Utility Revenue Bond: What It Is and How It Works
A utility revenue bond is a type of municipal bond issued to finance public utility projects—such as water and wastewater systems, electricity and gas infrastructure, hospitals, and waste treatment facilities—where debt service is paid from the revenues generated by the project rather than from general tax revenues.
How repayment works
- Debt service (interest and principal) is funded from the fees or charges customers pay for the utility service.
- This makes repayment dependent on the operating success and cash flow of the specific project, not on the issuer’s taxing power.
- Utility revenue bonds may be tax-exempt or taxable depending on use and structure.
Pledge types
- Gross revenue pledge: Bondholders are paid before the issuer pays most operating or maintenance costs. Revenues flow to debt service first.
- Net revenue pledge: Operating and maintenance expenses are paid first; remaining net revenues are used for debt service. Net pledges are common for essential utilities because ongoing upkeep is necessary to keep services running.
Key metrics and covenants
Investors and rating agencies look at several measures and legal protections:
– Coverage ratio (debt service coverage ratio): Net revenues divided by scheduled debt service. A higher ratio indicates a larger cushion to meet payments.
– Revenue-to-expenditure covenant: Requirements that the utility maintain a minimum ratio of revenues to expenses (often including debt service).
– Rate-setting authority: Whether the utility or issuer can raise customer rates to maintain required coverage.
– Seniority and lien structure: Priority of claims on revenue (e.g., senior lien vs subordinate lien).
– Reserve funds and insurance: Debt service reserves or policies that reduce payment risk.
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Risks to consider
- Project revenue risk: Revenues can fall due to decreased usage, economic decline, or regulatory changes.
- Customer concentration: If a few large customers account for a big share of revenue, the bond is more vulnerable if one reduces usage or leaves.
- Population and demand trends: Declining population or demand in the service area can reduce future revenue.
- Operational risk: Poor maintenance, outages, or inefficiencies that increase costs or reduce service.
- Legal/regulatory risk: Limits on rate increases or changes in regulatory treatment can affect ability to cover debt.
How utility bonds differ from general obligation bonds
- General obligation (GO) bonds are backed by the issuer’s taxing power or full faith and credit; repayment can come from multiple revenue sources or tax increases.
- Utility revenue bonds are repaid solely from project revenues, making them more project-specific in risk profile.
Why investors buy them
- Potentially higher yields than GO bonds to compensate for revenue risk.
- Often tax-exempt for federally tax-qualified projects, which can enhance after-tax returns for taxable investors.
- Revenue source can be relatively stable for essential services with predictable customer bases.
Evaluating a utility revenue bond
Consider:
– Coverage ratio history and covenant requirements
– Trend in usage, population, and economic activity in the service area
– Customer mix and any large industrial or institutional customers
– Condition and management of the utility’s infrastructure
– Credit rating and any reserve funds or credit support
Takeaways
- Utility revenue bonds finance essential-service projects and are repaid from project revenues rather than taxes.
- Key distinctions include gross vs net revenue pledges and dependence on the project’s cash flow.
- Investors should evaluate coverage ratios, customer concentration, rate-setting ability, and local demand trends to assess risk and return.