The Advantages of Municipal Revenue Bonds
Stable credit characteristics and potential yield advantage build a case for favoring revenue bonds over general obligation bonds.
Executive Summary
-Revenue bonds comprise around two-thirds of the municipal bond universe and provide stable quality and attractive income from debt financings of vitally essential projects.
-We believe that fundamental credit risk for most revenue bonds is stable in weak economic periods due to the essentiality or quasi-essential nature of the project.
-Revenue bond issuers ("public corporations") are not as labor intensive as state/local governments, and therefore are not experiencing the growing pension-funding gaps, which may have negative implications for general obligation (GO) debt.
-Infrastructure financing in the US has long relied on the municipal-bond market, with revenue-bond issuance a key source of funding for those projects.
Executive Summary
f
Revenue bonds comprise around two-thirds of the municipal bond universe and provide
stable quality and attractive income from debt financings of vitally essential projects.
f
We believe that fundamental credit risk for most revenue bonds is stable in weak
economic periods due to the essentiality or quasi-essential nature of the project.
f
Revenue bond issuers (“public corporations”) are not as labor intensive as state/local
governments, and therefore are not experiencing the growing pension-funding gaps,
which may have negative implications for general obligation (GO) debt.
f
Infrastructure financing in the US has long relied on the municipal-bond market, with
revenue-bond issuance a key source of funding for those projects.
Compelling Advantages of Municipal Revenue Bonds
When investing within the large and diverse municipal-bond market, with $3.8 trillion
of municipal debt outstanding and over 50,000 issuers, investors must generally choose
between two broad categories of bonds: revenue and general obligation. Both represent
high-quality investments; however, there are several fundamental reasons why Standish
favors revenue over GO bonds.
Revenue bonds
fund a wide variety of public projects, including: toll roads, bridges, water
and sewage plants, electric systems, airports, hospitals and public universities, among many
others. From a fundamental-credit standpoint, many of these “public corporations” are
virtual monopolies which deliver services with inelastic demand. Therefore revenues are
extremely reliable, even during weak economic cycles.
f
Revenue bonds are supported by dedicated income streams from specific projects
and sources. Each bond issue requires detailed credit analysis to identify and assess its
unique risks and characteristics.
f
Disclosures and financial reporting from revenue-bond issuers are often more frequent
and transparent than those of many local-government GO issuers.
f
While revenue-bond issuers lack the taxing power of state and local governments, issuers
generally have the ability to raise rates and fees to maintain financial performance and
meet bond covenants.
The Advantages of
Municipal Revenue Bo
nds
Stable credit characteristics and potential yield advantage
build a case for favoring revenue bonds over general
obligation bonds
April 2017
Daniel Marques, CFA
Senior Portfolio Manager
Daniel Barton, CFA
Head of Research for
Tax Exempt Bonds
THE ADVANTAGES OF
MUNICIPAL REVENUE BONDS
Page 2
General-obligation
bonds are backed by the ‘full faith and credit’ pledge of the issuer,
supported by taxes and fees. State GOs are mainly supported by sales and income taxes,
while local GOs are backed heavily by property taxes.
f
Tax revenues supporting GO bonds are tied to economic cyclicals.
f
Because GO bonds are backed by taxes paid by the public, voter approval is often
required to raise taxes.
f
Stock market volatility has implications for those issuers heavily dependent on capital-
gain tax revenues.
Rising Pension Burdens for GO Issuers
Compared to revenue-bond issuers, state and local GO municipalities are more labor-
intensive, which fuels a greater proportion of revenue share needed to cover pension and
healthcare costs. This gives rise to fiscal challenges, particularly for those issuers lacking
the financial flexibility to effectively meet escalating pension liabilities by either increased
contributions, raising tax revenues, issuing debt or reducing expenses.
While there has been widespread pension reform among state and local GO issuers, we
expect costs associated with pension and other post-employment benefits, such as health
care, to continue to outpace revenue growth. Furthermore, rating agencies have seemingly
increased their emphasis on pension-funding levels, leading to more negative-rating
actions in recent years.
Political Autonomy Is a Plus
We carefully examine the vacillations of the political environment to ensure state and
local administrations are driving prudent fiscal management; realistic budget forecasts,
willingness to take remedial steps to raise taxes and/or implement spending cuts, and pass
timely budgets and legislation. The willingness is increasingly as important as ability to pay.
We believe that essential-service revenue bonds are insulated from political risk due to
professional management, frequent independent rate-setting ability, dedicated tax-revenue
streams and operations, which are separate and distinct from the general government.
Special Revenue Bonds a Hidden Gem in Unlikely Event of Bankruptcy
In a rare municipal bankruptcy, as it pertains to revenue bonds, we find that security pledge
matters. The credit quality of a revenue bond is often bolstered by the issuer’s ability to
increase user fees and rates in the event that the dedicated revenue stream falls short of
projections. Special revenue bonds also have sole rights to dedicated revenue streams, and
are insulated from a state or local government insolvency. We particularly see relative value in
“special revenue” bonds. Standish favors these bonds particularly when market pricing does
not assign a premium to reflect this protective covenant. The bankruptcy code lists several
types of special revenue bonds, of which Standish focuses on those payable from revenues of
municipal utilities (water, sewer or electric) and those backed by special excise taxes.
While revenue-bond issuers
lack the taxing power of
state and local governments,
issuers generally have the
ability to raise rates and
fees to maintain financial
performance and meet bond
covenants.
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Revenue Bonds Make Up About 2/3 of the Muni Market
Infrastructure Project Exposure
Transportation
24%
Water & Sewer
13%
Health Care
13%
Education
11%
Power
8%
Special Tax (mixed)
7%
Leasing (mixed)
7%
Industrial Revenue
3%
Housing
2%
88%
Source: Standish, Bloomberg Barclays Muni Index as February 28, 2017
Revenue Bonds
Revenue
65%
State general
obligation
15%
Local general
obligation
12%
Pre-refunded
8%
THE ADVANTAGES OF
MUNICIPAL REVENUE BONDS
Page 3
Revenue Bond Excess Yield a Key Advantage
Municipal revenue bonds potentially offer a yield advantage versus GO issues, which makes
them attractive from a relative value standpoint. Due to a lack of familiarity and analytical
credit expertise amongst the largest buyer base of municipal bonds, retail investors,
demand for revenue bonds is less robust resulting in higher yields than would be justified
by the sector’s strong credit fundamentals.
Conclusion
At Standish, we believe a targeted allocation toward both general obligation and
revenue bonds is paramount when seeking to achieve optimal portfolio sector and credit
diversification. Both security types, with their differing repayment sources, carry various
levels of risk that can be addressed with thorough fundamental and quantitative analysis.
We further believe an overweight bias toward revenue bonds versus GO is warranted based
on the revenue sectors’ more stable credit characteristics, along with attractive relative
yield profile. We focus heavily on issuers in economically strong service areas with solid
credit characteristics and bond income sources that are better insulated from economic
slowdowns.
Municipal revenue bonds
potentially offer a yield
advantage versus GO issues,
which makes them attractive
from a relative value
standpoint.
Source: Center for Retirement Research, Barclays; reported as of 9/13/16
page 115
Revenues Historical Higher Average Yields vs. GOs
Source: BAML, Standish as of February 28, 2017
Moody's Upgrades Exceeded Downgrades - First time since 2008
-
1.00
2.00
3.00
4.00
5.00
6.00
7.00
Dec-96
Nov-97
Oct-98
Sep-99
Aug-00
Jul-01
Jun-02
May-03
Apr-04
Mar-05
Feb-06
Jan-07
Dec-07
Nov-08
Oct-09
Sep-10
Aug-11
Jul-12
Jun-13
May-14
Apr-15
Mar-16
Feb-17
Yield to Worst (%)
General Obligation
Revenue
60%
70%
2001
2003
2005
2007
2009
2011
2013
2015
250%
300%
350%
400%
450%
500%
Recession
period
Q308-
Q209
Revenue vs. GO Bond Comparison - Key Factors
General Obligation
Revenue
Pensions
Rising retiree costs, such as pension &
health care, can cause budget stress
and crowd out spending
Less pension exposure, as issuers are
generally less labor intensive
Default/
Bankruptcy
States as well as approximately 50%
of local governments, cannot file for
bankruptcy
Defaults/bankruptcies remain rare,
concentrated in non-essential
purpose issuers.
Economic Risk
Cyclical tax revenues sensitive to
economic swings
Predictable income / stability in weak
economy
Political Risk
Political considerations drive fiscal
management / failure to pass budgets
& legislation, reluctance to raise taxes
or reform pension system
Professional management, dedicated
revenues and separate operations
from local government
Bond Covenants
Unlimited taxing power
Special revenue status secures
protection in the event of local GO
bankruptcy
Excess Yield
Retail-investor demand is heavy which
compresses yield/spread levels
Lack of analytical expertise among
retail leads to wider spreads
Source: Standish as of March 31, 2017
The comments provided herein are a general market overview and do not constitute investment advice, are not predictive of any future market performance, are not provided as a
sales or advertising communication, and do not represent an offer to sell or a solicitation of an offer to buy any security. Similarly, this information is not intended to provide specific
advice, recommendations or projected returns of any particular product of Standish Mellon Asset Management Company LLC (Standish). These views are current as of the date of this
communication and are subject to rapid change as economic and market conditions dictate. Though these views may be informed by information from publicly available sources that we
believe to be accurate, we can make no representation as to the accuracy of such sources nor the completeness of such information. Please contact Standish for current information about
our views of the economy and the markets. Portfolio composition is subject to change, and past performance is no indication of future performance.
BNY Mellon is one of the world’s leading asset management organizations, encompassing BNY Mellon’s affiliated investment management firms, wealth management services and global
distribution companies. BNY Mellon is the corporate brand for The Bank of New York Mellon Corporation. Standish is a registered investment adviser and BNY Mellon subsidiary.
WP/Muni/Apr2017/4-5-17/BR
Standish Mellon Asset Management Company LLC
Boston • Pittsburgh • San Francisco
Standish Mellon Asset Management (UK) Limited
www.standish.com • info@standish.com
@StandishIM
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