What Is Conduit Financing?

Conduit financing is a means for private companies, nonprofit organizations (NPO), and public entities to raise capital via tax-exempt municipal bonds to fund large-scale projects that typically benefit the general public. Such projects can include hospitals, airports, industrial and housing projects, public facilities, and schools.

Municipal bonds are a form of revenue bonds known as conduit bonds and represent a public-private partnership.

Key Takeaways

  • Conduit financing raises capital for large-scale projects, such as hospitals and schools, via a municipal bond issuance.
  • The conduit borrower, rather than the conduit issuer, is responsible for making coupon payments to bondholders.
  • The cash flows generated from the public-private project backed by these bonds are used to make interest and principal payments.
  • The risks on conduit bonds are higher than typical munis as these bonds are not backed by the full faith of the issuing agency.

How Conduit Financing Works

When a conduit bond is issued, the entities that receive the funds from the issue are known as the conduit borrowers and are responsible for the interest and principal payments to the bondholders. In most cases, the conduit issuer is not responsible for repayment.

The debt of the bond is secured by the revenues from the project that the debt finances and the cash flow from the revenue-generating project is used to pay the bondholders. Revenues that secure these bonds are collected by the conduit issuer from the borrower and then paid to the bondholders.

The borrowing organization must repay interest and principal on the bonds, unless stipulated otherwise in a written agreement. For instance, if a local non-profit 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.

Common types of conduit financing include industrial development revenue bonds (IDRBs), private activity bonds (PABs), and housing revenue bonds—both for single-family and multifamily projects. Most conduit-issued securities are for projects that benefit either the public at large, such as airports, docks, sewage facilities, or specific population segments, including students, low-income homebuyers, and veterans.

Risks of Conduit Financing

The risks of conduit financing are higher as the bond is not backed by the full faith of the issuer. For a municipal bond, this means that it is not backed by municipal assets or taxes.

The investors of the bonds are actually investing in the project, as opposed to the credit standing of the bond issuer. As such, they are exposed to the risks that come with the development of a new project.

It is essential, therefore, that investors are clear on all details of the project being financed. That includes costs, time of completion, default risk, and future revenue generation, all of which can typically be found in the project's prospectus.

Benefits of Conduit Financing

Because the risk of a conduit bond is higher, the yield on the bond is usually higher as well, particularly when compared to traditional municipal bonds. Furthermore, as with other municipal bonds, it is simpler for an investor to transfer ownership and offload the inherent risk in conduit financing, compared to the corporate bond market.

Another advantage that conduit bonds hold over corporate bonds is that they are usually not taxed at the federal level on interest income. Investors might also be exempt from state taxation on interest payments if they live in the state in which the bond is issued or the bond is issued by a U.S. territory.

There is, however, no special treatment on capital gains. Conduit bond investors are still liable to pay taxes on the growth in value of their investments when they sell up like everybody else.