A utility bond is a type of municipal bond that is issued to finance the construction of public utility projects, such as water systems, sewer systems, electrical plants and various public projects. The issuer of a utility bond receives a cash payment at the time of issuance in exchange for a promise to repay the bond holder over time.
A utility bond is repaid from the operating revenues the project produces after the utility is finished. Bond holders may purchase bonds either directly from the issuer at the time of issuance, or at some time after issuance on the secondary market. In exchange for the invested capital, the bond holder receives interest payments over time, and a return of the invested principal on maturity. Principal and interest are secured by revenues derived from charges or rents from the facility built with the proceeds of the bond issue.
Generally, the issuer holds one year’s worth of debt service in a reserve fund to protect bondholders in the event that the project is delayed, or where revenues are otherwise less than previously estimated. Utility bonds provide exemption from federal taxes and many state and local taxes, as a result of which, investors usually accept lower interest payments than on other types of borrowing with comparable risk.
While buying utility bonds is viewed as a conservative investment strategy, it is not risk-free. If the issuer is unable to meets its financial obligations, it may be unable to make scheduled interest payments and/or fail to repay the principal upon maturity. Utility bonds range the full spectrum with regard to credit quality, and investors should rely on the credit ratings assigned by various credit agencies to ensure the safety of their investment. Moreover, most utility bonds pay a fixed rate of interest. If interest rates in the marketplace rise, the bond might end up paying a lower yield compared to newly issued bonds.
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