General obligation bonds

General Obligation Bonds: A Comprehensive Guide

General obligation bonds are a type of municipal bond issued by state and local governments, backed by the full faith, credit, and taxing power of the issuing entity. These debt securities are used to finance public projects that do not generate their own revenue streams, such as schools, parks, and general government buildings. Unlike other bonds, general obligation bonds are secured by the issuer's commitment to use any legally available resources, including tax revenues, to repay bondholders. This broad pledge is often considered a strong indicator of credit quality.

History and Origin

The concept of municipal borrowing to fund public works has deep historical roots, predating corporate debt by centuries. In the United States, the issuance of municipal bonds dates back to the early 1800s. The first officially recorded municipal bond was a general obligation bond issued by New York City in 1812 to finance a canal project.²⁴,,²³ This marked an early example of a government pledging its full taxing authority to fund public infrastructure. Throughout the 19th century, general obligation bonds became a cornerstone for urban development, funding everything from the Erie Canal to early public education systems and railroad expansion.²²,²¹ The market continued to expand significantly, though it experienced periods of default, particularly after speculative booms like the Panic of 1873.²⁰,¹⁹ The framework for municipal securities, including general obligation bonds, evolved over time, leading to the establishment of regulatory bodies like the Municipal Securities Rulemaking Board (MSRB) in 1975 to enhance investor protection.¹⁸,¹⁷

Key Takeaways

• General obligation bonds are municipal bonds backed by the issuer's full faith, credit, and taxing power.
• They typically finance non-revenue-generating public projects, such as schools and roads.
• Repayment to bondholders primarily comes from the issuer's general funds, often sustained by property taxes or other broad tax revenues.
• Issuance usually requires voter approval and is subject to constitutional or statutory debt limits.
• Compared to other municipal bonds, general obligation bonds often carry a strong credit rating due to their broad revenue backing.

Interpreting General Obligation Bonds

When evaluating general obligation bonds, investors focus on the issuer's overall financial health and its ability to levy and collect taxes. The strength of the pledge behind a general obligation bond is paramount. An unlimited-tax general obligation pledge, for instance, implies that the issuer can raise property taxes without limit to cover debt service, often requiring voter authorization. Conversely, a limited-tax general obligation pledge means the issuer can only raise taxes up to a statutory limit to meet its obligations., Understanding the specific type of pledge, as well as the issuer's economic diversity and population growth trends, is crucial for assessing the security of the investment. The long-term fiscal stability of the issuing government directly impacts the perceived safety and yield of these bonds.

Hypothetical Example

Imagine the city of Harmonyville needs to build a new public library, a project that will not generate its own income. To finance this, the city council proposes issuing $50 million in general obligation bonds with a 20-year maturity date and a 3% interest rate. Because these bonds will be repaid using taxpayer funds, a public referendum is held, and the citizens approve the bond issuance.

Upon approval, Harmonyville works with an underwriter to sell the bonds in the primary market. Investors who purchase these general obligation bonds are essentially lending money to the city. In return, the city pledges its full taxing authority, primarily through property taxes, to make regular interest payments to these bondholders every six months and return the principal amount at maturity. Even if unexpected budget shortfalls occur from other city services, Harmonyville is obligated to ensure the bond payments are made, potentially by increasing taxes if necessary and legally permissible.

Practical Applications

General obligation bonds are a vital tool for state and local governments to finance essential public services and infrastructure without relying on project-specific revenue. They are commonly used for:

• Public Education: Funding the construction and renovation of schools.
• Infrastructure Development: Building and maintaining roads, bridges, and public buildings.
• Public Safety: Financing police and fire department facilities.
• Parks and Recreation: Supporting the creation and upkeep of public parks and community centers.

These bonds enable municipalities to undertake projects that benefit the entire community, contributing to quality of life and economic growth. For investors, general obligation bonds are often attractive due to their potential tax exemption, where interest income may be exempt from federal income tax and sometimes state and local taxes, especially if the investor resides in the issuing state.¹⁶,¹⁵,¹⁴,¹³ This tax exemption allows highly-rated municipal issuers to borrow at lower rates than many other debt issuers.¹²,¹¹ The Municipal Securities Rulemaking Board (MSRB) provides extensive market facts and data on municipal bonds, highlighting the significant role individual investors play in this market.¹⁰

Limitations and Criticisms

Despite their reputation for relative safety, general obligation bonds are not without limitations or risks. While backed by the issuer's full faith and credit, the ability of a government to raise taxes or divert other revenues to cover debt service is not absolute. Constitutional or statutory debt limits can restrict the amount of debt a municipality can issue or the extent to which it can increase taxes.⁹, Economic downturns can reduce a municipality's tax base, making it harder to generate sufficient tax revenues for repayment.

Moreover, in severe financial distress, even the "full faith and credit" pledge may be challenged. A notable example is the Puerto Rico debt crisis, where the government defaulted on general obligation bond payments in 2016, despite a constitutional priority for these bonds, prioritizing essential services for its residents instead.⁸ This incident underscored that while general obligation bonds are typically considered very secure, unforeseen circumstances or political decisions can impact repayment, challenging the conventional wisdom surrounding their perceived invulnerability. Consequently, investors should perform due diligence by examining the official statement of the bond, which provides detailed disclosures about the issuer's financial condition and specific terms of the bond.⁷

General Obligation Bonds vs. Revenue Bonds

General obligation bonds and revenue bonds are the two primary types of municipal bonds, distinguished by their repayment sources and underlying security pledges. The key difference lies in what backs the bond.

Confusion between these two types of bonds can arise because both are issued by state and local governments. However, a general obligation bond relies on the broad financial capacity of the government, while a revenue bond's repayment is tied directly to the success and income generated by the specific project it financed. Understanding this distinction is critical for investors to assess the underlying risk and repayment certainty.

FAQs

What is the "full faith and credit" pledge?
The "full faith and credit" pledge means the issuer promises to use all available resources, including its taxing power, to repay its general obligation bond debt. This commitment is considered a strong guarantee of repayment.⁶,⁵

Do general obligation bonds always require voter approval?
While many general obligation bonds, especially those issued by local governments, require voter approval, it depends on state and local laws and constitutional provisions. This approval process ensures taxpayers agree to take on the debt that will be repaid through their taxes.⁴,

Are general obligation bonds tax-exempt?
Generally, the interest income from general obligation bonds is exempt from federal income tax. Additionally, if you are a resident of the state that issued the bond, the interest may also be exempt from state and local taxes, providing a significant benefit to investors.³,²,¹ This tax exemption can result in a lower yield compared to taxable bonds of similar credit quality.

How do credit rating agencies assess general obligation bonds?
Credit rating agencies evaluate the issuer's financial stability, economic strength, debt burden, and management practices. They typically assign investment grade ratings to general obligation bonds due to the issuer's strong pledge and ability to tax residents. However, they also consider factors like legal debt limits and the economic outlook of the municipality.