Combination Bonds: A Hybrid Security Backed by Government and Project Revenues

Highlights:

• Combination bonds are backed by both government guarantees and project revenues.
• They offer a dual source of security for investors, reducing risk.
• These bonds are often used to fund infrastructure or large-scale development projects.

A combination bond is a type of municipal bond that is secured by two primary sources of repayment: the creditworthiness of the government entity issuing the bond and the revenue generated from the specific project the bond is designed to finance. This unique structure gives combination bonds a dual layer of security, making them more attractive to investors, especially in projects where there might be some uncertainty regarding future revenue generation.

How Combination Bonds Work

Combination bonds are issued to finance large infrastructure or development projects, such as the construction of highways, bridges, schools, or public facilities. The bondholder is promised repayment from two sources: first, from the general credit of the government or municipal issuer, which ensures that the bond will be repaid even if the project itself faces revenue shortfalls, and second, from the actual earnings of the project that the bond was issued to fund.

For example, a city government might issue a combination bond to fund the construction of a toll road. If the tolls collected from drivers are insufficient to cover the bond repayments, the city’s general revenues, such as taxes, can be used to make up the difference. This dual-source security makes combination bonds less risky than bonds that are solely backed by project revenues, as it provides an additional safeguard against financial challenges.

Advantages of Combination Bonds

The primary advantage of combination bonds is the added security they provide to investors. Since they are backed by both the revenue from the project and the credit of the issuing government entity, they tend to have a lower risk profile than other types of bonds, especially those that are secured by only one source of repayment.

For governments and municipalities, combination bonds can be an attractive way to raise funds for large-scale projects. By leveraging both project revenues and general government credit, issuers can often secure better terms and lower interest rates than if they relied solely on the project’s earnings. This makes combination bonds an appealing financing option for infrastructure development.

For investors, combination bonds offer the potential for stable returns due to the dual repayment sources. While the project’s revenue is the primary source of repayment, the additional guarantee from the government or municipality provides reassurance that the bondholder will still be compensated if the project underperforms.

Comparison to Other Types of Bonds

Combination bonds differ from other types of municipal bonds, such as revenue bonds and general obligation bonds. Revenue bonds are only backed by the earnings from a specific project, such as tolls from a toll road or fees from a public utility. While revenue bonds offer the potential for high returns, they are riskier because they rely solely on the success of the project.

On the other hand, general obligation bonds are secured by the full faith and credit of the issuing government entity, which can use tax revenues or other sources to make bond payments. While these bonds are generally considered safer than revenue bonds, they do not offer the opportunity for higher returns based on specific project performance.

Combination bonds strike a balance between these two types by offering both project-based revenue and government-backed security, providing investors with a safer but still potentially profitable investment opportunity.

Risks Associated with Combination Bonds

While combination bonds offer increased security, they are not entirely risk-free. The success of the project itself still plays a significant role in the bond’s ability to generate the necessary revenue. If the project underperforms or faces unforeseen challenges, such as lower-than-expected toll collections or construction delays, the government’s backup guarantee will be crucial in ensuring bondholder repayment.

Additionally, the creditworthiness of the government or municipality issuing the bond is an important factor. If the government faces financial difficulties or becomes unable to fulfill its obligations, the value of the bond could be negatively affected. Even though the government’s credit provides a safety net, it cannot eliminate the risks associated with poor project performance or a deteriorating financial environment.

Applications of Combination Bonds

Combination bonds are particularly useful for financing infrastructure projects that have a steady revenue stream but may still carry some level of uncertainty. They are commonly used in the development of toll roads, airports, public transportation systems, and utility facilities, where there is a clear source of revenue but also a potential for fluctuating income due to external factors such as economic conditions, competition, or regulatory changes.

These bonds are also used in large-scale development projects that require substantial upfront capital investment. The dual security from both project revenues and the issuing government makes them more attractive to investors and can help municipalities secure funding for projects that would otherwise be difficult to finance.

Conclusion

Combination bonds are an appealing financing tool for both issuers and investors, offering a secure investment by combining government backing with revenue from a specific project. This dual-source security provides a level of protection for investors while allowing governments to raise funds for large infrastructure projects with potentially lower borrowing costs. However, like all investments, combination bonds carry some risk, particularly regarding the performance of the underlying project and the creditworthiness of the issuing government. Despite these risks, combination bonds remain a valuable option for funding projects that benefit from both public and private sources of repayment.