What if private investment could transform projects with public purpose? Private activity bonds (PABs) aim to do just that by combining the public-need mandates of state and local governments and risk-adjusted, profit-seeking motives of private capital groups.

　　PABs share many similarities and similar risk profiles with municipal bonds—many may consider PABs to be a subset of munis—but they are not exactly the same. Are you considering investing in one, or is your local government asking you to vote on a PAB issue in an upcoming referendum? Here’s what you need to know.

　　What is a private activity bond?Private activity bonds are issued by state or local governments, typically to finance projects that are privately owned but serve a public purpose. State governments, local governments, municipal authorities, public agencies, and development authorities may all issue PABs.

　　HospitalsAirportsRoads, highways, and bridgesPublic transportation systemsEducational facilitiesAffordable housingWater and sewage treatment plantsRenewable energy projectsAs a private activity bond investor, interest you earn may be free of federal taxes (and possibly state taxes too), provided the project serves the public good. The Internal Revenue Service (IRS) codifies which types of projects give tax advantages to PAB holders.

　　Projects that lack a clear public purpose or primarily benefit private interests may be financed with PABs, but investors holding these private activity bonds don’t get any tax benefits. Sports facilities, commercial office buildings, and privately owned luxury developments are all PAB eligible but don’t yield the customary tax breaks.

　　Private activity bonds vs. municipal bondsHow do municipal bonds and private activity bonds compare? Both types of bonds are issued by governments or government agencies, and both typically finance public goods. Tax-exempt status is contingent on the project type or how the funds are used for both municipal and private activity bonds. (Municipal bonds that fund nonpublic purposes, such as pension obligations, don’t receive favorable tax treatment.)

　　But that may be where the similarities end. Private entities are integral to the issuance and risk underwriting of PABs and not at all relevant to municipal bonds. Government entities issuing municipal bonds are fully responsible for their repayment, while private enterprises are responsible for meeting PAB financial obligations.

　　Private activity bonds are typically perceived as more risky than municipal bonds. The safety of municipal bonds stems from their government backing, as governments can use tax revenues to fund bondholder payments if needed. The lack of a “tax increase fallback option” makes default more likely in a PAB than a muni bond.

　　How do private activity bonds work?Private activity bonds may finance many different types of projects, but the process from conception to project completion and bond repayment is much the same.

　　1. A private developer initiates a project. The first step is for a private entity, such as a real estate developer or nonprofit organization, to conceive of a public benefit project that requires financing.

　　2. The developer proposes PAB issuance by a public authority. The developer approaches a public authority to formally propose that a private activity bond be issued for the project. The public authority evaluates the public purpose of the project, if any, in the process of approving or denying the bond issue.

　　3. The public authority approves and issues the bond. Approval typically requires a public hearing and in many cases will require public approval via a referendum. With PAB approval granted, the government or governmental agency issues a private activity bond on behalf of the private entity that owns the project. The PABs are then sold to investors.

　　4. The developer uses the funds. The monies raised by the PAB are used to complete the project. The finished project very likely provides some public benefit.

　　5. Investors get repaid. The project developer repays PAB investors over time, usually with regular interest payments and a lump-sum payment when the bond reaches maturity. The project’s owner is solely responsible for satisfying PAB repayment obligations.

　　6. Investors enjoy tax benefits. Assuming that the project serves a public purpose, the PAB investors supporting the project are exempt from paying federal taxes on any interest earned.

　　Key risks of private activity bondsJust as with any investing activity, investing in private activity bonds carries some risks, including those conferred by any type of bond investing:

　　Construction risk. Delays or cost overruns during construction could compromise a project developer’s ability to meet its financial obligations to bond investors.Revenue risk. The ability of a new project to generate enough revenue to repay bond investors is generally unproven before the project is built. For example, in 2023, a New Jersey shopping and entertainment complex, American Dream mall, was forced to pay its creditors nearly $390 million after a PAB default, due in part to a steep fall in mall traffic during and after the COVID-19 pandemic.Operational risk. A project operator that mismanages or operates a project poorly may default on PAB repayments. Examples of operational inefficiencies leading to default include the San Diego South Bay Expressway in 2010 and an affordable housing complex in North Carolina, Renaissance at Concord Apartments, which defaulted in 2011 after operational issues including construction quality, maintenance cost overruns, and poor budgeting. Interest rate risk. Rising interest rates can reduce a bond’s market value, affecting bondholders who wish to sell during inflationary periods.Regulatory risk. Changes in laws, regulations, or tax policies may impact a project’s viability or the tax-exempt status of private activity bonds. For example, in the 1990s, several local cable television services defaulted on PABs when federal telecommunications regulations encouraged competition. Bond investing always includes some measure of default risk, but conducting a bit of research into the private companies responsible for bond repayment can help to minimize this risk for investors.

　　The bottom linePrivate activity bonds occupy a unique position in the investing landscape. Although they’re issued by public authorities, only private enterprises assume repayment responsibilities and only investors assume default risks. PABs often appeal to developers because they can reduce borrowing costs and enable large projects to be realized. Investors love PABs for the tax breaks.

　　But before you allocate any of your portfolio to a private activity bond, do your homework to ensure that the project is worthy of your investment. And if you’re asked to approve a PAB in a ballot initiative, now you can better weigh the pros and cons of that particular funding proposal in the context of the underlying project.