Revenue bonds are issued to finance the construction of a revenue generating facility that provides essential services such as water or electricity. Revenue bonds are known as self-supporting debt, because they generate a dedicated revenue stream to pay off bondholders. When a facility financed does not generate enough funds to repay its debts, the bondholders, not taxpayers, bear the risk. Revenue bonds are rated according to a facility’s potential to cover operating expenses and repay bondholders’ interest and principal when due. Revenue bonds are not covered by taxes; therefore, they are not subject to statutory limits such in the case of GO bonds. The followings are key factors to consider when assessing the quality of a revenue bond: 1) the facility assembled should be able to generate adequate revenue; for example, a toll on a rural highway might not generate sufficient revenues to cover the debt service on its outstanding bonds. In addition, a facility should avoid a location where better alternatives are easily attainable, 2) sources of revenue should be a necessity. Essential services, such as water and electricity generate constant revenues, 3) callable bonds should establish a high yield to worst call in order to protect their investors, 4) the net revenues’ pledge to pay a facility’s operating expenses need to adhere to a specific order of flow of funds. A typical net revenue pledge may allocate revenues in the following order. First, current operating and maintenance expenses are paid. Second, the remaining funds are used to pay off the outstanding debt. The first debt payment covers interest and principal maturing in the current year. Thereafter, the remaining cash balance funds a debt service reserve fund that normally holds enough cash on hand to pay an entire year of debt service. Excess reserves are kept in a reserve maintenance fund used for general maintenance, and any excess cash thereafter is typically applied toward expanding the facility. Leftover balances end up in a surplus fund normally used for anything from redeeming bonds to investing in improvements. It is important to note, that some issuers implement a gross revenue pledge for a flow of funds. In this case, debt service is a priority expense followed by operating and maintenance expenses. Remaining cash balances are then deposited in a surplus fund.
There are four mathematical ratios normally found in a bond prospectus that can in turn help investors determine a community’s ability to meet its debt obligations: 1) debt ratio, 2) debt per capita ratio, 3) collection ratio, and 4) coverage ratio. A debt ratio of 5% is considered reasonable for a municipality. This is the net debt to assessed valuation or $5,000 of debt per every $100,000 of assessed property value. Most analysts prefer to use estimated valuation because property values tend to vary between different communities. The debt per capita takes into account a city’s tax burden. Larger cities can assume more debt per capita because of a diverse tax base. In order to calculate debt per capita, a city’s tax income is divided by its population. Since bonds are normally longer-term investments, looking at debt trends is crucial for finding out whether the ratios are rising or falling. The collection ratio, indicates whether a community’s credit conditions either deteriorate or improve. In this case, taxes collected are divided by taxes assessed. The coverage ratio, is used to illustrate the number of times annual revenues of a facility cover its debt service. A debt service coverage of 2:1 is considered adequate for a typical revenue bond. On the other hand, utility revenue bonds require lower debt service coverage of 5:4 to be considered adequate because they provide essential services. In summary, the debt service coverage ratio is used to analyze revenue bonds, while community demographics and tax service ratios are used to analyze GO bonds.