DEFINITION of 'Conduit Financing'

Conduit financing is a financing arrangement involving a government or other qualified agency using its name in an issuance of fixed income securities for a non-profit organization's large capital project. The government or other qualified agency is not responsible for paying the required cash flows to investors - all cash flows come directly from the project.

BREAKING DOWN 'Conduit Financing'

Conduits are special purpose vehicles (SPVs) created by banks to provide short-term financing to corporations. Through conduits, banks sell short-term debt, such as commercial paper, and use the proceeds from the sale to purchase loans, such as credit card debt, student loans, auto loans, and mortgages. These loans are financial assets that are used as collateral for investors and are not included in the balance sheet of the financial institution. As the maturity date for an existing short-term debt looms closer, a conduit issues new debt, the proceeds of which are used to settle the repayment obligations of the maturing debt.

Conduit financing occurs when a governmental entity issues tax-exempt municipal bonds to finance a project managed by non-profit corporations, private companies, or other governmental bodies. These entities that receive the funds from the issue are known as the conduit borrowers, and they are responsible for the interest payment and principal repayment to be made to lenders and investors. In effect, the debt is guaranteed by the revenue from the project that the debt finances generates. The conduit issuer collects these payments from the borrowers and transfers them to bondholders.

Types of municipal securities used for conduit financing include private activity bonds (PAB), multi-family housing revenue bonds, and industrial development bonds. Sales of these conduits provide capital expenditures for projects, such as airports, hospitals, private schools, housing, and public works.

Lenders, though conduit financing, are exposed to prepayment risk, that is, the risk that debtors or borrowers of the underlying assets in a conduit will repay their debt before the maturity date. If a borrower pays off the loan early, the loan will no longer earn any interest, which affects the money available for payment to investors. In order to compensate bondholders for the loss of future income they may incur due to prepayment, the borrower is required to pay a yield maintenance, which is a prepayment premium or fee paid by the borrower to allow lenders attain the same yield as if the borrower made all scheduled interest payments up until the maturity date.

Investors in conduit bonds are not taxed on their interest income on the federal level. If the bonds are issued in the state in which an investor lives, owning conduit bonds may also exempt the investor from state and local taxation on interest payments. The tax-free feature of municipal bonds allows borrowing of money for these projects at lower interest rates. However, any capital gains are subject to a capital gains tax and must be reported to the Internal Revenue Service (IRS). It is important to note that some of these bonds issued for conduit financing are subject to the alternate minimum tax (AMT).

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