What Is Conduit Financing?

Conduit financing is a means of financing for private companies, non-profit organizations, and public entities via tax exempt municipal bonds to raise capital for 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 also known as revenue bonds or conduit bonds.

Key Takeaways

  • Conduit financing raises capital for large-scale projects such as hospitals and schools.
  • Capital is raised through municipal bonds issued by governmental agencies.
  • The conduit issuer is not responsible for payments to bondholders but rather the conduit borrower must make payments.
  • The cash flow generated from the project being financed is used to make interest and principal payments.
  • The risks on conduit bonds are higher as the 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 guaranteed by the revenue from the project that the debt finances and the cash flow from the revenue-generating project is used to pay the bondholders. Types of municipal bonds used for conduit financing include private activity bonds (PAB), multi-family housing revenue bonds, and industrial development bonds.

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 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 not taxed at the federal level on interest income, which also makes conduit bonds more attractive than corporate bonds for some investors. Investors are 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.