What are revenue bonds and how do they work?

An investor considers adding revenue bonds to her portfolio.

SmartAsset and Yahoo Finance LLC may earn commission or revenue from the links below.

Revenue bonds are municipal bonds issued to finance specific projects such as utilities, airports, or toll roads. These bonds differ from general obligation bonds in that they are repaid only through revenue generated by the project (such as tolls or fees) rather than tax revenue. Investors favor them because of their connection to tangible assets and their unique risk-reward characteristics compared to other types of municipal bonds.

If you are considering revenue bonds, financial advisor can help you determine how they fit into your portfolio.

Revenue bonds are debt securities issued by municipalities, government agencies, or other public entities to finance specific projects that generate revenue. These bonds differ from general obligation bonds in that they are tied only to the revenue generated by the projects they finance, such as toll roads, power plants or mass transit systems. Rather than relying on taxes to repay bondholders, issuers use revenue such as tolls, fees or lease payments.

Revenue bonds are considered project-specific, meaning the success and financial viability of the funded project are key to repayment. This structure typically appeals to investors who prefer to have their investments directly tied to income-producing assets.

Revenue bonds work by designating a specific income stream to cover interest payments and principal repayments. When the issuer sells these bonds, the investor provides upfront capital that is then allocated to the construction or improvements of a revenue-generating project. Over time, revenue from the project (such as utility bills, bridge tolls, or ticket sales) would be collected and used to make periodic payments to bondholders.

The repayment structure typically includes a trust agreement outlining how the income generated will be managed. In many cases, funds are used first to repay bonds and then to cover operating expenses. In addition, some revenue bonds are backed by reserve funds or third-party guarantees, providing investors with additional assurance.

However, these bonds are not without risk; if the project's revenue is lower than expected, the issuer may have difficulty meeting its payment obligations. This makes due diligence on the project and its revenue projections very important for investors.

Financial advisors compare revenue bonds to their clients' general obligation bonds.

General obligation (GO) bonds and revenue bonds are two different types of municipal securities, each serving different purposes and carrying unique risks. GO bonds are backed by the issuer's tax authority, whereas revenue bonds are only dependent on the revenue generated by a specific project.

Here are some of the key differences between these bonds:

Source of repayment: GO bonds are repaid through the issuing entity’s general revenues, including tax revenues such as property or sales taxes. Revenue bonds, meanwhile, rely solely on revenue from items such as tolls, utility fees or ticket sales.
Risks and benefits: GO bonds are generally less risky because they are tax-backed, but interest rates tend to be lower. Revenue bonds carry higher risk because repayment depends on the success of the project, which may result in a higher yield.
Purpose: GO bonds fund general public programs like schools, parks, and roads, while revenue bonds fund specific, self-sustaining projects like bridges, power plants, or stadiums.
Voter participation: General obligation bonds typically require voter approval due to their reliance on tax revenues, while revenue bonds typically do not require voter approval because they are not backed by taxes.

Retail investors have several ways to purchase revenue bonds, including through a brokerage account, a mutual fund that specializes in municipal bonds, or directly from the issuer during an initial public offering. These bonds can also be purchased on the secondary market, allowing investors to buy and sell at current prices. For starters, investing in a municipal bond fund or ETF can provide a diversified portfolio across different industries and issuers.

When considering revenue bonds, it is important to evaluate the financial stability and earnings potential of the financing project. Investors should focus on the project's revenue history and forecasts, any reserves established to protect bondholder payments, and the bond's credit rating from agencies such as Moody's or Standard & Poor's, which indicates the issuer's ability to meet its financial commitments. ability.

Investors should also be aware of the tax implications of revenue bonds. These bonds often come with tax benefits, such as exemption from federal and sometimes state and local taxes, which can be especially beneficial for those in higher tax brackets. The specific tax benefits depend on the purpose of the bond and the location of the investor.

Revenue bonds tie repayment to the financial success of a specific project and may have higher yields than general obligation bonds but are riskier because repayment depends on the performance of the project. The bonds attract investors looking for potential tax benefits and investments tied to actual infrastructure projects. However, you should first evaluate a project's income potential, credit rating, and risk to determine whether these investments are consistent with your financial goals and risk tolerance.

A financial advisor can help you analyze your investments and manage your portfolio's risk. Finding a financial advisor isn’t difficult. SmartAsset's free tool matches you with vetted financial advisors serving your area, and you can have a free introductory call with your advisor to decide which one you think is the best fit for you. If you're ready to find an advisor who can help you achieve your financial goals, get started today.
If you're wondering how much tax you'll pay on selling an investment, SmartAsset's capital gains calculator can help you estimate.

What are revenue bonds and how do they work? appeared first on SmartReads by SmartAsset.