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U.S. Department of Transportation U.S. Department of Transportation Icon United States Department of Transportation United States Department of Transportation

Public Roads - Spring 1995

Highway Bonds: An Emerging Option for Increasing Highway Financing

by Tom Howard


There is an urgent need for investment in transportation capital infrastructure improvements -- a need that greatly exceeds available financing. Estimates indicate that $51.6 billion must be spent each year for the next 20 years to maintain the current condition and performance of the highway infrastructure. This need compares to projected spending of $38.7 billion per year for an estimated annual investment shortfall of almost $13 billion. In addition, there is a backlog of more than $300 billion in highway and bridge capital requirements.

From where will all this money come? Traditional resources, long since tapped, obviously cannot provide the level of support needed. In recognition of this fact, the Intermodal Surface Transportation Act of 1991 (ISTEA) encouraged transportation decision makers to seek out and use additional funding sources. Consequently, transportation decision makers are systematically examining all possible financing options. Bond issuance is one such option.

Highway Bonds: Basic Concepts

What is a bond?

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. Almost all highway bonds are municipal bonds, which are issued by state and local government entities to finance their various projects and expenses.

Bonds have long been an important mechanism for financing highway improvements. In 1893, Massachusetts became the first state to use bonds to borrow funds for highway purposes, although the territory of Idaho issued "wagon road" bonds as early as 1890. Since then, all but two states -- Nebraska and Wyoming -- have issued highway bonds. Over the last 20 years, there has been a significant increase in the number of municipal bonds, including highway bonds, issued. State and local bond obligations totaled about $47 billion at the end of 1992.

What makes highway bonds appealing?

The interest income earned from municipal bonds, including highway bonds, is exempt from federal tax. The savings that this federal tax exemption affords to state and local issuers lets them borrow more cheaply than other issuers.

What kinds of highway bonds are there?

For convenience, highway bonds can be broken down into three categories: general obligation bonds, revenue bonds, and hybrid bonds.

  • General obligation bonds are backed by the full faith and credit of the issuing government. Most states rely on income taxes or sales taxes for their revenues. The full faith and credit backing implies that all sources of revenue, unless specifically limited, would be used to pay debt service on this type of bond.
  • Revenue bonds are backed by a specific source of revenue, usually linked to the particular function for whose support the bond is being issued. Highways and bridges thus may be financed by revenue bonds that are backed by tolls, concessions, and direct fees. State and local governments issuing revenue bonds usually must pay slightly higher interest rates to cover increased investor risk if revenues do not materialize.
  • Hybrid bonds are those with characteristics of both revenue and general obligation bonds. For example, one hybrid -- a moral obligation bond -- is a bond backed by revenues as well as by a nonbinding pledge from the issuing state that it would consider making up any deficiency in state revenues. Other hybrids include double-barrel bonds, which are bonds backed by both revenues and the full faith and credit of the issuing government.

Figure 1 shows the flow of funds from investors, through the financial community, to state and other governmental issuers of transportation bonds.

How do highway bonds work?

Municipal bonds are usually issued in denominations or multiples of $5,000; this amount is the bond's par, or face, value that is paid when the bond reaches maturity. In general, bonds are structured so that the life of the bond is equal to the usual life of the facility. The term of financing for a very-long-term project such as a highway or bridge facility is generally limited to 20 or 30 years.

Every bond has a coupon rate, which is the interest rate stated on the bond and payable to the bondholder. The interest on most highway bonds is paid semiannually. For example, a $10,000 bond with a coupon rate of 6 percent would pay the bondholder $600 a year in two $300 installments.

Bonds also have a yield rate; this is the effective rate of return to the investor determined by the price the investor paid for the bond, the coupon rate, and the maturity date. For example, if that same bond were reduced in price to sell at $8,000, the current yield would increase to 7.5 percent ($600 divided by $8,000).

The price and yield of highway bonds fluctuate -- as do those of other bonds -- based on activity in other credit markets, overall economic activity, inflation, and Federal Reserve policy.

All bonds have a credit rating, which is a benchmark for determining investor risk. All investments are a tradeoff between risk and reward. A credit rating provides a simplified measure of how risky a bond is likely to be. The credit rating also determines how much the issuer will have to pay for capital and affects the interest rate levels at which the bond trades. In general, the lower the rating, the higher the yield the issuer must offer.

Three independent companies publish credit ratings upon request for highway and other municipal debtors. The ratings, which are determined by objective rating criteria such as the issuer's current debt, economic base, finances, and management, evaluate the issuer's solvency and liquidity. The rating categories or grades span the highest quality investment (Aaa or AAA) down to bonds currently in default (D). (See figure 2.)

How do bond issuers attract investors?

State and local governments usually can increase their access to capital and reduce their borrowing costs by improving their standing in the credit markets. The following lists a few mechanisms for doing this:

  • Bond insurance and letters of credit can be obtained to assure lenders and bondholders that they will be repaid if the issuing government should default.
  • A bond bank is an institution that pools together individual bond offerings. Governments with lower credit ratings or little access to credit can unite to issue one large bond series and thereby reduce both cost and risk.
  • State revolving funds may assist credit by serving as direct or indirect credit enhancement to state and local highway bonds. By providing support for bonds or loan repayments, these revolving funds can work much like bond insurance or the bond banks described above.
Grade Moody's S&P Fitch Description
Investment Grade Aaa AAA AAA "Giltedge" Highest quality investment with least risk. Interest payments are protected by a large or exceptionally stable margin and principle is secure.
AA AA AA Judged to be of high quality. Fluctuation of margin is slightly higher than AAA or other long-term risks are slightly higher.
A A A Upper medium grade obligations. Factors providing security for principle and interest are adequate.
Baa BBB BBB Medium grade, neither highly protected nor poorly secured. Currently adequate protection but long-term suggests susceptibility to interruption or impairment.
Non- Investment Grade Ba BB BB Some speculative elements. Protection is moderate. Future uncertainty toward fluctuations in coverage.
B B B Lack characteristics of desirable investments. Assurance of protection and coverage small over time.
Caa CCC CCC Poor standing. Uncertainty of current payment of principal and interest.
Ca CC CC Highly speculative standing. Often in default with other market shortcomings.
C C C Extremely poor prospects of even attaining real investment standing.
  D D Default.


Current Trends in Highway Bond Financing

The tax-exempt market, in general, has grown in the past decade to become a major part of the U.S. investment industry. In 1992, municipal bond volume exceeded $235 billion; in 1983, it was only $83 billion. In that same 10-year period, transportation bond issuance increased to $25.9 billion from $4.8 billion.

Highway bond financing also increased significantly during this period. In 1992, state governments issued $6.4 billion in original issues ("new" funds -- see figure 3) and refinanced an additional $3.1 billion. Comparable 1983 totals were $1.1 billion in new funds and $1.3 billion in refinancing. Moreover, when local bonds are also considered, total bond issuance for highways and bridges equaled $12.4 billion in 1992.

Why has highway bond issuance increased so dramatically? Several factors -- aside from the refinancing of old debt -- are at work:

  • Program needs. While federal spending for infrastructure has increased as a result of ISTEA legislation and legislation passed in the 1980s, program needs have increased even more quickly. As noted, there exists a backlog of $300 billion in highway and bridge needs, and unfinanced needs are currently increasing by about $13 billion annually. Thus, state and local governments have turned more and more to capital markets.
  • Reduced interest rates. The reduced interest rate environment of the early 1990s created opportunities to issue new money bonds as well as refinance debt issued in the 1980s.
  • Improved financial products. Spurred by program needs, levels of investor and issuer sophistication, and competition in the bond industry, the types of bond and bond-related products available have improved strikingly in recent years. For example, the number of state and local issuers accessing the highway bond market rose from 182 in 1988 to 263 in 1992; this suggests a greater willingness on the part of local governments to use all tools available to them. (See figure 3.)


Figure 2 (Left) - New highway bonds issued by state transportation or toll authorities, 1983-1992​​​​​.
Figure 3 (Right) - 1992 transportation bond issues by mode (includes refinancing).​​​


Transportation decision makers are showing an increased awareness of the importance of using every available revenue stream to secure bond and other financing. More than ever, state and local governments are expanding their financing bases beyond traditional highway user fees and tolls to include transportation improvement districts -- special units of local government organized to make transportation improvements and legislated the power to incur debt and levy taxes -- and legislated support for bonds.

Bonds and Federal Legislation

ISTEA and other existing federal-aid legislation make it possible for federal-aid highway funds to support bond financing.

Section 1012 of ISTEA relaxes many earlier restrictions on toll financing. Because toll financing and toll authorities are often financed though bonds, ISTEA provides the flexibility for increased bond financing. Initial construction, reconstruction, and the conversion of certain free facilities to tolls are all permitted under section 1012.

Section 1044 of ISTEA allows a credit to the state for toll revenues generated. While actual bond issuance does not constitute a credit, the toll revenues that result from bonds are often associated with bond issuance.

Sections 115 (Advance construction) and 122 (Bond retirement) of Title 23, United States Code Highways, provide for federal reimbursement for federal-aid highway projects initially financed from bonds issued by states and local governments. Under current law, a state that uses the proceeds of bonds for the construction of primary, interstate, urban extensions, or interstate substitute projects may claim federal reimbursement on that portion of the bonds used to retire the bonds. Certain interstate interest costs may also be eligible for federal reimbursement.

Recent Proposed Legislation and Developments

In the 103rd Congress, last year, Sen. Max Baucus (D-Mont.) and Rep. Robert A. Borski (D-Pa.) introduced bills that would have given states greater flexibility in highway financing and further encouraged the issuance of highway and transit bonds. While Congress adjourned without enacting either bill, this legislative attention is evidence of a growing interest in state bonds and other innovations as means of increasing highway capital investment.

The Baucus bill -- the State Transportation Financing Improvement Act, Senate bill 1714 --

would have allowed states to establish their own revolving funds with certain federal-aid highway funds used as seed money. These revolving funds could have been used to either purchase bond insurance or directly enhance credit. Recent research conducted for the Federal Highway Administration (FHWA) indicated that, if such legislation had been enacted in 1993, an investment of about $2 billion in credit enhancement activities of state revolving funds could have resulted in almost $6 billion in new bond issuance.

Legislation introduced by Borski would have established an infrastructure reinvestment fund to provide current financing for ISTEA highway and transit programs. The Infrastructure Reinvestment and Economic Revitalization Act, H.R. 3489, would have created an infrastructure reinvestment fund that would be financed through five cents per gallon from the Highway Trust Fund and other revenues over 30 years. The fund would have provided for the near-term financing of a very large ISTEA program, which would have been repaid over 30 years. While H.R. 3489 pertained to a federal bond rather than a state municipal bond program, it did seek to address the same underinvestment issue that state bonds seek to address.

As part of the U.S. Department of Transportation (DOT) restructuring effort, State Infrastructure Banks (SIBs) are included as part of the department's new program design. SIBs are intended to encourage innovative and user-fee types of infrastructure financing to better leverage federal dollars and encourage private investment, such as state bonds. The fiscal year 1996 DOT budget included $2 billion for seed money to start these banks. Program details and legislative language for the SIBs is currently being developed.

FHWA Innovative Financing Program

In March 1994, FHWA established an Innovative Financing Test and Evaluation Project (TE-045) to help identify actions to encourage increased investment in transportation. The agency sought to increase and improve investment in highway and other surface transportation infrastructure. More than 25 states submitted more than 60 innovative finance proposals. These proposals included several projects that directly or indirectly supported highway bond financing. Increased use of Section 1012, Section 1044 matching provisions, expanded eligibility to include bond interest as an eligible cost, and post-ISTEA commitments were among the proposals states submitted to FHWA. Several of these proposals have since been accepted.

Conclusion: Evaluating Bonds as an Option

There is no right or wrong answer as to the appropriateness of highway bond financing as an option for meeting transportation infrastructure needs. It is certainly a viable mechanism -- one that state and local governments are increasingly turning to and one that federal efforts are supporting and encouraging. However, bond financing should be evaluated -- along with other available financing options -- based on the application of certain financing criteria. A comprehensive financing plan should be developed and evaluated based on its revenue potential (ability to raise revenues), equity (fairness of ratio of costs to benefits), efficiency (which pertains to the ability of the governments to collect these revenues), and political acceptability.

Selecting the correct financing plan is only one element of highway projects. It is, however, a very important element. In some cases, bond financing may be the most viable financing option. Transportation decision makers should make use of this option when it is the most appropriate means of advancing needed highway and other surface transportation projects.

Tom Howard is a transportation specialist in the Legislation and Strategic Planning Division of FHWA's Office of Policy. He has a bachelor's degree in economics from Fordham University and master's degrees from Fairfield University in education and from George Washington University in public administration. He has worked in the highway finance field for more than 15 years.