Revenue Bonds and the Cash Trap Mechanism

Infrastructure projects last for many years. As a result, different sources of funding are used at different points of time in the project. As mentioned in the previous articles, most of the time, bank loans are used during the construction phase of the project. However, at the same time, bonds are the preferred source of debt funding after the project has become operational.

A special type of bond called a revenue bond is commonly used in order to fund infrastructure projects. In this article, we will have a closer look at what revenue bonds are and how they function.

What are Revenue Bonds?

Revenue bonds are debt instruments that are commonly floated by infrastructure companies. Their name is derived from the fact that these bonds are secured by the revenues of an income-producing project. It needs to be understood that since revenue bonds are almost exclusively issued by government entities, there is a misconception that these bonds are secured by the government. The reality is that in most cases, the bondholders only have a right to the cash flows of the project or the portfolio of projects for which bonds have been issued. In the event of a default, people holding revenue bonds will not be able to ask the government to make good their loss.

This is the major difference between government debt and revenue bonds. Government debt is secured by the tax revenue generated by the government. On the other hand, revenue bonds are secured only by the cash flow, which will be created by the infrastructure project being securitized. Since the risk profiles of both bonds are different, the yields provided by both bonds are also quite different. Government debt symbolizes almost risk-free investments. Hence, their interest rates are also quite low. On the other hand, revenue bonds may be quite risky, and hence, sometimes, their yield can be quite close to the ones which are provided by private companies.

How Do Revenue Bonds work?

1. The cash flows being controlled by revenue bonds are not managed by the government or the special purpose entity which has been created to manage the infrastructure project. Instead, a special trust is set up to act as a neutral party and balance the interests of the bondholders as well as the shareholders. This trust oversees the cash flow, which has been generated by the project as well as how the cash is being disbursed.

2. The trust governing the revenue bonds has clear guidelines about how the cash flows of the project need to be prioritized. This is often referred to as a cash flow waterfall. This is because cash flows to the top levels, and only when the levels are full does the cash flow downstream. A typical cash flow waterfall would first fund the operating and maintenance expenses required to keep the project in good shape so that the revenue stream continues. In many cases, capital expenditure is given second priority. Then the leftover money is used to service the outstanding debt. Once that task has been completed, the leftover money is used to fill up reserves and surpluses. Only after all these payments and appropriations have been done can the equity investors distribute any money amongst themselves.

3. Revenue bonds work like private companies. This means that the debt service coverage ratio becomes a very important number when it comes to revenue bonds. The covenant which governs the bond prescribes a minimum debt service ratio that needs to be maintained. This ensures that too many bonds are not issued while the cash flow backing the bonds may not be too little.

4. In the case of revenue bonds, generally, there are clear and well-defined guidelines regarding the debt coverage ratio. There are restrictions regarding the historical debt service ratio, which has been maintained as well as the projected debt service ratio, which may have to be maintained in the future. Generally, a debt service ratio of 1 can be considered to be adequate. However, most revenue bonds prescribe the maintenance of a ratio of anywhere between 1.3 to 1.7. The extra money acts as a cushion and protects the bondholders from unforeseen events. The process of creating these extra reserves, which can be kept as a rainy day fund, is called the “cash trap” mechanism.

5. The extra money is kept as a reserve. In the future, if the cash flows from the project are not sufficient to meet the obligatory debt payments, money can be taken from these reserve accounts. The drawdown of the reserve accounts is considered to be a proactive step, which means that it prevents default. However, the act of withdrawing money from a reserve account could itself constitute a default since it means that the cash flows generated by the project were not enough to cover the debt service payments.

6. If there is no drawdown from the reserve fund for a stipulated number of years, this fund can then be used to retire the senior-most debt. Once the debt is retired, the amount requires to service the debt reduces. As a result, it becomes easier to maintain the debt service coverage ratio.

To sum it up, the revenue bond is a financial tool that has been created specifically for the purpose of funding the operational phase of infrastructure projects. Hence, it has many features that are useful for infrastructure companies.