The municipal bond market began as a general obligation market similar to the Treasury market. Since then, the market has grown to include revenue bonds backed by specific municipal revenue sources and private activity bonds (PAB) designed to finance private projects that benefit the public.
Conduit bonds are a type of PAB designed to capture the tax benefits of municipal bonds to advance private projects.
In this article, we will take a closer look at conduit bonds, implications for investors, and tips to keep in mind when considering them for your portfolio.
Check out this article to learn more about PABs.
What Are Conduit Bonds?
Conduit bonds are municipal securities designed to raise capital for revenue-generating projects that benefit the public. For example, a for-profit real estate development firm may issue conduit bonds to finance the construction of student housing or low-income housing projects. The issuer collects the tax or revenue used to secure the bonds and distributes it to the bondholders, but the conduit borrower is ultimately responsible for the debt obligations.
Common types of conduit bonds include:
- Industrial development revenue bonds, or IDRBs
- Private activity bonds, or PABs
- Housing revenue bonds for single- and multi-family projects
The issuers of conduit bonds typically include:
- Hospitals or health systems
- Private K-12 schools or universities
- Charitable organizations
- Affordable housing developers
- Waste or energy companies
For investors, conduit bonds may be exempt from federal, state or local income taxes on interest income, which makes them more appealing than similar corporate bonds. They also usually have higher yields than traditional muni bonds, which could make them appealing to aggressive investors looking to generate high income. The trade-off is that these bonds can be much riskier since they’re not backed by taxation or municipal assets.
For companies, conduit bonds may have lower financing costs than corporate bonds or other debt products. The municipal bond market also makes it easier for bondholders to transfer ownership to another investor rather than other corporate debt markets. This means that bondholders may be better aligned with the issuer’s long-term plans since those that aren’t aligned have an easy way to exit the opportunity.
Implications for Investors
Conduit bonds are a type of municipal bond, but they carry a greater level of risk and higher yields. In other words, they are much more comparable to a revenue bond than a general obligation bond. The bond isn’t secured by taxpayer dollars or municipal assets, which means that the bondholder is dependent on the ability of the issuer to make interest and principal payments – not the state or local government that simply coordinates the payments.
Investors can analyze conduit bonds in the same way that they would analyze any other kind of bond. Prospectuses provide a detailed overview of the project along with financial statements and other information. Investors should read over these documents to determine the default risk of a given bond over the period of time. It’s also important to look at any non-traditional covenants or other arrangements that could impact the bond’s risk profile.
Most investors treat conduit bonds as an alternative high-yield bond product. Unlike corporate bonds, they provide an added potential tax benefit that could make them more attractive. Investors should consider their individual tax situation to determine if these bonds have the potential to increase their after-tax returns. If so, they could make a great addition to a diversified bond portfolio as a way to increase income.
Be sure to read this article to learn more about due diligence process for investing in municipal securities.
Conduit Bonds at Play
Let’s take a look at two examples of conduit bonds to see how they work.
The Wall Street Journal cited one of the most contentious examples of a conduit bond – Million Air Interlink Inc. The company needed funding to refurbish three airplane terminals for affluent customers in private jets, but it was turned down by several local banks in Houston. The company turned toward two small Florida towns with no airports that agreed to issue up to $76 million in conduit bonds on behalf of the private jet firm.
A more common example of a current conduit bond is the Wisconsin Public Finance Authority Taxable Revenue Bond (CUSIP: 74442PDH5). The 2017 bond is payable solely from Albert Einstein College of Medicine and the promissory note is guaranteed by the Montefiore Medical Center. The $50 million bond paying 4.45 percent was issued to pay for the refinancing of other debt obligations for the organization’s projects.
You can use our municipal bond screener to find the right municipal bonds for your portfolio, including conduit bonds that offer higher yields than other muni bonds.
The Bottom Line
Conduit bonds are a great way for private companies, non-profit organizations or other entities to lower their borrowing costs when financing projects for the public good. For investors, they are a great way to realize the potential tax benefits of municipal bonds, as well as the potentially higher yields. The trade-off is that there may be greater risks associated with these bonds, which makes it important to read the prospectus and continuing disclosures.