Financial Markets and Institutions (2-downloads)

Revenue bonds, by contrast, are backed by the cash flow of a particular 

revenue-generating project. For example, revenue bonds may be issued to build a

toll bridge, with the tolls being pledged as repayment. If the revenues are not suf-

ficient to repay the bonds, they may go into default, and investors may suffer losses.

This occurred on a large scale in 1983 when the Washington Public Power Supply

System (since called “WHOOPS”) used revenue bonds to finance the construction

of two nuclear power plants. As a result of falling energy costs and tremendous

cost overruns, the plants never became operational, and buyers of these bonds lost

$225 billion. This remains the largest public debt default on record. Revenue bonds

tend to be issued more frequently than general obligation bonds (see Figure 12.4).

Note that the low interest rates seen in recent years have prompted municipali-

ties to issue record amounts of bonds.

95

94

93

98

97

96

00

99

01 02 03 04 05 06 07 08 09

92

91

90

89

88

87

86

85

84

General obligation bonds

Revenue bonds

Amount Issued

($ billions)

0

50

100

150

200

250

300

350

400

450

F I G U R E   1 2 . 4

Issuance of Revenue and General Obligation Bonds, 1984–2009 

(End of year)

Source:

http://www.federalreserve.gov/econresdata/releases/govsecure/current.htm 

table 1.45 line 2,3

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288

Part 5 Financial Markets

Risk in the Municipal Bond Market

Municipal bonds are not default-free. For example, a study by Fitch Ratings reported

a 0.63% default rate on municipal bonds. Default rates are higher during periods when

the economy is weak. This points out that governments are not exempt from finan-

cial distress. Unlike the federal government, local governments cannot print money,

and there are real limits on how high they can raise taxes without driving the pop-

ulation away.

Corporate Bonds

When large corporations need to borrow funds for long periods of time, they may

issue bonds. Most corporate bonds have a face value of $1,000 and pay interest semi-

annually (twice per year). Most are also callable, meaning that the issuer may redeem

the bonds after a specified date.

The bond indenture is a contract that states the lender’s rights and privileges

and the borrower’s obligations. Any collateral offered as security to the bondhold-

ers will also be described in the indenture.

The degree of risk varies widely among different bond issues because the risk

of default depends on the company’s health, which can be affected by a number of

variables. The interest rate on corporate bonds varies with the level of risk, as we dis-

cussed in Chapter 5. Bonds with lower risk and a higher rating (AAA being the high-

est) have lower interest rates than more risky bonds (BBB). The spread between the

differently rated bonds varies over time. The spread between AAA and BBB rated

bonds has averaged 1.15% over the last 10 years. As the financial crisis unfolded

investors seeking safety caused the spread to hit a record 3.38% in December 2008.

Access

http://bonds.yahoo

.com

, for information on 

10-year Treasury yield,

composite bond rates for

U.S. Treasury bonds,

municipal bonds, and

corporate bonds.

G O   O N L I N E

Interest Rate

(%)

0

2

4

6

8

10

12

14

16

18

1996 1998 2000 2002 2004

1994

1992

1990

2006 2008

1988

1986

1984

1982

1980

1978

1976

1974