General Obligation bonds, which are also referred to as GOs, are municipal bonds which provide a way for state and local governments to raise money for projects that may not generate a revenue stream directly. Examples of the types of projects funded by General Obligation bonds are the construction of public schools and highway systems.
They are called “General Obligation” bonds because they are not backed by a specific revenue producing project or asset. Instead, they are backed by the “full faith and credit” of the issuer. In simple terms that means the bonds are backed by the State or local government’s ability to tax, and to raise taxes if necessary, in order to pay bondholders. For States this power comes in the form of State Income Taxes and/or a Sales Tax. For local governments it normally comes in the form of property taxes.
In addition to being backed by their issuer’s ability to tax, General Obligation Bonds are often cited as being the safest type of municipal bond for other reasons as well. Unlike companies which go out of business all the time, municipalities have a stronger incentive to preserve their credit, because they can’t really just go out of business. They need to come back to the bond market for an unlimited amount of time into the future, in order to fund new projects for their residents. Secondly, state Law often sets the conditions under which a municipality can issue GO bonds and the type of security they can use.
As Annette Thau points out in “The Bond Book”, not all General Obligation Bonds are rated AAA (the safest rating) for a reason:
Theoretically that power [to tax] is unlimited because bond indentures state that they are backed by the full taxing power of the issuer. In the real world the power to tax is limited by political and economic considerations….In the event there is an economic crunch who will the issuer pay? Its teachers, its policemen and fire department or its bondholders?
We saw an example of exactly what Annette talked about in her book recently in Harrisburg PA who missed a $5.27 Million payment on their General Obligation Bonds so they could “ensure sufficient cash flow so the citizens of Harrisburg continue to receive essential services.”
There are other examples, but as you can read more about in our article on municipal bond defaults, safety and ratings, the default rate on all types of municipal bonds is around .13%. For General Obligation Municipal Bonds its even lower.
This lesson is part of our Free Guide to the Basics of Investing in Municipal Bonds. Continue to the next lesson here.
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