What Is a Conduit Issuer?
A conduit issuer is an organization, usually a government agency, that issues municipal securities to raise capital for revenue-generating projects where the funds generated are used by a third party (known as the "conduit borrower") to invest in some project or activity that has a public benefit. The conduit financing is typically backed by either the conduit borrower's credit or funds pledged toward the project by outside investors. If a project fails and the security goes into default, it falls to the conduit borrower's financial obligation, not the conduit issuer.
- A conduit issuer is (usually) a government entity that issues securities on behalf of another entity to raise funds for a project or activity with some public purpose to be administered by a third party.
- Conduit issuers act as a pass-through to issue bonds and collect revenues to repay the bonds, but they are not liable for repayment themselves.
- Investors can enjoy a higher return and tax advantage status by purchasing bonds from conduit issuers, but they should keep in mind that the conduit issuer does not back the bonds.
Understanding Conduit Issuers
Conduit bond issuers act as pass-throughs for the issuance of a bond and the collection of revenues to make payments to bold holders and pay off the bond. Typically these arrangements are used to finance a specific investment or activity that has some public purpose or public benefit but will be owned, operated, or administered by an entity that is separate from the government entity acting as the conduit issuer. This allows the special purpose entity to benefit from the existing finance and administrative infrastructure and access to capital markets that the conduit issuer already has established.
Common types of conduit financing include industrial development revenue bonds (IDRBs), private activity bonds, and housing revenue bonds (both for single-family and multifamily projects). Most conduit-issued securities are for projects to benefit the public at large (i.e., airports, docks, sewage facilities) or specific population segments (i.e., students, low-income home buyers, veterans).
Taxes, fees, and revenues that secure bonds are collected by the conduit issuer from the borrower and then paid to the bondholders, but the conduit issuer is usually not responsible for repayment. Rather, it's the borrowing organization that must repay interest and principal on the bonds, unless stipulated otherwise in a written agreement. For instance, if a local nonprofit hospital wants to build a new maternity center and uses conduit financing to fund the project, it is the hospital, not the conduit issuer, that is responsible for debt repayment.
Investing and Conduit Bonds
Investors in conduit bonds usually benefit from higher yields than general obligation municipal bonds, while also enjoying the same federal tax-free interest income. If an investor lives in the same state where the bonds are issued, they may be exempt from state and local taxation on interest payments. But any tax-free benefits from a municipal bond apply only to the interest income. Capital gains are still subject to the capital gains tax. Some municipal bonds may also be subject to the alternative minimum tax.
Risks for Conduit Issuers
Higher returns come with higher risks, and since conduit bonds are not backed by the full faith and credit of the issuing government or agency, it's important for investors to understand they are investing in the project, not the conduit issuer. As such, a potential investor should engage in adequate due diligence to ensure that the endeavor has a reasonable chance of success. Even if a project has a compelling story and research indicates a high probability of success, the credit quality of the bond still matters. Ratings for a prospective bond investment can be checked with the three major bond rating agencies, which are Standard & Poor's, Moody's, and Fitch.