North Carolina local governments are increasingly choosing revenue bonds as the best way to finance improvements to their water and sewer systems. Revenue bonds are a form of borrowing money for which the security to the lender is a pledge to apply the system’s net operating revenues to repay the loan. There is no physical collateral pledged to the lender as there is in an installment financing, and no promise to use tax money as there is for a general obligation bond.
For a variety of reasons, North Carolina local governments were slower to adopt revenue bond financing than were localities in other states, and revenue bonds took on an aura of complexity and strangeness. In the past several years, however, more and more localities are finding the advantages of revenue bonds to be a good match for their needs. Revenue bonds offer excellent flexibility for funding an on-going program of utility system improvements, although revenue bond financing documents impose restrictions on the financial aspects of system operation that are usually not present with other financing options.
Here’s a closer look at some of the features of revenue bond financing:
Flexibility for on-going borrowing
This is probably the number one advantage of using revenue bonds for your projects.
Revenue bonds do not require a pledge or mortgage of any physical collateral. This means that when you are working on a financing, you don’t need to worry about whether your project has good collateral value, or whether you are trying to improve property that already has a lien on it.
You may well find a bank or two that will take a lien on water or sewer lines, for example, but not all of them will. If you are trying to improve a water treatment plant that already has a lien on it, then you are locked in to either working with that same bank on the new loan, or having to refinance the original loan even if that doesn’t otherwise make sense (because banks generally won’t accept a second lien position). And eventually, you may run out of assets to put liens on.
With revenue bonds, on the other hand, you are placing a lien only on your system’s net operating revenues. The financing documents will set out predetermined, objective standards for borrowing additional money for additional system improvements. This means that for your second (and subsequent) revenue bonds, you may end up working with a variety of lenders without the need to get the consent of the prior lenders, or the need to pay off your prior lenders with perhaps onerous prepayment penalties.
If you know you will have a series of system improvements, big or small, over time, then starting off with revenue bonds will make your on-going borrowing program more flexible and responsive to your overall financial and system goals. This is especially important because if you start off with a series of installment financings, you end up with a bunch of old loans that you need to resolve when making the shift to revenue bonds.
Imposed standards for system performance
Revenue bond documents will require the system operator to generate net operating revenues on a cash basis at a level above the bare minimum to pay the bills (such as, net revenues must equal at least 120% of debt service). For some systems this may be a problem. If your system can cover its bills but there is either the inability or unwillingness to improve the operating margin, then revenue bonds may not work for you – same thing if you are subsidizing the utility fund from the general fund.
Revenue bond documents will impose a variety of other standards for operating the system that wouldn’t be in your installment financing or general obligation bond documents. Most of these can be chalked up to principles of good management – for example, diligently collect your accounts — but again, they wouldn’t be contractual obligations under other forms of financing.
On the other hand, for some borrowers these restrictions provide a welcome level of external discipline on operations. Some borrowers find it useful to be able to point to the requirements of bond documents to explain the need for rate increases or other changes in system operation.
Not everything then has to be a revenue bond forever
Just because you have a revenue bond program in place, that doesn’t mean you have to use revenue bonds for every future system borrowing need. Revenue bond documents will provide “carve-outs” to allow you to supplement revenue bond financing with some other loans without the need for complying with your document tests for additional borrowings. These carve-outs will usually include, for example, loans under government programs and limited installment financings for system-related equipment and vehicles.
Easier legal procedures
There are no public hearing, voter approval or newspaper notice requirements for issuing revenue bonds. Installment financings usually require a public hearing after published notice, and general obligation bonds generally require voter approval at a bond referendum.
Different types of financing documents
When you do your first revenue bond issue, the documentation and process can seem long and complicated. For many in North Carolina it’s just less familiar than an installment financing, and that can make people hesitant. But a revenue bond issue is not inherently more complicated than an installment financing, and the process does not have to take any longer. Documentation and timing for a second revenue bond is much more streamlined than for a general obligation bond or installment financing of the same size.
Ability to leverage across utility systems
Sometimes a local government will have a utility system that is performing well financially, and others that are not. For example, water systems generally make money, and sewer systems often do not. A revenue bond program allows you to combine the systems into a single enterprise system for the purposes of the financial performance standards referenced above, thereby allowing the stronger system to carry part of the burden for the weaker system.
Some localities are finding this particularly useful for funding stormwater management costs. A stormwater management plan may point to a capital improvement that can’t easily be funded or financed based on any reasonable stormwater management fee. By combining your utilities for financing purposes, you can support a revenue bond issue for the stormwater capital needs that leverages the financial strength of your water and sewer utilities. You could follow this same system for solid waste or parking enterprises, among others, if you concluded that was how you wanted to approach these financing needs.
Different structure of transaction costs
The documentation for the first revenue bond issue will be less familiar to you and will establish a framework for future borrowings. Therefore, this first issue may require a higher level of time and attention from staff as compared to a more familiar form of financing that will stand alone. The LGC application fee for any revenue bond issue is $12,500 (as opposed to zero for a general obligation bond or $1,250 for a bank-placement installment financing). Further, depending on system performance and the nature of your borrowing, the LGC may require an outside consultant to provide an analysis of the system’s expected ability to service revenue bonds over time. This leads to generally higher borrowing costs for an initial revenue bond issue.
In addition, the LGC, and usually the lenders, will require that you have a bond counsel on your side for a revenue bond issue. This is probably a good idea in any event for the first issue because you are setting the framework for subsequent issues, and you want to be sure you have someone looking out for your long-term interests. There are of course many circumstance under which hiring your own bond lawyer would not be required by the LGC or the lender for an installment financing, even though that might be a good idea for you anyway.
On the other hand, a revenue bond issue doesn’t require a real estate title insurance policy as would an installment financing, and those policies can cost several thousand dollars. Other than the LGC application fee, financing costs for subsequent revenue bond issues should not be higher than for similarly-sized installment financings or GO bond issues, and the process and documentation for the subsequent revenue bond issues should be quicker and simpler than for other forms of financing.
Potentially longer financing terms and level payment amortization
The LGC will generally allow 25-year maturities on revenue bonds, when you need that extra time, while limiting GO bonds and installment financings to 20-year terms. One must still find a lender willing to offer that length of financing, however, and right now it’s hard to find bank-placement financing of any type for more than a 15-year term (of course, USDA will buy your revenue bond with a 40-year maturity if you qualify for that financing). It’s relatively simple to get 20-year financing on a general obligation bond, if you can get through the hoops and pay the costs of that financing.
The LGC will allow amortization on a level-payment basis, with principal deferred until the project will be placed in service, for any enterprise fund borrowing – whether revenue bonds, GO bonds or installment financing.
Ability to match the borrowing amount to the need
You will set the final borrowing amount for a revenue bond issue just before loan closing, so you can be sure you are not borrowing too much, or too little, money. This flexibility is similar to what you’d have in an installment financing, but you must set the maximum amount of your general obligation bond issue at the time you set the bond referendum. You can always borrow less than the authorized amount of general obligation bonds, but most folks are hesitant to set the amount of bonds too high above a current estimate (even if the bonds won’t be issued for a long time after developing that estimate).
Comparable placement options and interest rates
Revenue bonds can be sold through private bank placements or issued through public offerings in the securities markets, just as installment financings can. General obligation bonds for new projects generally need to be sold in the public markets under LGC policies.
When you are looking at a bank placement, revenue bonds and installment financings will likely have comparable interest rates, and some lenders will even prefer revenue bonds. In the public markets interest rates for revenue bonds will again be roughly the same, or perhaps slightly better, than interest rates for comparably-rated installment financings. It can sometimes be difficult, however, to get your revenue bonds up to the bond rating you would get for your installment financings, and in the public markets your bond rating is closely linked to your interest rate results.
If you have a water and sewer system and haven’t looked at the revenue bond alternative, it’s worth your while to do so the next time you’re thinking about your capital financing plan. Revenue bonds might be your best approach.
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