A double-barreled bond is a type of municipal bond secured by two distinct entities: the revenue generated from the project that the bond is funding, as well as the local government. This means that if the project's cash flows fall short, the issuer is responsible for covering the payments promised to the bond's lenders and investors. A double-barreled bond is a great way to reduce the bond's default risk, but this safety comes at a price. The interest rate on a double-barreled bond tends to be lower compared to other types of municipal bonds.
Basics
A dual-security municipal bond, or a combination bond, combines two distinct sources of backing for interest and principal payments: revenue generated from a specific project and the issuer's tax capacity. If the project's cash flows experience a shortfall, the issuer steps in to ensure that the municipal bond's lenders and investors receive their promised payments.
Bonds Unveiled
Bonds are debt instruments issued by governments and corporations that investors seek for their yield or interest rate, paid at maturity. The interest rate is known as the coupon rate. Bonds are issued with a face value, and upon maturity, investors receive their principal investment back, with any excess being interest earnings. Some bonds offer variable or fixed interest payments, disbursed by the issuer, often semi-annually. Notably, if sold before maturity in the secondary bond market, investors may experience gains or losses based on the original purchase price.
Municipal Bonds
Both federal and state governments employ municipal bonds issued by states, municipalities, or counties to fund capital projects, such as infrastructure, schools, and public buildings. Investors anticipate interest income and the return on their principal investment upon maturity. Payments can stem from the issuing entity (general obligation bond) or a specific revenue source (revenue bond). Municipal bonds typically enjoy exemptions from federal and state taxes.
General Obligation Bond
General obligation bonds, funded from the municipal issuer's general funds, bear the full faith and credit of the issuer. This may include the authority to increase taxes to meet payment obligations.
Revenue Bond
Revenue bonds are secured by the earnings from a specific project or source. If the revenue fails to cover bond obligations, the municipality is not obligated to repay investors. For bonds issued on behalf of private or non-profit entities (e.g., private activity bonds or conduit bonds), the underlying borrowers assume repayment responsibility. The issuer pays interest and principal using project-generated revenues.
Double-Barreled Bond
A double-barreled bond combines revenue and general obligation payments. Secured by both a designated revenue source and the governmental body's taxing power, it blends revenue and general obligation pledges. If project revenue falls short, the municipality covers interest payments from general funds, as detailed in the trust indenture.
Advantages of Dual-Security Bonds
Double-barreled bonds offer a risk-reduction benefit for bondholders by mitigating the likelihood of default, which occurs when an issuer cannot meet interest or principal payments. These bonds derive their safety from being supported by both a revenue source and the unwavering backing of the municipal government, thereby diminishing the risk of investors losing their capital.
However, this safety net often entails a trade-off in the form of lower interest rates. The dual guarantee, originating from two distinct sources, allows the municipal issuer to minimize its borrowing costs by offering reduced interest rates. Typically, investors are willing to accept a lower yield on these bonds, as they offer a reduced risk profile compared to bonds secured solely by a single source.
Double-Barreled Bond Example
Consider a hypothetical scenario where a local city issues a double-security municipal bond to finance a new toll road bypass project. If the toll revenue falls short of meeting the interest and principal payments (debt service), the issuing city steps in to bridge the shortfall using its general fund. These bonds are secured by the toll revenue stream as the initial security level and further reinforced by the full faith and credit of the issuing city as the secondary security level.
Conclusion
Double-barreled bonds serve as a valuable tool for reducing default risk in municipal financing. These bonds offer dual layers of security, with revenue from specific projects and the unwavering support of local governments providing a safety net for investors. While this added security mitigates risk, it often results in lower interest rates, reflecting the reduced level of uncertainty for bondholders. Double-barreled bonds exemplify the synergy between public and project-based funding, ensuring the successful completion of vital community projects while safeguarding investor interests.