What is a Combination Bond
Combination bonds typically are municipal bonds in which the interest and principal payments are pledged by two distinct entities: revenue from a defined project, and the issuer and its taxing power. In the event that the project cash flows fall short, the issuer covers the payments promised to the muni bond's lenders and investors.
Combination bonds are also known as double barrel bonds.
BREAKING DOWN Combination Bond
A combination bond has financial backing from two sources: the issuing agency and the revenue from an existing or proposed source that will benefit from the funding. Combination bonds differ from general obligation municipal bonds, which have just the full faith and credit backing of the issuing government agency. Combination bonds also differ from revenue bonds, which only have the backing of future revenues. Because of the extra safety provided by combination bonds, they pay a lower rate than comparable general obligation or revenue bonds.
When interest and principal payments are made from a combination of revenue and general obligation, the bond is referred to as a combination bond. A combination bond, as specified in the trust indenture, is a municipal bond secured by both a defined source of revenue and the full faith and credit or taxing power of the governmental body. In effect, this type of bond carries both a revenue and general obligation pledge. If the project does not generate enough revenue to fulfill the interest payments to investors, the municipality will make the payments instead from its general funds.
Combination Bond Example
Assume a local city issues a combination muni bond to raise funds for a new toll road bypass. In the event that the cash flows from the tolls are unable to cover the interest or principal payments, the shortage would be covered by the issuing city from its general fund. These bonds are payable with the toll revenue stream, which is the first level of security, and guaranteed by the full faith and credit of the issuing city, which is the second level of security.
A combination bond reduces the default risk that bondholders may be exposed to, due to the fact that the bond payments are backed by a revenue source and guaranteed by the municipal government. By guaranteeing payment using two sources, the municipal issuer is able to reduce its cost of borrowing by offering lower interest rates on combination bonds. Since there is a reduced risk of holding these bonds, investors will be willing to accept a lower yield on these bonds than bonds secured by only one source.