You may have often wondered how governments fund major projects like schools, airports, hospitals, stadiums, and more, without taking on too much risk.
Their solution to facilitate a large-scale, community-benefitting project without taking much risk is by providing government-issued, tax-free, public funding to a third-party obligor, or borrower. This borrower takes on conduit debt to develop the project and therefore owns the project and all the involved risks.
Today, we will discuss conduit debt, the financing project associated with conduit debt, the involved risks, and the benefits, to help you understand the term and its part in helping governments build large projects without taking much risk.
However, to understand conduit debt, we must first understand conduit financing.
What is conduit financing?
Conduit financing is a way for large entities like public entities, other governments, non-profit organizations (NPO), or private companies, to obtain funding for a large project that benefits the community.
Governments issue municipal bonds to raise funds for these large-scale projects without taking on too much risk.
The bonds help raise money from the public and the raised money is tax-exempt because the bonds are issued by a state or government agency, which are government issuers.
Common types of conduit financing
The most common types of conduit financing include:
- Industrial Development Revenue Bonds (IDRBs)
- Private Activity Bonds (PABs)
- Housing Revenue Bonds for single- and multi-family units
These are all bonds for funding projects that benefit the community.
Conduit financing is closely associated with conduit debt but before we get into that, let’s understand some other key terms.
Here are a few key terms to know regarding conduit debt and financing.
The conduit borrower is the public entity, private company, or NPO, that borrows the money for funding a school, hospital, or any project that benefits the community.
The government or government agency that issues municipal bonds to raise funds for the project is the conduit issuer.
The municipal bonds issued for a conduit financing project are known as conduit bonds and they symbolize a public-private partnership to the bondholder.
What is conduit debt?
Conduit debt is simply the debt owed in a conduit financing project. Since the funds come from bondholders, conduit debt is owed to the bondholders. Conduit debt includes the principal payments and interests.
This raises the question, who is responsible to pay the conduit debt?
Who pays conduit debt?
The conduit borrower is the third-party obligor responsible to pay the conduit debt. This means they have to make the principal payments and interests, that make up the conduit debt, to bondholders. They make payments from the revenue of the project that is funded by the bondholders.
However, this is not done directly by the third-party obligor, rather the conduit issuer is the intermediary in this transaction. The government issuers that issued the conduit bonds are responsible for collecting the conduit debt from the borrower and paying the bondholders.
For example, if an NPO wants to build a school by obtaining conduit financing and taking on conduit debt, they are the third-party obligor responsible for the repayment of the conduit debt, not the conduit or government issuers, or the state or local government.
Benefits of conduit debt
Conduit debt is highly beneficial to all the parties involved in the project, especially the bondholders and the borrowers, who get tax exemptions owing to the higher risk they take in the project.
Benefits for the borrowers
The conduit borrower receives tax-exempt funding needed for their project. They would otherwise be unable to get tax relief on funding from other sources. This is what makes this type of debt so attractive to an entity, or third-party obligor, that is interested in developing a revenue-generating project that will benefit the community.
Benefits for the bondholders
Since there is more risk involved in conduit bonds, the yields are also higher for bondholders, especially when compared to other municipal bonds. Moreover, unlike corporate bonds, there are typically far fewer taxes and the nature of municipal bonds allows the bondholder to easily transfer ownership.
Benefits for the issuers
The issuer facilitate the development of a project that benefits the community while eliminating any risks in the project. The tax exemptions they offer are an incentive for third-party borrowers and investors to take the risks involved in a community-benefitting project.
Benefits for the public
The general public, or public segments like veterans, low-income households, or students, benefit from the services provided by the project.
Risks of conduit debt
Just as there are many benefits, there are also many risks involved with conduit debt. The biggest risks are taken by the bondholders and conduit borrowers, which makes sense because they are also the ones to gain the most if the project succeeds.
The first risk being that the high-yielding municipal bonds issued for the project are not backed up by government issuers. This means that the state or local government is not securing the conduit bond with taxes or government assets.
Instead, the borrowers are responsible for repayments of the bonds. Moreover, the conduit debt is not completely secure either, it is secured by the revenue from the project, which means there is little to no return if the project fails.
The bondholders are not investing in a reliable government project or the government issuer. Instead, they are investing in the third-party project that the high-yielding bond fund.
The credibility of the project is less because, even though the government wants it to succeed, they are not backing it with their assets.
Therefore investors, or bondholders, face the same risks that come with any new private project, only with some tax benefits, that exclude tax exemption on capital gains.
Potential bondholders must always study the prospectus, understand the risks involved, and read the continuing disclosures before investing their money.
Similarly, the third-party obligor of the conduit debt faces the same risks involved with any new project. They have to generate revenue and ensure that they do not fail in their venture and default. They are obligated to pay the conduit debt owed to the bondholders or face the consequences.
They take all the risks in return for government-issued public funding that comes with tax exemptions.
The government issuers and the public, on the other hand, are virtually risk-free when it comes to conduit debt for such a project. The only real disadvantage for the government issuers is that they do not own or generate any revenue from the project if it succeeds.
In conclusion, conduit debt is a highly beneficial type of debt for the borrower, issuer, investor, and the public. However, as with any high-yielding practice, it comes with higher risks for the investor and borrower.
Most importantly, however, it allows a third-party obligor to obtain tax-free funding for a project that benefits the community at large.
The part played by conduit debt, and the financing associated with conduit debt, are what allow the government to fund the development of large projects like schools, hospitals, airports, housing projects, and more, without taking much risk.