How Safe Are Your Revenue Bonds?

In case you didn’t know, the U.S. territory of Puerto Rico is in financial hardship. The country issued about $120 billion in municipal bonds and now cannot pay the interest let alone the principal. The bonds were easy to sell because yields on Puerto Rico bonds are tax-free for federal and state income tax purposes. There has also been the assumption states and territories could not default on their debt obligations.

A recent court ruling regarding Puerto Rico may have significant consequences for municipal bonds issued on the mainland. In late March, the First Circuit court (based in Boston) ruled that municipalities under Chapter 9 bankruptcy protection do not have to make debt payments – even if the underlying bonds are secured by special revenues. As background, a municipality can issue bonds such as utility, transportation, or sanitation bonds that use service fees to re-pay the principal and interest (so called revenue bonds). The assumption has always been as long as a project was generating cash flow, bondholders would receive payment –regardless of the municipalities overall financial condition.

This new ruling may significantly impact municipalities that have questionable finances. For example, the city of Chicago has a junk bond rating, but its water revenue bonds have a noticeably higher bond rating. The reason is that the underlying projects would continue to generate a revenue stream that would be “earmarked” to pay back bondholders – regardless of the city’s overall financial condition. With this ruling, it seems that if Chicago goes into Chapter 9, those revenue bonds could be consolidated with all other Chicago debt.

In the U.S., there is a reported $1.2 trillion of special revenue bonds that have been issued. If this ruling is confirmed, bondholders of lower quality municipalities will likely see rating downgrades and, for any new projects, a higher interest cost. Even for more financially sound municipalities, we would expect a higher cost of new projects simply because of the uncertainty that now exists.