What Is a Double-Barreled Bond?
A double-barreled bond is a municipal bond in which the interest and principal payments are pledged by two distinct entities—the revenue from a defined project and the issuer and its taxing power. In the event that the project cash flows fall short, the issuer covers the payments promised to the muni bond's lenders and investors. Double-barreled bonds are sometimes referred to as combination bonds.
- A double-barreled bond is a municipal bond whereby the interest and principal payments are pledged or backed by two distinct entities.
- A double-barreled bond is backed by the revenue generated from the project the bond is funding as well as the local government.
- If the project cash flows fall short, the issuer covers the payments promised to the muni bond's lenders and investors.
- A double-barreled bond helps bondholders to reduce the bond's default risk, but that safety comes at a price, in the form of a lower interest rate.
How Double-Barreled Bonds Work
A bond is a debt instrument issued by a corporation or government for the purpose of raising funds. Bonds are purchased by investors since they typically offer a yield or interest rate to be paid at the bond's expiration date—called the maturity date. The interest rate that bonds pay is called the coupon rate.
Bonds are sold at a purchase price—called the face value—and at maturity, an investor redeems the bond for the original investment amount with any amount above the face value being the interest gain. Some bonds offer variable or fixed interest payments made by the issuer whereby the interest is paid at various times throughout the year, typically twice.
It's important to note that the principal amount—the original purchase amount—is only returned if the bond is held to maturity. If the bond is sold before maturity in the secondary bond market, the investor could have a gain or loss depending on the original purchase price (face value) and the sale price.
Both federal and state governments issue bonds in order to borrow money. Municipal bonds are bonds issued by a state, municipality, or county to raise money for capital projects, such as infrastructure development, schools, and public buildings. Investors expect a timely and periodic stream of interest income on these bonds and, upon maturity, repayment of their principal or original amount invested. Interest payments and principal repayments may be made from the issuing entity (general obligation bond) or from a single revenue source (revenue bond).
Municipal bonds are essentially loans from investors to the local government and are typically exempt from federal taxes as well as most state taxes.
General Obligation Bond
A general obligation bond has its debt obligations made from the general funds of the municipal issuer. These bonds are backed by the full faith and credit of the issuer, and may have the full authority to increase taxes in order to meet its payment obligations.
A revenue bond is a muni bond that is backed by the revenues generated from a specific project or source. Typically, when a revenue bond is issued to fund a project, the municipality doesn't have to pay investors if the revenue from the project doesn't cover the bond payments or obligations. If municipalities issue debt on behalf of private or non-profit organizations through bonds such as private activity bonds (PAB) or conduit bonds, the underlying borrowers agree to repay the issuer. The issuer, in turn, pays the interest and principal on the securities solely from the revenue stream of the projects undertaken by the borrowers.
When interest and principal payments are made from a combination of revenue and general obligation, the bond is referred to as a double-barreled bond. A double-barreled bond, as specified in the trust indenture, is a municipal bond secured by both a defined source of revenue and the full faith and credit or taxing power of the governmental body. In effect, this combination bond carries both a revenue and general obligation pledge. If the project does not generate enough revenue to fulfill the interest payments to investors, the municipality will make the payments instead from its general funds.
Benefits of Double-Barreled Bonds
A double-barreled bond helps bondholders by reducing their default risk on the bond. Default is when an issuer can't make the interest or principal payments. Since the bond payments are backed by a revenue source and guaranteed by the municipal government, bondholders can reduce their risk of losing their investment.
However, that safety can come at a price, in the form of a lower interest rate. The guaranteed payment from two sources helps the municipal issuer to reduce its cost of borrowing by offering lower interest rates. Typically, if there's a reduced risk of holding the bonds, investors are willing to accept a lower yield versus other bonds secured by only one source.
Example of a Double-Barreled Bond
Let's assume a local city issues a double-barreled muni bond to raise funds for a new toll road bypass. In the event that the cash flows from the tolls are unable to cover the interest and principal payments (debt service), the shortage would be covered by the issuing city from its general fund. These bonds are, thus, payable with the toll revenue stream, which is the first level of security and guaranteed by the full faith and credit of the issuing city, which is the second level of security.