Bonding and Debt Instruments

One way to raise equity for a transportation project is to issue bonds. A bond is a written promise to repay borrowed money on a definite schedule, usually at a fixed rate over the life of the bond. Transportation bonds are traditionally municipal bonds, which are issued by state and local government entities to finance their various projects and expenses.

Recent years have spurred some noteworthy bonding innovations. State and local governments as well as transportation agencies and authorities have issued bonds backed by money sources not previously used to secure debt.

Municipal/Public Bond Issues

Municipal bonds represent borrowing by state or local governments to pay for special projects, such as highways or transit systems. The interest income earned from municipal bonds is exempt from Federal tax, and if issued in the investor’s state of residence, from state and local taxes as well. The savings afforded to state and local issuers from this Federal tax exemption (and sometimes state and local tax exemptions) allows them to borrow more cheaply than other issuers. There is no single agency that handles municipal bond issues. However, there are brokerage firms that specialize in bringing out municipal bond issues.

States that do not use bond financing pay for projects either by accumulating sufficient funds before beginning the project or paying for the project from current revenues. Those states tend to have a more consistent level of revenues and disbursements than states which use bond financing.

Revenue Bonds

Revenue bonds are used to finance municipal projects that generate revenue (a toll road or bridge, for example). This revenue is used to make interest and principal payments to the bond holders. Often, states and their subdivisions create certain agencies and authorities to perform specific tasks. Many times, the agency or authority has the ability to levy charges and fees for its services. These bonds are analyzed in terms of historical or potential earnings compared with the bond requirements. Usually, the yield is higher than that of a general obligation bond due to greater risk. Taxes that would back a general obligation bond are more secure than most project-backed revenue sources.



Most toll roads are financed by borrowing debt backed by future toll revenues. Toll-based finance is straightforward and very much akin to the municipal finance model. First, a public authority needs to be vested with the responsibility of developing toll roads within its given jurisdiction. After completing the appropriate feasibility studies, the authority issues bonds against anticipated toll revenues and uses the proceeds to fund the construction of the toll road. Once the toll road is open to traffic, the authority pays back its debt and interest costs using toll revenues collected on the facility. This model is attractive to investors as the interest they make on their holdings is exempt from federal and state income taxes. The toll-based finance model may also be used in conjunction with public-private partnerships. In this case, a private sector partner would arrange financing for the project and then repay the debt from toll revenues. Private activity debt for toll projects can be issued on a tax exempt basis using private activity bonds.

Reliance on toll-backed financing necessitates detailed financial feasibility assessments along with financial planning to evaluate the role of equity versus debt and repayment structuring. It also demands rigorous traffic and revenue forecasts, subject to multiple sensitivity tests and some form of risk analysis. Such financing requires a variety of additional institutional arrangements, including debt issuing authority and a bond rating process.


Farebox revenue bonds involve the issuance of debt by a transit agency, secured by pledging revenues collected from transit system operation. Farebox revenue bonds are rare because most transit systems operate at substantial deficits. Transit riders on average pay less than 40 percent of transit operating costs. Federal, state, and local subsidies are necessary to maintain operations.

For a traditional revenue bond, such as one for a water or sewer system, an issuer covenants to charge rates that will produce revenues sufficient to cover operating and maintenance costs and debt service. Such a covenant is called a “rate covenant”. A “coverage factor” is also commonly desired in which the issuer will covenant to maintain revenues in excess of operations and maintenance expenses by a certain multiple of the annual debt service owed on its outstanding obligations. Factors of 1.10, 1.25, 1.5, or 2 times the coverage have all been used to seek investment grade ratings on revenue debt.

However, because a transit system does not produce sufficient net farebox revenues to cover debt service, a gross revenue pledge is employed. A gross revenue pledge measures gross revenues to debt service and requires substantial coverage (typically 3 or 4 times debt service).

To evaluate the potential transaction, the viability of the system is analyzed to determine how creditworthy it is. How essential the system is to the local economy may be more important to a credit analysis than an impractical rate covenant. For example, it would not be desirable to require an increase in rates by way of a rate covenant if the result would be fewer riders and ultimately less revenue. Rate increases may also lead to less public and political support for subsidy payments.

Large metropolitan systems with well-developed routes and consistent ridership levels are most appropriate for farebox revenue borrowing. Even with such a transit system, other dedicated subsidy sources such as sales taxes or bridge tolls may be essential to obtain an investment grade rating on debt. Overall employing farebox revenue bonds requires determining if they represent sufficient security for financing. Additionally, the authority for a transit agency to issue them is a legal issue governed by state law.

General Obligation Bonds

General obligation bonds are issued for municipal projects that do not generate revenue (such as a government office building). They can be used for surface transportation projects. These bonds are backed by the “full-faith-and-credit” of the issuer. Many bonds issued by states, cities, or county districts also have the added security that they can raise property taxes to assure payment. This guarantee is of an unlimited nature. The issuer can raise taxes as high as they want to pay the bonds. If the property tax is not paid, the property can be sold at auction giving the bond holder a superior claim above mortgages, mechanical liens, and other encumbrances.


California Proposition 1B Transportation Bond Program
In November 2006, voters in California passed the largest general obligation bond package ever placed on a single ballot. The $37.3 billion package comprised four separate sectors of state infrastructure: transportation, housing, education, and flood control. The largest of the bonds was for transportation-Proposition 1B, the Highway Safety, Traffic Reduction, Air Quality, and Port Security Bond Act of 2006. A total of $19.925 billion in new funding for transportation was made available to a broad range of new and existing programs including highway and local road improvements, transit, goods movement and air quality improvements, and safety and security projects. These general obligation bonds represented a significant increase in state funding for transportation in California and have been spent over the 10 years since passage, as dictated by the bond act.

Limited and Special Tax Bonds

Limited and special tax bonds are payable from a pledge of the proceeds against a specific tax. This tax could be a gasoline tax, a special assessment, incremental sales tax, or ad valorem (property) tax levied at a fixed price. Unlike general obligation bonds and their unlimited ability to raise taxes, with these bonds, the issuer is limited by the specific source for the revenue to pay the bonds.

Sales tax revenue bonds, for example, have been issued by several California transportation authorities and transit districts. The sales tax bonds differ from most transportation financings because the debt is paid from sales taxes and not from transportation revenues. This type of financing may require special enabling legislation to facilitate the direct disbursement of tax revenues from the tax collecting entity to the trustee of the bond issue in order to perfect the pledge of those tax revenues and to ensure higher credit ratings.


Los Angeles County Measure R
Measure R passed in Los Angeles County, CA in 2008 is a 30-year ½ percent sales tax to finance city transportation improvement projects and countywide transit and highway projects. Los Angeles County Metropolitan Transportation Authority (Metro) is authorized to sell limited tax bonds secured by the sales tax revenue.

Tax Credit Bonds

Tax credit bonds are a debt instrument where, rather than investors/bondholders receiving periodic interest and principal payments, they receive federal tax credits of up to 100 percent of the interest amount in lieu of or in addition to partial interest payment over the life of the bond and full repayment of principal upon its maturity. Investors apply the tax credits to their federal tax liability. In turn, the borrower is responsible for paying off the principal at maturity (in a balloon payment), which it can do by different means, such as investing a portion of the bond proceeds in Treasury securities sufficient to pay off the principal or otherwise setting aside local revenues over the life of the bond. A technical paper prepared for the National Surface Transportation Policy and Revenue Study Commission estimates the federal subsidy in present value terms for financing of this nature to be 75 percent over a 25-year bond in the case of a 100 percent subsidy. As such, tax credit bonds afford borrowers significant project savings, as their responsibility would only be 25 percent in present value terms. The paper also identifies several other benefits associated with tax credit bonds including:

  • Subsidy Efficiency – because borrowers can receive 100 percent of the financial subsidy, taxable tax credits are more economically efficient than other types of tax incentives
  • Market Discipline – the government does not assume any credit risk and tax credit bonds are only issued when a project is backed by a reliable repayment stream
  • Reduced Administration – the federal government does not manage or oversee the program, as it would with a direct grant or federal loan program
  • Budget Leveraging – tax credits do not require discretionary budget resources; their budgetary cost is amortized over the bond’s term, rather than scored upfront or during a project’s construction period, as is the case for grants

Tax credit bonds have only been available for surface transportation projects during 2009 and 2010 as Build America Bonds authorized under the American Recovery and Reinvestment Act (ARRA). Additional information is available from the FHWA Center for Innovative Finance Support.

Grant Anticipation Revenue Vehicles (GARVEEs)

A GARVEE is a designation applied to a debt financing instrument that has a pledge of future Federal-aid for debt service and is authorized for Federal reimbursement of debt service and related financing costs. This financing mechanism generates up front capital for major highway projects that a state may be unable to construct in the near term using traditional pay-as-you-go funding approaches.

States can receive Federal-aid reimbursements for a wide array of debt-related costs incurred in connection with an eligible debt financing instrument, such as a bond, note, certificate, mortgage, or lease; the proceeds of which are used to fund a project eligible for assistance under Title 23. Bond-related costs eligible for Federal-aid reimbursement include interest payments, retirement of principal, and any other cost incidental to the sale of an eligible bond issue. The issuer may be a state, political subdivision, or a public authority.

The use of advance construction or partial conversion of advance construction also facilitates state issuances of GARVEEs. They are generally used in conjunction with advance construction to enable using Federal-aid funds for future debt service payments. The GARVEE bond technique enables a state to accelerate construction timelines and spread the cost of a transportation facility over its useful life rather than just the construction period. The use of GARVEEs serves to expand access to capital markets as an alternative or in addition to potential general obligation or revenue bonding capabilities.

Transit agencies are using similar mechanisms to borrow against future Federal-aid funding. While transit financings are quite similar to the GARVEE type instruments, the transit debt mechanisms are known as Grant Anticipation Notes (GANs).

Additional Information

Additional information on GARVEEs is available from the FHWA Center for Innovative Finance Support:

Grant Anticipation Notes (GANS)

Like highway agencies that utilize GARVEEs, transit agencies can also borrow against future Federal-aid funding. While transit bonding is quite similar to highway bonding, the transit bonds are referred to as GANs. A transit agency issues bonds secured with a pledge of Federal-aid assistance, thus amassing up-front capital, and pays down the bonds over a period of time as the Federal funds are received.

Although interest costs for transit revenue bonds had been eligible for Federal reimbursement since Federal authorization legislation enacted in 1982, it was not until the provisions of TEA-21 in 1998 that permitted an agency to issue bonds backed solely or primarily by anticipated Federal formula reimbursements. Firewall provisions established by TEA-21 that separate transportation funding from appropriations for other domestic purposes and simplified interest reimbursement provisions help make it possible for transit agencies to pledge Federal aid as the sole source of repayment, without having to encumber other transit revenue sources. The interest rate allowed in TEA-21, for all capital programs, is the best rate reasonably available at the time of financing.

Federal transit capital funding is apportioned by formula (referred to as “formula funds”) or allocated on a discretionary basis (“discretionary funds”) by Congress and FTA.

The Federal Transit Administration provides further information on sources of Federal funding for transit programs.



Formula grant programs allocate funding to states based on population, ridership, and system extent (e.g. route miles, vehicle revenue miles, and passenger miles). FTA’s primary discretionary grant program for funding major transit capital investments, including rapid rail, light rail, bus rapid transit, commuter rail, and ferries is the Fixed Guideway Capital Investment (“New Starts”) program.

For transit New Starts projects that are offered more than one year’s worth of funding, FTA is required to enter into multi-year agreements known as Full Funding Grant Agreements (FFGAs). FFGAs indicate FTA’s intention to support a project, up to a specified level of funding. An FFGA will typically specify the maximum level of Federal participation and the schedule of funding for the project (e.g., $400 million, at $50 million per year for eight years). However, FFGAs are subject to appropriation (fulfillment of Federal requirements) and FTA priorities. Each fiscal year, FTA makes recommendations on which projects will receive funding and publishes a notice in the Federal Register indicating the level of funding provided to each project.

While transit agencies may use the discretionary funds provided through FFGAs to repay debt, these funds are not guaranteed to arrive on schedule because they are subject to annual appropriations. Because discretionary funds provided under an FFGA are project-specific, there is limited ability to shift funds between projects in the event of a shortfall.

Thus, the credit risks for a transit GAN backed by a discretionary FFGA may be higher than for a transit GAN backed by formula funding at an equivalent coverage level. A grantee can increase coverage levels by borrowing less than the FFGA amount (essentially providing the coverage required for a good rating opinion) so that even if Congress appropriates significantly less than the budget request, there is likely to be enough of an appropriation to at least cover required debt service.


An example of a past transaction that has explicitly relied on a pledge of future FFGA funding is the Hudson-Bergen Light Rail project in New Jersey. It was supported primarily by a transit GAN, issued against anticipated discretionary funding. As a secondary pledge, the financing was also backed by a pledge from the state’s transportation trust fund, in the event that FFGA funds were not forthcoming.

Private Activity Bonds

SAFETEA-LU amended Section 142 of the Internal Revenue Code to add highway and freight transfer facilities to the types of privately developed and operated projects for which private activity bonds (PAB) may be issued. This change allows private activity on these types of projects, including development, design, finance, construction, operation, and maintenance, while maintaining the tax-exempt status of the bonds. PABs are issued by a public, conduit issuer on behalf of a private entity. The private entity is the obligor on the PABs. No substantive changes have been made to the PAB program by subsequent legislation.

The law limits the total amount of such bonds to $15 billion and directs the Secretary of Transportation to allocate this amount among qualified facilities. The $15 billion in exempt facility bonds is not subject to state volume caps, the maximum amount of tax-exempt PABs that may be used in a state in a given year.

Additional Information

PAB allocation is managed by the U.S. Department of Transportation Build America Bureau, which maintains information on allocations to date, applying for an allocations, and process.

Nonprofit 63-20 Financing

The use of nonprofit corporations (sometimes referred to as “63-20 Corporations”) in structuring public/private infrastructure financings can preserve the ability for a project to be financed with tax-exempt bonds, while maintaining for both the public and private participants most of the benefits of private development.

Public benefit corporations have long been used as a vehicle to finance the construction of public buildings, including hospitals, court houses and schools. Historically, such projects have been accomplished through the use of nonprofit corporations to avoid statutory debt limitations and other restrictions. In some cases, private developers in association with public agencies around the country have utilized the nonprofit structure to develop major transportation projects, particularly those involving innovative contracting and public-private partnerships. Rather than issuing debt through an established conduit, debt issuance is done through a nonprofit corporation pursuant to IRS Revenue Ruling 63-20.

Further information on the use of 63-20 nonprofit public benefit corporations to finance surface transportation projects is available from the FHWA Center for Innovative Finance Support Alternative Project Delivery website.

Private Bond Issues

Private firms and entities can issue bonds to raise money. Corporate bonds are debt obligations, or IOUs, issued by private and public corporations. Companies use the funds they raise from selling bonds for a variety of purposes, from building facilities to purchasing equipment to expanding the business.

When an investor buys bonds, he or she lends money to the corporation that issued it, which promises to return the money, or principal, on a specified maturity date. Until that time, it also pays the investor a stated rate of interest, usually semiannually. The interest payments an investor receives from corporate bonds are taxable. Because corporate bonds must be sold on a taxable basis, they are less attractive as a vehicle for financing transportation investments.

Certificates of Participation

Certificates of Participation (COPs) are tax-exempt bonds issued by state entities usually secured with revenue from an equipment or facility lease. COPs enable governmental entities to finance capital projects without technically issuing long-term debt. This can be advantageous, as the issuance of long-term debt is commonly subject to voter approval and other state constitutional and statutory requirements.

A purpose-formed state entity issues tax-exempt bonds with maturities that match the lease term of assets that are purchased by the state entity with the proceeds from the bond issue. In the case of transit assets, the state entity then leases the equipment to one or more transit agencies. The underlying lease or installation sale agreement furnishes the revenue stream necessary to secure the bond. The resulting lease payments, most often made with a combination of formula grant funds and local matching share, are then “passed through” to the bondholders by the state entity.

Qualified Projects

COPs have been used primarily for transit investments, as transit operations often rely on capital equipment, such as rolling stock, buses, or depots that are well suited to lease agreements. Although they are perhaps less commonly used for road projects, COPs may also present creative financing options for certain highway related investments, such as automated toll collection or ITS equipment.


The COP process usually begins when a transit agency has ordered vehicles or contracted for a facility, which a finance corporation undertakes to pay for and complete. The assets are then leased to the transit provider at terms sufficient to repay the bondholders. The Federal grants that were committed to the original purchase are thus no longer needed for that purchase, allowing the transit system to reprogram the funds for other projects and accelerate their completion.

One of the most recent developments in transit finance is the ability to promise the use of future Federal transit formula grants as partial security for the leases underlying COPs. While it is not possible to pledge such funds formally (doing so would compromise the tax-exempt status of the debt), providers of commercial credit have viewed such promises as enhancing the creditworthiness of the overall transaction, primarily based on the transit system’s record of grant receipts over the years. It is possible for the interest expense associated with lease payments to be reimbursed by Federal grants at the 80 percent matching level. The framework for implementing Federally-funded COP transactions derives from FTA’s Final Rule on Capital Leases (49 CFR 639, October 15, 1991; amended December 10, 1998).


How Transit COPs are Structured (pdf)
Excerpted from the Transit Cooperative Research Program’s “Report on Innovative Financing Techniques for Transit Agencies,” Legal Research Digest, (August 1999).

FTA’s Final Rule on Capital Leases (pdf)
This final rule implements changes enacted by TEA-21, which allows all FTA capital investment grant funds (49 U.S.C. 5309) to be used for leasing facilities and equipment if a lease is more cost effective than purchase or construction. Before the enactment of TEA-21, recipients were permitted to lease assets only with funds received from FTA urbanized area formula grants (49 U.S.C. 5307). This rule amends FTA’s leasing regulation to extend this option to all FTA funds, to the extent a recipient meets all other regulatory requirements.

Case study: The Sacramento Regional Transit District (pdf)
Issued $32.44 million in COPs. Excerpted from the Transit Cooperative Research Program’s “Report on Innovative Financing Techniques for Transit Agencies,” Legal Research Digest, (August 1999).

Case study: Culver City, CA and the California Transit Finance Corporation (pdf)
Issued $9.66 million in COPs. Excerpted from the Transit Cooperative Research Program’s “Report on Innovative Financing Techniques for Transit Agencies,” Legal Research Digest, (August 1999).

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