What Are General Obligation Bonds?

By Markets Fool.com

Though there's no such thing as a risk-free investment, general obligation bonds are usually considered one of the closest things to it. These are municipal bonds used to fund public works projects, and backed by the full faith and credit of the issuing municipality. When general obligation bonds are issued, the municipalities behind them pledge to use all available resources, including taxes and general funds, to repay bondholders as scheduled.

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General obligation versus revenue bonds

There are two main types of municipal bonds: general obligation bonds and revenue bonds. General obligation bonds are used to finance public projects like parks and schools that don't actually make any money. Rather, their purpose is to serve the public good.

Revenue bonds, on the other hand, are used to finance projects with built-in revenue streams, like toll roads, utilities, and transportation systems. Although revenue bonds are backed by specific sources of revenue, they're generally considered riskier than general obligation bonds: if a project fails or falls short in terms of revenue, the municipality has no other options for repaying bondholders. With general obligation bonds, the issuing municipality can, and is expected to, use all means necessary to repay bondholders. This could mean selling off assets, as well as raising taxes, or imposing new taxes or fees.

Historically, there have been far fewer general obligation bond defaults than revenue bond defaults. However, general obligation bonds typically offer lower interest rates than revenue bonds since the risk of default is so low.

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Types of general obligation pledges

Though the principle behind general obligation bonds is that issuer must essentially do everything in its power to make good on its payments, there are two types of pledges upon which municipalities can issue these bonds: limited tax pledges and unlimited tax pledges.

A limited tax pledge requires the issuing municipality to raise property taxes to fulfill its payment obligations to bondholders, but only up to a certain limit. Voter approval is usually not required to issue general obligation bonds with limited tax pledges.

With an unlimited tax pledge, the issuing municipality can raise taxes as much as necessary in order to fulfill its debt obligations. Typically, voter approval is needed before issuing general obligation bonds with unlimited tax pledges, and as such, these bonds can often be more difficult to issue. Furthermore, the tax revenue collected under an unlimited pledge can only be used to satisfy the bond obligations; it cannot be used for other purposes.

Benefits of general obligation bonds

Like all municipal bonds, the interest earned on general obligation bonds is exempt from federal taxes, and those who buy municipal bonds issued by their respective home states can avoid state and local taxes too. Furthermore, buying general obligation bonds gives investors the chance to invest in their own communities.

Because there's no revenue stream associated with general obligation bonds, it's important to check the issuing municipality's credit rating before making the decision to invest. Since these bonds are secured by the full faith and credit of the issuer, the higher its credit rating, the safer the investment is likely to be.

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