolution or trust indenture. In most cases, a basic fund, known as the reserve fund, is established, into which all receipts and income derived from the operation of the project are deposited. Moneys in the reserve fund are then distributed monthly by the trustee or other handler of funds in the order cited above.
The first claim on the reserve fund usually is a pro-rated amount to meet the cost of operation and maintenance, as set forth in the annual budget. Without proper O&M funds, a facility may experience severe loss of income. Therefore, revenue bonds most commonly are payable from net revenues, that is, gross receipts less operating and maintenance costs.
The bond service account constitutes an amount that, with other such monthly payments, will be sufficient to pay the next semiannual interest payment, as well as the principal next serially maturing. In the case of term bonds, a mandatory sinking fund is sometimes required in lieu of principal payments on serial bonds.
Payments into a debt service reserve fund, in the case of serial bonds, are usually accumulated and maintained equivalent to one year's maximum principal and interest requirements. This fund is gradually built up to equal a full year's debt service. In the case of term bonds, the requirement usually is two years' interest.
A renewal and replacement fund, sometimes called a replacement reserve, is established to replace equipment or provide necessary repairs beyond normal maintenance. Funds are paid into this account in an amount recommended by the consulting engineer and may be cumulative.
Payments are made into a reserve maintenance fund to meet unusual or extraordinary maintenance charges that have not been budgeted. Some jurisdictions combine the reserve maintenance and renewal and replacement funds. In other cases, an effort is made to establish a working capital fund equivalent to about one-tenth of a year's gross revenues to cover such unforeseen contingencies.
Moneys remaining in the reserve fund after the foregoing distributions are made may be placed in the surplus fund, to be divided into various categories such as the following:
(1) Redemption account used to retire bonds in advance of maturity.
(2) Payment in lieu of taxes when an authority purchases a going operation that has been a corporate unit, payments may be made in lieu of taxes either by legislative requirement or to create good will.
(3) Other lawful payments including improvements and extensions of the facility, support of other bond interest, etc.
Issuance of Additional Bonds
When a facility is being constructed, it is not always possible to foresee just what the future may hold. It may be necessary to increase the size of the facility or to make other improvements that will require additional financing. Therefore, sufficient leeway should be provided in the indenture or resolution to permit the issuance of additional bonds.
If bonds of equal rank are permitted, safeguards must be set up against the undue dilution of the security of the original bonds. There are two basic types of trust indentures:
(1) the closed end indenture, which does not permit the issuance of parity bonds other than those necessary to complete the project where initial financing proves insufficient; and
(2) the open end indenture, which permits the issuance of additional bonds but provides a formula prescribing the conditions to be met. In the first case, additional bonds must be junior in lien to the then outstanding bonds.
Special Assessment Bonds
Special Assessment Bonds often are considered a special form of revenue bonds since the debt service is payable only from the proceeds derives from a special assessment levies against those who benefit from the facilities constructed (e.g., special assessments for curbs and gutters in certain residential areas). The burden of financing special assessment bonds falls on those individuals or properties receiving the greatest benefits from the improvements. In some cases, however, the property owners who must pay the assessments have had little or no say in the issuance of the bonds for which they must meet the debt service commitments Such is the case with the so-called Mello-Roos bonds in the State of California.
After the passage of the property tax-cutting Proposition 13 in 1978, funding for local infrastructure improvements in dried up. The State legislature adopted special legislation that permitted the creation of special taxing districts which empowered local governments to cooperate with developers to achieve more flexible funding options to finance streets, schools, sewer and water facilities and other specific improvements in primarily new residential areas. Billions of dollars of bonds were issues to finance these improvements with the homeowners served by these facilities obligated to pay off the bonds through annual assessments added to their property tax bills.
Until the residential development has been completed and all of the property has been transferred to individual owners, however, the burden of the assessment is shared by the developer and the homeowners that have moved into the area. When the California real estate market experienced some slow downs in the early 1990's, some developers where forced to file for bankruptcy, prompting banks or other investors to begin fore-closure proceedings on the development. The bank then assumes financial responsibility for the special assessment bonds. In many cases, bond payments are delinquent and the banks must either assume this additional obligation or use any reserves in the bond offering to pay off the bond-holders.
In 1994, nearly 5 percent of all Mello-Roos bond issues were reported as experiencing some degree of financial difficulty primarily due to due to significant delinquencies. The value of the bonds in trouble was nearly $300 million. Examples include: (1) an $8.1 million bond issues by the County of Los Angeles in 1988 for a Mello-Roos district in which nearly 22 percent of the bond payments are delinquent by local real estate developers; (2) a $7.4 million Mello-Roos district in the northwest area of the City of San Bernardino which experienced a 77 percent delinquency rate; and (3) a 211-acre housing and commercial project in the City of Oxnard on which the developer stopped payment on the bonds in 1991 and the bonds went into default in October, 1993.
Several changes in the Mello-Roos enabling legislation were adopted in 1993 in an effort to prevent abuses and to reduce risks to municipalities and homeowners in the event of default caused by bankrupt developers. Tighter rules for policing the bonds were adopted, and city and county agencies are now required to limit fee increases to homeowners in the event of default. Developers are required to do a better job of disclosing to home buyers that they will be living in a Mello-Roos district and how much in special district taxes they will be required to pay.
Summary
Revenue bonds can play an important role in the long-range planning of capital facilities. It must be clearly established, however, that revenues generated by the proposed project are sufficient to: (1) cover the cost of operations, maintenance, and debt service; (2) provide a comfort-able margin of working capital; and (3) create a reserve fund for emergencies and to cover possible declines in income. In short, revenue bonding must be approached with the principles of sound management and debt administration firmly in mind.