Post by Alex Anderson on Jun 23, 2011 10:59:42 GMT 4
Prison bonds are a subset of a fixed income security class called lease revenue bonds (LRBs). Lease revenue bonds used to finance prisons have a few characteristics that make them attractive to investors--not the least of which is their relative safety compared to their yield. Further, they are exempt from state taxation for residents of the state of issue.
If you're looking for enhanced yield without imprudently ratcheting up your risk, read on.
Shoving aside the legal fiction created by these transactions, a lease revenue bond is actually a loan made to the state by the bond holders that is repaid by income (revenue) generated by the project. Lease revenue bonds are most commonly used for revenue-generating projects such as toll roads, bridges, hospitals, parking facilities, recreational projects, telephone systems and colleges. Voters don't have to approve LRBs because they are supposed to be self-sustaining from the lease revenue they generate and don't take money from the general fund.
When voters began rejecting general obligation bonds for prison construction, state treasurers, along with law firms and investment bankers, worked a way around the constitutional and statutory restrictions on such debt. They began using lease revenue bonds to construct correctional facilities.
On the plus side for investors, prisons are a growth industry and the lease revenue bonds to construct correctional facilities are exempt from state income tax. California has led the charge in using LRBs to build its prisons since the 1980s. Other states active in this financing technique include New York, Texas, Florida, Alaska and Michigan.
The difference between traditional revenue bonds and lease revenue bonds is one of mechanics. Traditional revenue bonds fund construction of a facility that actually generates revenue for use in debt repayment. Since prisons don't generate any revenue, the crafty state treasurers had to figure out a way to create some.
Here's what they came up with: The state creates an entity or agency to build the prison. The agency floats bonds to the public to cover construction of the facility. The agency then leases the right to use the completed prison to the state. The state pays the entity lease payments. The entity uses the lease payments to service the bond debt. Essentially, the state takes money from one pocket (the general fund appropriations to the prison system) and puts it into another pocket (the agency created for the facility), and then the agency distributes the money to the bondholders.
The state dips into the general fund for payment as if this were a regular lease. Title to the facility cedes to the state once the bonds are repaid and retired. You may ask if this is state-sponsored debt? Technically, no. It does not appear on the state's balance sheet because the state doesn't own an asset on which it is obligated to pay. Instead, the state can stop making the lease payments if it so chooses. However, if the state did that, there would likely be a downgrade of its credit rating. Further, the resulting cost in higher interest on future bond issues would likely far exceed any savings.
These bonds are tax exempt at the state level if issued by the holder's state of residence. Lease-revenue bonds pay interest at tax-exempt rates. Yields are slightly higher than yields on general obligation bonds.
Where can your money feel safe? Not many places lately. For the muni bond market, it seems that all the usual suspects for bond repayment--property tax, sales tax and income tax--are declining fast. This can place the revenue stream in jeopardy, which could also place your coupon payments in jeopardy. Not so for prison bonds. Since these are state lease obligations, the state has the authority to raise taxes if necessary to pay its obligations.
One caution: Prison bonds of the lease revenue variety pay a higher interest rate for a reason--they're more risky than regular general obligation bonds. The state's general fund does not back repayment as it does general obligation bonds. Instead, continued repayment of prison bonds is subject to lease payments from the states, which are themselves subject to legislative appropriations. Should appropriations cease, the bonds will default.
Prison systems incarcerate offenders. Any state that would stop making lease payments on its correctional facility bonds and set incarcerated offenders out on the streets would have some explaining to do. The stakes are too high for society to permit such default. We think the risk is minimal for prison bonds.
If you're looking for enhanced yield without imprudently ratcheting up your risk, read on.
Shoving aside the legal fiction created by these transactions, a lease revenue bond is actually a loan made to the state by the bond holders that is repaid by income (revenue) generated by the project. Lease revenue bonds are most commonly used for revenue-generating projects such as toll roads, bridges, hospitals, parking facilities, recreational projects, telephone systems and colleges. Voters don't have to approve LRBs because they are supposed to be self-sustaining from the lease revenue they generate and don't take money from the general fund.
When voters began rejecting general obligation bonds for prison construction, state treasurers, along with law firms and investment bankers, worked a way around the constitutional and statutory restrictions on such debt. They began using lease revenue bonds to construct correctional facilities.
On the plus side for investors, prisons are a growth industry and the lease revenue bonds to construct correctional facilities are exempt from state income tax. California has led the charge in using LRBs to build its prisons since the 1980s. Other states active in this financing technique include New York, Texas, Florida, Alaska and Michigan.
The difference between traditional revenue bonds and lease revenue bonds is one of mechanics. Traditional revenue bonds fund construction of a facility that actually generates revenue for use in debt repayment. Since prisons don't generate any revenue, the crafty state treasurers had to figure out a way to create some.
Here's what they came up with: The state creates an entity or agency to build the prison. The agency floats bonds to the public to cover construction of the facility. The agency then leases the right to use the completed prison to the state. The state pays the entity lease payments. The entity uses the lease payments to service the bond debt. Essentially, the state takes money from one pocket (the general fund appropriations to the prison system) and puts it into another pocket (the agency created for the facility), and then the agency distributes the money to the bondholders.
The state dips into the general fund for payment as if this were a regular lease. Title to the facility cedes to the state once the bonds are repaid and retired. You may ask if this is state-sponsored debt? Technically, no. It does not appear on the state's balance sheet because the state doesn't own an asset on which it is obligated to pay. Instead, the state can stop making the lease payments if it so chooses. However, if the state did that, there would likely be a downgrade of its credit rating. Further, the resulting cost in higher interest on future bond issues would likely far exceed any savings.
These bonds are tax exempt at the state level if issued by the holder's state of residence. Lease-revenue bonds pay interest at tax-exempt rates. Yields are slightly higher than yields on general obligation bonds.
Where can your money feel safe? Not many places lately. For the muni bond market, it seems that all the usual suspects for bond repayment--property tax, sales tax and income tax--are declining fast. This can place the revenue stream in jeopardy, which could also place your coupon payments in jeopardy. Not so for prison bonds. Since these are state lease obligations, the state has the authority to raise taxes if necessary to pay its obligations.
One caution: Prison bonds of the lease revenue variety pay a higher interest rate for a reason--they're more risky than regular general obligation bonds. The state's general fund does not back repayment as it does general obligation bonds. Instead, continued repayment of prison bonds is subject to lease payments from the states, which are themselves subject to legislative appropriations. Should appropriations cease, the bonds will default.
Prison systems incarcerate offenders. Any state that would stop making lease payments on its correctional facility bonds and set incarcerated offenders out on the streets would have some explaining to do. The stakes are too high for society to permit such default. We think the risk is minimal for prison bonds.