The tax-free municipal bond market is massive. It is the mechanism through which cities, counties, and states build roads, schools, hospitals, airports, sewage facilities, water lines, and so much more. Yet, not all municipal bonds are created equally. From a broad perspective, there are two categories of municipal bonds. The first are known as General Obligation bonds, or GO bonds, for short. The second are known as Revenue bonds.
These two types of municipal bonds differ in the source of cash flows that will be responsible for repaying the investors who provide the capital to issue the bonds. This brief rundown will explain the major differences, and explain which of the two has been a safer choice, historically. This can empower you to know which type of securities you are adding to your portfolio and, I hope, allow you to sleep better at night by understanding what it is you actually own.
General Obligation Municipal Bonds
The broadest, and often most secure, type of municipal bonds are known as General Obligation bonds. These are backed by the full faith and credit of the issuer, including the power of the municipality to tax its citizens. From tiny towns in the middle of the country to massive states like California, municipal bonds vary wildly in strength based on the population, demographics, and economic diversity of the citizens living and working in the territory, as well as the debt levels and budgetary outlook of the government entity issuing the bonds.
Many investment analysts divide General Obligation municipal bonds into two subcategories:
- Unlimited Tax General Obligation Bonds: These municipal bonds are backed by the total taxing power of the issuer. It can often use property taxes, sales taxes, special taxes, and other sources of income to repay the bonds, as well as the interest owed to investors.
- Limited Tax General Obligation Bonds: These municipal bonds are backed by specific, narrow taxing power. For example, a town might pass a bond to build a bridge and agree to a 1¢ increase in sales tax for every $1.00 generated within the city limits for five years to pay for the debt.
Throughout the past century, General Obligation municipal bonds have been among the safest bonds issued in the world. A significant contributor to this safety is the fact that most of these types of bonds are only created when taxpayers vote on bond issues. That means the population of an area is committed to the expenditure, and there is often more than sufficient assets or taxing power built into the voting language to repay the investors who provide the funds.
Revenue Municipal Bonds
A revenue bond issued by a municipality is one that is backed by a specific stream of revenue. For example:
- A city may build a stadium or convention center and then require usage fees when it is booked for major concerts, meetings, or sporting events, with the fees supporting the bonds.
- A municipality might build an airport and then levy fees on the airlines that fly into the airport, the stores located in the terminal, the parking garages that passengers use to park their cars, and fees applied to individual flight tickets bought by customers.
- A county may build a hospital, which will then use cash from regular, ongoing operations to pay back the bonds.
- Sewage bonds are issued by municipalities to build water lines and sewage treatment facilities. The bonds are repaid using usage fees and assessment fees.
Which Is Better - General Obligation Municipal Bonds or Revenue Municipal Bonds?
As is the answer with most things in life, it depends on the specifics of the municipal bond issue you are considering buying or selling, as well as the price at which you enter into a transaction. However, as a general rule, all else equal, General Obligation municipal bonds are safer and less likely to default than Revenue municipal bonds. The reason, which you have already guessed, is that the municipality has a broader source of potential cash sources into which it can dip if it finds itself unable to make the interest payments or repay the money it was loaned when the bill comes due at the maturity date. Nevertheless, don't rely on that rule because it isn't always true.
Beyond this, don't forget that inflation can be a major enemy of your municipal bond portfolio and that you might want to utilize a municipal bond laddering strategy if you are worried about the future of interest rates.