General obligation bond

What Is a General Obligation Bond?

A general obligation bond is a type of municipal bond that is issued by state and local governments to finance public projects, backed by the full faith and credit of the issuing entity. This means the issuer pledges its entire taxing power and all available general revenues to repay bondholders. These instruments fall under the broader category of municipal bonds, which are a key component of fixed income investing. Unlike some other municipal bonds, general obligation bonds are not tied to the revenue generated by a specific project; instead, their repayment relies on the issuer's general ability to levy taxes, such as property, sales, or income taxes. Investors consider general obligation bonds based on the financial health and stability of the issuing government, including its taxing capacity and economic base.

History and Origin

The concept of municipal debt to fund public services dates back centuries, with early examples found in Renaissance Italian city-states. In the United States, the issuance of municipal bonds began in the early 19th century. The first officially recorded municipal bond was a general obligation bond issued by New York City in 1812 to finance canal construction.¹⁸, This early use set a precedent for states and localities to undertake significant capital projects through debt financing. Throughout the 1800s, general obligation bonds funded a wide array of public works, including urban improvements, free public education, and railroad expansion, significantly shaping the development of U.S. communities.¹⁷,

Key Takeaways

• General obligation bonds are municipal debt instruments backed by the full faith and credit of the issuing government.
• Repayment is typically sourced from the issuer's general tax revenue (e.g., property, sales, income taxes), rather than project-specific revenues.
• These bonds are frequently used to finance non-revenue-generating public projects, such as schools, roads, parks, and public safety facilities.
• Investors often view general obligation bonds as relatively low-risk due to the broad taxing power backing them, although default risk is always present.

Formula and Calculation

The pricing and yield calculation for a general obligation bond, like most bonds, involves its face value, coupon rate, and time to maturity. While there isn't a unique "general obligation bond formula," the present value of its future interest payments and principal repayment determines its market price. The yield to maturity (YTM) is the total return an investor can expect if they hold the bond until it matures, taking into account the bond's current market price, par value, coupon interest rate, and time to maturity.

The formula for the present value of a bond is:

Where:

• (P) = Current market price of the bond
• (C) = Coupon payment per period
• (r) = Discount rate (yield to maturity)
• (F) = Face value (par value) of the bond
• (N) = Number of periods to maturity

This calculation helps investors evaluate the attractiveness of a general obligation bond relative to other investment opportunities.

Interpreting the General Obligation Bond

The interpretation of a general obligation bond largely hinges on the financial strength and stability of its issuer. Investors assess the issuer's credit rating, which reflects its capacity and willingness to meet its debt obligations. A higher credit rating typically indicates lower perceived risk and may result in a lower interest rate for the issuer and a lower yield for the investor. Conversely, a lower credit rating suggests higher risk and demands a higher yield.

When evaluating a general obligation bond, analysts scrutinize the issuer's economic indicators, such as population trends, employment rates, local economic diversity, and overall debt burden. Strong, growing tax bases provide greater assurance of repayment capacity. These bonds are often considered a conservative investment, especially when issued by financially robust entities.

Hypothetical Example

Imagine the City of Evergreen decides to build a new public library and renovate several community parks. These projects do not generate direct revenue. To finance this, the city council proposes issuing $50 million in general obligation bonds with a 20-year maturity and a 3% annual coupon rate.

The proposal is put to a public vote, as is often required for general obligation bonds, and residents approve it. Once approved, the city works with an underwriter to prepare an official statement, detailing the city's financial condition, its tax base, existing debt, and the specifics of the new bond issue.

An investor, Ms. Chen, purchases $10,000 worth of these Evergreen City general obligation bonds. She will receive $300 in annual interest payments (3% of $10,000) for 20 years. At the end of the 20-year term, she will receive her $10,000 principal back. The city's commitment to repay Ms. Chen and other bondholders is backed by its ability to collect property taxes from its residents. If the city faced a budget shortfall, it would theoretically have the power to raise property taxes to ensure bond repayment.

Practical Applications

General obligation bonds are a fundamental tool for state and local governments to finance essential public services and infrastructure that typically do not generate their own revenue streams. They are widely used for:

• Infrastructure Improvements: Funding for roads, bridges, public transit systems, and water and sewer facilities.¹⁶,¹⁵
• Educational Facilities: Construction and renovation of schools, universities, and public libraries.¹⁴,¹³
• Public Safety: Building and upgrading police stations, fire stations, and emergency response centers.¹²,¹¹
• Recreational Facilities: Developing parks, community centers, sports fields, and other public amenities.¹⁰,⁹
• Affordable Housing: Financing projects aimed at increasing the availability of affordable housing units.⁸

The full faith and credit pledge of the issuer makes general obligation bonds attractive to investors seeking stable income and perceived lower default risk compared to other securities.

Limitations and Criticisms

While generally considered secure, general obligation bonds are not without limitations or criticisms. Their primary drawback lies in the fact that their repayment hinges on the issuer's financial health, which can be susceptible to economic downturns, population decline, or mismanagement. If a municipality experiences severe financial distress, its ability to collect sufficient tax revenue may be compromised, potentially leading to default.

Notable instances of municipal defaults, such as Detroit's bankruptcy in 2013 and Puerto Rico's debt crisis starting in 2015, highlighted that even general obligation bonds are not immune to failure, and in some cases, bondholders have taken significant losses.⁷,⁶ These events challenged the long-held perception of general obligation bonds as universally safe investments and underscored the importance of thorough due diligence by investors. Furthermore, the reliance on the issuer's general funds means that bondholders do not have a claim on specific revenue-generating assets, which can complicate recovery in the event of default.⁵

General Obligation Bond vs. Revenue Bond

The primary distinction between a general obligation bond and a revenue bond lies in the source of repayment and the collateral backing the bond.

Confusion often arises because both are types of municipal bonds issued by state and local governments. However, their fundamental difference in security and repayment mechanism dictates their risk profiles and the types of projects they are suitable for financing. Investors assess the creditworthiness of a general obligation bond by looking at the issuer's overall financial health, while a revenue bond's creditworthiness is tied directly to the performance and cash flow of the project it funds.

FAQs

What is the "full faith and credit" pledge?

The "full faith and credit" pledge means the issuing government promises to use all its available resources, including its taxing power, to repay the general obligation bond. This is the strongest pledge a municipality can offer.⁴

Are general obligation bonds tax-exempt?

Interest income from most general obligation bonds is exempt from federal income tax. Additionally, if you are a resident of the state that issues the bond, the interest may also be exempt from state and local taxes, offering a "double" or "triple" tax exemption.

How do general obligation bonds get approved?

General obligation bonds often require voter approval because they are backed by the taxing power of the community. This ensures public consent for potential future tax increases to repay the debt.³

Who regulates general obligation bonds?

While municipal bonds, including general obligation bonds, are largely exempt from the registration requirements of the Securities Act of 1933, they are subject to anti-fraud provisions of federal securities law. The Securities and Exchange Commission (SEC) and the Municipal Securities Rulemaking Board (MSRB) oversee market participants and aim to enhance investor protection and transparency in the municipal bond market.²,¹