Municipal Bond Types

Industrial Development Revenue (IDR) Bonds

Industrial Development Revenue bonds (IDR bonds), also known as Industrial Revenue Bonds (IRBs) or Private Activity Bonds, represent a unique category within the municipal bond market. These bonds are issued by a governmental entity but are used to finance facilities for private companies. The government serves as a conduit issuer, borrowing on behalf of a private entity that will use the proceeds for constructing manufacturing plants, warehouses, office buildings, or other business facilities.

The mechanics of an IDR bond work as follows: a municipality or state agency issues tax-exempt bonds, and the proceeds are used to build or acquire a facility. The facility is then leased to a private company, and the lease payments from that company serve as the revenue source to pay debt service on the bonds. The credit quality of an IDR bond depends entirely on the financial strength of the private company using the facility, not on the creditworthiness of the issuing governmental entity. The government's taxing power is not pledged.

Because IDR bonds benefit private entities, they are subject to special restrictions under federal tax law. The Tax Reform Act of 1986 imposed volume caps on the amount of private activity bonds that each state can issue annually. These volume caps limit the total dollar amount of tax-exempt private activity bonds that can be issued in a state each year, typically calculated based on population.

Private Activity Bond Rules

Under the Internal Revenue Code, a bond is classified as a "private activity bond" if more than 10% of the bond proceeds are used by a private entity and more than 10% of the debt service is paid from or secured by private business revenues. Private activity bonds are generally taxable unless they fall into specific categories that qualify for tax-exempt treatment, known as "qualified private activity bonds." Qualified categories include:

• Airport bonds
• Dock and wharf bonds
• Solid waste disposal facility bonds
• Qualified residential rental project bonds (multi-family housing)
• Water and sewage facility bonds
• Small issue manufacturing facility bonds (up to $10 million)
• Student loan bonds
• 501(c)(3) bonds (non-profit organizations such as hospitals and universities)

Housing Bonds

Housing bonds are a major category of municipal bonds used to promote affordable housing. They serve a critical public policy function by making homeownership and rental housing more accessible to low- and moderate-income families. There are two primary types of housing bonds: single-family mortgage revenue bonds and multi-family housing revenue bonds.

Single-Family Mortgage Revenue Bonds

Single-family mortgage revenue bonds are issued by state or local housing finance agencies to provide below-market-rate mortgages to qualified first-time homebuyers. The bond proceeds are used to purchase mortgages or provide mortgage loans through participating lending institutions. The mortgage payments from homebuyers serve as the revenue source to pay debt service on the bonds.

To qualify for these programs, borrowers must generally meet specific criteria: they must be first-time homebuyers (not having owned a home in the prior three years), their income must be at or below a specified percentage of the area median income, and the purchase price of the home must be within certain limits. These requirements ensure that the bonds serve their intended purpose of promoting affordable housing.

Multi-Family Housing Revenue Bonds

Multi-family housing revenue bonds finance the construction or rehabilitation of apartment complexes that provide affordable rental housing. A key requirement is that a specified percentage of the units (typically 20% to 40%) must be reserved for tenants whose income is at or below a certain percentage of the area median income. Rental income from the tenants serves as the revenue source to pay debt service on the bonds.

Multi-family housing bonds issued for qualified residential rental projects may qualify for tax-exempt status as qualified private activity bonds. The issuer is typically a state or local housing finance agency acting as a conduit, and the actual developer and operator of the housing project is often a private entity. The credit quality depends on the occupancy rates and rental income of the project, though credit enhancement through government programs such as Section 8 rental assistance can provide additional security.

Education and Health Care Bonds

Education Bonds

Education bonds encompass several categories of municipal securities used to finance educational facilities and programs. Public school district GO bonds are among the most common municipal bonds issued. These bonds are backed by the property taxes within the school district and are used to build new schools, renovate existing facilities, and purchase equipment. Because they are GO bonds, they carry the full faith and credit of the school district.

Higher education bonds are issued by state universities, community colleges, and private colleges and universities (through conduit issuers). Public university revenue bonds may be secured by tuition and fee revenues, dormitory revenues, or auxiliary enterprise revenues such as bookstores and parking facilities. Private university bonds are typically issued as 501(c)(3) bonds, which are a category of qualified private activity bonds available to non-profit organizations.

Student loan revenue bonds are issued by state student loan agencies to provide funding for student loan programs. The repayment of the student loans provides the revenue to service the bonds. These bonds carry risks related to student loan default rates and repayment timing. Federal guarantee programs (such as the former FFELP program) historically provided credit enhancement for student loan bonds, though most federal student lending now occurs through the Direct Loan program.

Health Care Revenue Bonds

Health care revenue bonds finance hospitals, nursing homes, assisted living facilities, and other health care institutions. These bonds represent one of the largest sectors within the revenue bond market. The revenue source is typically patient payments, including fees from Medicare, Medicaid, and private insurance companies.

Health care bonds are among the more complex and risky municipal bonds to analyze because of the many factors that can affect hospital and health care facility revenues. Key risk factors include:

• Regulatory Risk: Changes in Medicare and Medicaid reimbursement rates can significantly impact revenue. Government policy changes can reduce payments or impose new compliance costs.
• Competition: New hospitals or outpatient facilities can draw patients and revenue away from existing facilities.
• Demographic Changes: An aging population may increase demand for certain services but also increase the proportion of patients covered by lower-paying government programs.
• Technology and Capital Requirements: Health care facilities must continually invest in new technology and equipment, requiring significant capital expenditures.
• Staffing: Shortages of nurses, physicians, and other health care workers can increase labor costs and limit the ability to serve patients.
• Uncompensated Care: Charity care and bad debt from uninsured patients can strain finances.

Non-profit hospitals typically issue their bonds through conduit issuers as 501(c)(3) bonds. For-profit hospitals do not qualify for tax-exempt financing. The credit analysis of hospital bonds typically examines debt service coverage ratios, operating margins, patient volumes, payer mix (the proportion of patients covered by Medicare, Medicaid, private insurance, and self-pay), and the facility's competitive position within its service area.

Special Tax and Special Assessment Bonds

Special Tax Bonds

Special tax bonds are secured by a specifically designated tax rather than by the issuer's general taxing power. Unlike GO bonds, which pledge all available taxes, special tax bonds rely on revenue from a single, identified tax source. Common examples include bonds backed by sales tax revenue, hotel/motel occupancy taxes, gasoline taxes, tobacco taxes, or excise taxes. The key distinction is that the issuer does not pledge its full faith and credit; only the designated tax revenue is available to pay debt service.

Special tax bonds carry risks related to the specific tax source. For example, a bond backed by hotel occupancy tax revenue would be vulnerable to a decline in tourism or a recession that reduces hotel stays. A bond backed by tobacco tax revenue might be affected by declining smoking rates over time. Investors and analysts must carefully evaluate the stability and growth prospects of the designated tax revenue when assessing these bonds.

Special Assessment Bonds

Special assessment bonds finance improvements that benefit a specific group of properties, and the cost is assessed against those properties. Common examples include sidewalk construction, street paving, sewer line installation, and streetlight installation in a specific neighborhood. The property owners who benefit from the improvement are assessed a proportionate share of the cost, and these assessment payments are the revenue source for the bonds.

Special assessment bonds are not GO bonds because they are not backed by the issuer's general taxing power. They are also not traditional revenue bonds because the revenue comes from assessments rather than user fees. They occupy a hybrid position in the municipal bond market. The credit quality depends on the ability and willingness of the assessed property owners to make their payments. If property values in the assessed area decline, or if property owners are unable or unwilling to pay, the bond could face repayment problems.

Double-Barreled Bonds

Some municipal bonds are "double-barreled," meaning they are backed by two sources of revenue. Typically, a double-barreled bond is a revenue bond that also carries the full faith and credit pledge of a governmental entity. For example, a water revenue bond might be backed by both water system user fees and the general taxing power of the municipality. The additional GO pledge provides extra security for bondholders, which generally results in a higher credit rating and lower borrowing cost.

Other Municipal Bond Types

Moral Obligation Bonds

Moral obligation bonds are issued by a state agency or authority, with a provision that the state legislature may (but is not legally required to) appropriate funds to replenish a debt service reserve fund if it is drawn upon. The "moral obligation" is a political commitment rather than a legal one. If the issuer cannot make debt service payments from project revenues, the state has a moral (but not legal) obligation to step in. Because the obligation is not enforceable, moral obligation bonds typically carry a lower credit rating than full GO bonds but a higher rating than pure revenue bonds.

Certificates of Participation (COPs)

Certificates of participation represent shares in a lease-purchase agreement between a governmental entity and a private vendor or financing entity. The government enters into a lease agreement to use an asset (such as a building, equipment, or vehicle), and investors purchase certificates that entitle them to a proportionate share of the lease payments. COPs are not technically bonds, and they do not constitute debt for purposes of statutory debt limits. This makes them an attractive financing option for governments that have reached their borrowing capacity.

The key risk of COPs is "non-appropriation risk." Because the government's obligation is annual (lease payments must be appropriated each year by the governing body), there is a risk that the legislative body may choose not to appropriate funds for future lease payments. If this occurs, the certificate holders may not receive their payments. This appropriation risk is the primary reason COPs typically carry lower credit ratings and higher yields than GO bonds.

Build America Bonds (BABs)

Build America Bonds were created by the American Recovery and Reinvestment Act of 2009 as a temporary program to stimulate infrastructure investment during the financial crisis. Unlike traditional municipal bonds, BABs are taxable bonds, but the federal government provides a subsidy to the issuer equal to 35% of the interest cost. BABs were designed to appeal to a broader investor base, including pension funds and foreign investors who do not benefit from tax-exempt interest. The program expired at the end of 2010, but outstanding BABs continue to trade in the secondary market.