General Obligation Bonds: How Municipal GO Bonds Work

Introduction to General Obligation Bonds

Two types of municipal bonds exist: revenue bonds and general obligation (GO) bonds. General obligation bonds offer investors a relatively safe investment opportunity while providing states and local governments with funds for community improvement. These bonds are debt instruments issued by states and local governments to raise funds for public works. General obligation bonds are backed by the full faith and credit of the issuing municipality — that is, the municipality commits its full resources to paying bondholders, including general taxation and the ability to raise additional funds through credit. The ability to back up bond payments with tax funds is what makes GO bonds distinct from revenue bonds, which are repaid using the revenue generated by the specific project the bonds are issued to fund.

General obligation bonds give municipalities a means to raise funds for projects that do not provide direct sources of revenue, such as roads, bridges, and parks. As a result, GO bonds are typically used to fund projects that serve the entire community.

The primary reason municipal GO bonds are such low-risk investments is that they are backed by the full faith and credit of the municipalities that issue them. The municipalities can apply funds raised from various kinds of taxes. The default risk of GO bonds is low since the municipality has the option of raising taxes to meet its obligations.

How GO Bonds Are Repaid

States and local municipalities that levy income or sales taxes may apply the revenue they generate to pay principal and interest on GO bonds. Various kinds of fees, such as license fees, can be used as well. Most cities, towns, and villages, however, typically rely on various kinds of taxes based on the value of private and business holdings within the municipality. Property and real estate taxes are the most common types of taxes available to municipalities.

Municipalities may also repay bondholders by borrowing more money. When interest rates decrease, municipalities may call a bond issue, which means the bond issuer repays the principal before the bond matures. The municipality may then re-fund the debt by making a new bond issue at a lower interest rate.

Because the credit of a municipality stands behind them, GO bonds typically carry high bond ratings reflecting the municipality's power of taxation. A city always has the option of raising tax rates or levying new taxes in order to meet its obligation to bondholders. As a result, municipalities rarely default on GO bonds. GO bonds typically rate alongside U.S. Treasury securities and high-grade corporate bonds in terms of investor confidence. However, the trade-off for safety is lower returns. General obligation bonds typically pay lower interest than revenue bonds because the credit behind them makes the possibility of default low. Many GO bonds offer tax-free returns, however, which can compensate for lower interest rates — especially for investors in higher tax brackets. For example, for an investor in the 28% tax bracket, a 5% yield from a tax-free municipal issue would be equivalent to a 6.9% yield from a taxable bond issue.

Investment Characteristics of GO Bonds

General obligation bonds, like most municipal bonds, are typically sold in denominations of $5,000. While it is sometimes possible to buy directly from the municipality, most GO bonds are purchased on the secondary market. If GO bonds are bought through secondary dealers such as brokers, a minimum purchase of $25,000 or more may be required.

Several opportunities exist for investors who want the benefits of GO bonds without the high purchase prices. A number of mutual fund companies offer shares in managed open-end or closed-end municipal security funds. Another alternative is a unit investment trust, an unmanaged pool of GO bonds. These pooled funds give investors a chance to participate in a diversified portfolio of municipal bonds without the need to lay out a large initial sum. A typical minimum purchase for these pooled investments is $1,000.