What Is Conduit Financing?
Conduit financing is a means of raising capital for private companies, non-profit organizations, and public entities 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. These municipal bonds are a form of revenue bonds known as conduit bonds and represent a public-private partnership.
- Conduit financing raises capital for large-scale projects such as hospitals and schools via municipal bond issuance, but managed by a non-governmental organization or firm.
- The conduit issuer is not responsible for making coupon payments to bondholders; rather the conduit borrower must make such payments.
- 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.
Understanding Conduit Financing
When a conduit bond is issued, the entities that receive the funds from the issue are known as the conduit borrowers and they are responsible for the interest and principal payments to the bondholders. The conduit issuer is not responsible for repayment in most cases.
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, but the conduit issuer is not usually 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 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 to benefit the public at large (i.e. airports, docks, sewage facilities) or specific population segments (i.e. students, low-income home buyers, 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. For an investor in such a case, it is essential for them to be clear on all details of the project being financed. This 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 higher as well, particularly when compared to traditional municipal bonds. And as with other municipal bonds, it is simpler for an investor to transfer ownership of a bond when compared to the corporate bond market, making it easier to offload the inherent risk in conduit financing.
Furthermore, investors of conduit bonds are usually not taxed at the federal level on interest income, which also makes conduit bonds more attractive than corporate bonds for some investors. Investors are typically still taxed on the state level unless the investor lives in the state in which the bond is issued. In that case, it is possible that they will be exempt from state taxation on interest payments. All capital gains are still held to a capital gains tax.