What Is a General Obligation Bond (GO)?
A General Obligation Bond (GO) is a type of municipal bond issued by a state or local government entity, such as a city, county, or school district, to finance public projects or services. Unlike other forms of debt, General Obligation Bonds are backed by the "full faith and credit" of the issuing government, meaning the issuer pledges its entire taxing power and all available general revenues to repay the bondholders. This broad backing makes GO bonds a cornerstone of the fixed income market within the broader category of debt securities. Investors in General Obligation Bonds typically view them as relatively low-risk investments due to the issuer's ability to raise taxes or fees to meet their payment obligations.
History and Origin
The practice of municipal borrowing to finance public endeavors predates corporate debt by centuries, with roots tracing back to early Renaissance Italian city-states. In the United States, the issuance of municipal bonds began in the early 19th century, serving as a crucial tool for financing nascent infrastructure development. The first officially recorded municipal bond was a General Obligation Bond issued by New York City in 1812 to fund a canal project.6 This marked the beginning of municipal debt's significant role in American development, as cities increasingly relied on bonds to finance urban improvements and establish public education systems throughout the 1800s. The popularity and growth of the municipal market eventually led to the creation of regulatory bodies. In 1975, with the support of the industry and the Securities and Exchange Commission (SEC), Congress established the Municipal Securities Rulemaking Board (MSRB) to create rules and promote transparency in the municipal securities market, particularly as individual investor participation grew.5
Key Takeaways
- General Obligation Bonds are issued by state and local governments and are secured by the issuer's full taxing power.
- They are considered less risky than many other types of bonds because the issuer can typically raise taxes or utilize general revenues to make interest payments and repay the principal.
- GO bonds are often used to finance essential public works projects like schools, roads, and public buildings.
- Interest income from many General Obligation Bonds is often exempt from federal income tax and, in some cases, state and local taxes, offering tax-exempt income to investors.
- Despite their perceived safety, General Obligation Bonds carry some default risk, although historically, this risk has been very low compared to corporate bonds.
Formula and Calculation
The pricing of a General Obligation Bond, like other bonds, involves calculating the present value of its future cash flows, which include periodic interest payments and the repayment of the principal at maturity. The formula for the present value of a bond is:
Where:
- ( P ) = Current market price of the bond
- ( C ) = Periodic coupon payment (annual interest rate * face value / number of payments per year)
- ( r ) = Market bond yield or discount rate per period
- ( F ) = Face value (par value) of the bond
- ( n ) = Total number of periods until maturity
This calculation helps investors determine a fair price for a bond given prevailing interest rates and the bond's promised payments.
Interpreting the General Obligation Bond (GO)
When evaluating a General Obligation Bond, investors interpret its value based on the financial health and stability of the issuing authority. A strong local economy, diverse tax base, and sound fiscal management contribute to the perceived safety of a GO bond. Credit rating agencies assign a credit rating to these bonds, which reflects their assessment of the issuer's ability and willingness to meet its debt obligations. A higher credit rating typically indicates lower default risk and often results in a lower bond yield, as investors are willing to accept a smaller return for greater security. Conversely, a lower credit rating suggests higher risk and demands a higher yield to compensate investors. Understanding the issuer's economic stability and budgetary practices is crucial for interpretation.
Hypothetical Example
Imagine the City of Evergreen decides to issue $50 million in General Obligation Bonds to finance the construction of a new public library and upgrade its wastewater treatment plant. The bonds have a face value of $5,000 each, a 20-year maturity, and an annual coupon rate of 3.5%, paid semi-annually.
An investor, Sarah, is considering buying one of these bonds.
- Calculate Semi-Annual Coupon Payment: The annual interest is 3.5% of $5,000, which is $175. Since payments are semi-annual, each payment is $175 / 2 = $87.50.
- Total Payments: Over 20 years, there will be 20 * 2 = 40 semi-annual payments.
- Maturity: At the end of 20 years, Sarah will receive her $5,000 principal back.
The City of Evergreen's promise to pay Sarah $87.50 every six months and $5,000 at maturity is backed by its general fund, which includes property taxes, sales taxes, and other municipal revenues. This commitment makes the General Obligation Bond an attractive option for investors seeking consistent income backed by a broad revenue stream.
Practical Applications
General Obligation Bonds are widely used by state and local governments across the United States to fund a vast array of essential services and infrastructure projects. Their practical applications include financing:
- Education: Construction and renovation of public schools and universities.
- Transportation: Building and maintaining roads, bridges, and public transit systems.
- Public Safety: Funding police stations, fire departments, and emergency services facilities.
- Utilities: Developing and upgrading water, sewer, and sanitation systems.
In times of economic uncertainty, such as the COVID-19 pandemic, the ability of states and localities to issue General Obligation Bonds and other municipal debt becomes critical for maintaining public services and stimulating local economies. During the pandemic, the Federal Reserve established the Municipal Liquidity Facility (MLF) to provide a liquidity backstop to the municipal bond market, purchasing newly issued, short-term notes from eligible state and local governments. This intervention aimed to ensure that these entities could continue to access financing to provide essential services, highlighting the vital role General Obligation Bonds play in fiscal policy and the broader financial markets.4
Limitations and Criticisms
While General Obligation Bonds are generally considered safe investments, they are not without limitations or criticisms. One primary concern is the potential for an issuing entity to face financial distress, which could lead to a default, though historically rare. For example, some municipalities have faced severe budgetary challenges during economic downturns, impacting their ability to service debt. While GO bonds are backed by the taxing power, the willingness or capacity of a government to raise taxes may be politically constrained or limited by the local economic cycles. Additionally, the tax-exempt status of municipal bonds, including GO bonds, is sometimes criticized for disproportionately benefiting high-income investors and for representing a form of federal subsidy to state and local governments, which could be reevaluated during periods of federal budgetary strain.
General Obligation Bond (GO) vs. Revenue Bond
General Obligation Bonds and Revenue Bonds are the two main types of municipal bonds, differing primarily in their repayment source and the security pledged to bondholders. A General Obligation Bond is secured by the full faith and credit of the issuing government, meaning the government commits its general taxing power and non-earmarked revenues to repay the debt. This broad backing makes GO bonds generally perceived as less risky. In contrast, a Revenue Bond is repaid solely from the revenues generated by the specific project it finances, such as tolls from a highway, user fees from a water system, or lease payments from a public facility. If the project's revenues fall short, bondholders may not be fully repaid, as there is no claim on the general taxing authority. This distinction means Revenue Bonds typically carry a higher risk and, consequently, often offer higher interest rates than General Obligation Bonds to compensate investors for that increased risk.
FAQs
What does "full faith and credit" mean for a General Obligation Bond?
"Full faith and credit" means that the issuing government pledges its unrestricted ability to levy taxes and other general revenues to repay the General Obligation Bond. This commitment provides a strong guarantee to bondholders, making the bond highly secure.
Are General Obligation Bonds always tax-exempt?
Interest income from most General Obligation Bonds is exempt from federal income tax. Additionally, if you are a resident of the state or locality that issues the bond, the interest may also be exempt from state and local taxes, leading to a concept known as double tax-exempt or triple tax-exempt status. However, some specific municipal bonds, including certain GO bonds issued for private activities, may be taxable.
How safe are General Obligation Bonds?
General Obligation Bonds are considered among the safest investments in the fixed income market, often second only to U.S. Treasury securities. This is primarily due to the issuer's fundamental power to tax its residents and businesses to ensure repayment. Historically, the default rates for municipal bonds, particularly General Obligation Bonds, have been significantly lower than those for corporate bonds.3,2,1
Can a city or state default on a General Obligation Bond?
While rare, a city or state can default on a General Obligation Bond. Defaults typically occur during severe economic crises or periods of extreme fiscal mismanagement. However, even in such cases, GO bonds often have a stronger claim to repayment than other forms of municipal debt because they are backed by the issuer's general taxing authority.
What factors affect the interest rate on a General Obligation Bond?
The interest rate, or coupon rate, on a General Obligation Bond is influenced by several factors, including the prevailing market interest rates, the bond's maturity period, the creditworthiness of the issuing government (reflected in its credit rating), and the general supply and demand dynamics in the bond market. Bonds from issuers with stronger financial standing and higher credit ratings typically offer lower interest rates.