Local municipalities, such as counties, cities and towns, will issue two basic types of bonds that allow them to fund infrastructure projects. While general order bonds provide for the essential funding of local government and have a low risk of the issuer not paying off its obligations, revenue bonds fund projects with less certain returns, higher potential returns and a larger degree of risk, according to Morningstar. In the worst-case scenario, a revenue bond default leaves the investor with a complete loss on his investment.
Municipalities use revenue bonds in order to fund the construction, expansion or renovation of speculative projects that generate user fees, such as airports, industrial parks, sports stadiums, publicly owned power plants, hospitals and toll roads. These projects usually rely on a single income source from which the organization that runs the project will repay revenue bond holders, leaving the organization particularly vulnerable to not having the money to pay its bond obligations.
Revenue bond issues are secured by a project's potential for future revenue collection, which can lead to default if project planners did not anticipate construction cost overruns or lower than expected revenues, according to Morningstar. A municipality will default on revenue bonds if the project does not generate enough income to redeem the bonds when they reach maturity or pay interest on the bonds.
Unlike a general obligation bond where a municipality backs the bonds with its full faith, revenue collection powers and credit, an issuer who defaults on a revenue bond has no obligation to redeem the bonds at a future date or to liquidate its assets in order to compensate bondholders, according to Public Bonds. If a revenue bondholder does not have insurance, his bonds almost always become worthless.
Half of all municipal bondholders purchased private insurance in order to protect themselves in the event of default as of 2011, according to Muni Bond Advisor. With revenue bond insurance, bondholders will pay a monthly premium for coverage based upon the risk of their bonds and will submit a claim to their insurance agency after a default occurs. This insurer will then pay for 100 percent of their losses. Insurance mitigates the risk of default that revenue bond investors face and decreases their potential profits.
In rare circumstances, revenue bondholders can litigate to collect their money from a municipality or a third party if a party’s negligent actions caused the revenue bond default, according to Public Bonds. For example, a bondholder can sue the municipality that issued the bonds if the municipality agreed to morally or financially support the project with other local revenue and defaulted on its obligation. Alternatively, a revenue bondholder could decide to sue the bond issuer for underwriting fraud.
- Morningstar: Course 209, What Are Revenue Bonds?
- Morningstar: Course 209, Revenue Bond Security
- Muni Bond Advisor: Bond Insurance
- U.S. Securities and Exchange Commission. "What Are Municipal Bonds?" Accessed June 26, 2020.
- U.S. Securities and Exchange Commission. "Bond Funds and Income Funds." Accessed June 26, 2020.
- Morningstar. "Municipal Bond Funds." Accessed June 26, 2020.
- Fidelity. "Bonds vs. Bond Funds." Accessed June 26, 2020.
- American Association of Individual Investors. "How Credit Ratings Affect Bond Valuations." Accessed June 26, 2020.
Chris Hamilton has been a writer since 2005, specializing in business and legal topics. He contributes to various websites and holds a Bachelor of Science in biology from Virginia Tech.