For those building a fixed-income portfolio, it is beneficial to spend time understanding the details behind different bond issues. Investors gravitate toward general obligation bonds that are secured by the taxing and borrowing power of the issuing government, and escrowed pre-refunded bonds which offer the highest credit rating because of the escrowed securities that collateralize them.
But investors should also consider revenue-backed issues tied to “essential” revenue.
While U.S. and global economies are generally trending positive, the flow of funds to local governments remains uncertain. There are many hurdles facing state and local governments. States receive significant funding from federal sources. This funding is being reduced and future support remains uncertain. Local governments receive on average 30 percent of their revenues from state aid and 4 percent from federal aid. Reduced support makes it more difficult for local governments to operate. While we do not foresee systemic defaults, we do anticipate continued deficit reduction by restructured payrolls and benefits, reduced public services, and increased taxes.
In contrast to general obligation bonds, revenue bonds allow us to analyze a current stream of revenue and project future flows. The allure of the right revenue bond is price inelasticity (increases in price have relatively little impact on demand). Does anyone know what their sewer bill rate is? Will you stop flushing the toilet if your sewage rate is raised by 4 percent?
Do we care if these revenue bonds are in states with structural deficits like Illinois or California? Not really. In fact, there may be greater value in states with perceived problems. People still need to use roads, water and toilets. These bonds can be compelling choices.