4.3 Revenue Bonds

What Backs a Revenue Bond

A revenue bond is secured solely by the income a specific facility or project generates — tolls, user fees, lease payments — and not by the issuer's taxing power. If the project does not earn enough, bondholders have no claim on tax revenue. Because the credit depends entirely on the enterprise, revenue bonds generally carry higher yields and higher risk than GO bonds, and they usually do not require voter approval.

Common Types of Revenue Bonds

Exam Tip: A special tax bond is a revenue bond even though a tax pays it — the key is that it is funded by an excise tax dedicated to the bonds, not by the issuer's general taxing power.

The Flow of Funds

The flow of funds is the indenture provision that dictates the priority in which collected revenue is applied each period. The two structures behave oppositely, and the exam tests the order constantly.

Net Revenue Pledge (most common)

Under a net revenue pledge, O&M is paid before bondholders — debt service comes out of the "net" left after operating the facility.

Gross Revenue Pledge (rarer)

Under a gross revenue pledge, debt service is paid first, before O&M. This is more favorable to bondholders, which is why it is uncommon — most issuers must keep the facility running first.

Protective Covenants

Revenue bond indentures contain legally binding covenants that protect holders:

• Rate covenant — the issuer promises to set user fees high enough to produce a stated coverage ratio. Coverage = Net Revenue ÷ Annual Debt Service. A 1.25x covenant means net revenue must be at least 125% of debt service. Example: $1.25 million of net revenue for every $1 million of debt service.
• Additional bonds test (ABT) — before issuing more parity (equal-lien) debt, the issuer must prove revenues already cover both existing and proposed debt service, typically at 1.20x-1.50x. This stops dilution of current holders.
• Maintenance covenant — keep the facility in good repair.
• Insurance covenant — carry adequate property/casualty insurance.
• Catastrophe (call) clause — if the facility is destroyed, insurance proceeds are used to call the bonds.
• Books-and-records / non-discrimination covenants — keep audited records; do not favor select users.

Open-End vs. Closed-End Indentures

Analyzing a Revenue Bond

Key Point: Essential-service revenue bonds (water, sewer, electric) are stronger credits than discretionary ones (sports, convention centers) because demand is inelastic.

The Trust Indenture and the Trustee

A revenue bond is governed by a trust indenture — the contract between the issuer and a trustee (usually a bank) who acts for the bondholders. The trustee monitors compliance with the covenants, holds the reserve funds, and can pursue remedies on default. Unlike the Trust Indenture Act of 1939, which compels indentures for most corporate bonds, municipal bonds are exempt from that act, yet most large revenue issues use an indenture anyway because investors demand the protections.

Coverage and Feasibility — A Worked Example

Assume a toll-bridge authority projects $9 million of gross revenue, $3 million of operating and maintenance expense, and $4 million of annual debt service.

• Net revenue = $9M - $3M = $6M.
• Debt service coverage = $6M / $4M = 1.5x.

A 1.5x figure comfortably clears a typical 1.25x rate covenant, leaving a cushion if traffic softens. If the same bridge later wants to issue parity bonds that would push annual debt service to $5M, the additional bonds test asks whether projected net revenue still covers it at the required ratio: $6M / $5M = 1.2x — which may fail a 1.25x ABT, blocking the new issue until revenue rises or a junior (closed-end) structure is used.

The Feasibility Study and Catastrophe Risk

For a new project with no operating history, an independent feasibility study by traffic, demographic, or rate consultants projects demand and revenue; underwriters and rating agencies lean heavily on it. The catastrophe call clause matters here too: if a hurricane destroys the bridge, the indenture directs insurance proceeds to call the bonds at par rather than rebuild, protecting holders from a facility that can no longer earn.

Revenue Bond Red Flags Checklist

• Coverage drifting toward 1.0x as costs rise.
• A discretionary, non-essential facility facing free alternatives (a tolled bridge next to a free one).
• An open-end indenture allowing unlimited parity debt.
• Optimistic feasibility projections that demand high near-term usage growth.
• Weak or missing rate-covenant language giving the issuer no duty to raise fees.