A debt service reserve fund is a source of “backup” funding used to pay interest and principal if the money otherwise used such as taxes or fees is not enough to make payments.
Debt service reserves may be particularly important with revenue bonds, where bonds are repaid only with revenues generated by the project being financed. Because these revenues, generally fees or other charges for services, may fluctuate or be unpredictable, investors may be concerned with the issuer’s ability to pay principal and interest on time. As a result, the bond contract may include a debt service reserve requirement that requires issuers to maintain a certain amount of money in a debt service reserve fund (the maximum annual debt service or 10 percent of the bonds’ par value, for example).
Debt service reserves may be funded with bond proceeds; if the issuer needs $100 million for projects and $10 million for its debt service reserve, for example, it may structure its bonds to receive $110 million in proceeds. Debt service reserves may also be funded with any excess revenue generated by the project being financed, or guaranteed with a letter of credit or surety bond purchased from a third party.