How Does a General Obligation Bond Work? (Detail Explanation)

General obligation bonds are municipal bond which are backed by the ability of Government agency/entity to earn the revenue.

The revenue can be made by the Government agency/entity in the form of tax revenues or any operating income from the projects. 

So, there is no collateral for the bonds but the creditworthiness of the governmental entity issuing the bonds. The proceeds from the issuance of the bonds can be invested by the Government body/agency in the development of the projects.

Further, it’s important to note that these bonds are different from revenue bonds, although both types of loans are municipal loans.

The difference is that the repayment for the revenue bonds can be made with the income generated from the projects/operating income. On the other hand, for the General Obligation bonds, the repayment can be made with income and taxes.

The working mechanism of General Obligation Bonds

The working mechanism of the General obligation bonds is simple and easy to understand. Consider municipality is to construct some park and needs finance to do so. The municipality issues the General obligations bonds and gets finance to build the park.

Since general obligation bonds are backed by operating income and the Municipality’s power to collect the taxes, the investors feel comfortable because the Government can manage the revenue and taxes to pay back their investments.

So, these loans generally receive higher credit ratings due to the lower probability of default.

Types of the General Obligation Bonds

General Obligation Bonds have two main types: Limited tax general obligation and the Unlimited General Obligation bond. Let’s discuss the types and the differences between them.

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Limited General Obligation bond

The Limited General Obligation bonds are the bonds that are secured by the limited taxing power of the issuing government authority.

For instance, the repayments of the loan’s principal and interest may be backed/guaranteed by the ability of the municipalities to raise the taxes on the property.

For instance, if the county hospital is re-constructed by the Government entity using Limited General obligations bonds.

The repayment of the bond’s principal and interest can be made by raising the taxes on medical services provided by the county hospital.

So, the tax base of the limited general obligation bonds is narrower. Hence, the yield for this type of loan is higher as the taxation base is lower.

Unlimited General Obligation bond

The unlimited General Obligations bonds are the bonds secured by the unlimited taxing power of the issuing authority. The municipality can raise taxes by several tax sources, including property tax, special tax, sales tax, etc.

These types of loans carry lower risk as the ability of the Government to collect the taxes is higher. Hence, these bonds have a lower interest rate as the taxation base for the repayments of the bonds is higher and the risk is lower.

Advantages of General Obligation Bonds

Strong guarantee

The guarantee from the Government is considered to be a vital motivating factor for the investments. That’s because of the higher bargain power of the Government and higher competence to complete the projects.

For instance, during the project’s progress, the Government comes to know that they need to raise the budget for the completion of the project. They can issue further bonds, making it difficult for private lenders to raise funds and default immediately.

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Higher safety

The power of the Government to collect tax is considered to be an excellent and safe investment. It increases the level of comfort for the investors that their investment is in safe hands, and the chances of default are lower.

In addition to this, general obligation bonds have a greater level of safety than other municipality bonds as these bonds are backed by the power of the Government to collect the taxes rather than operational revenue from any specific project.

Tax-free income

The interest earned on the General Obligations Bonds is free from the federal income tax. If the state of your residence issues the bonds, the income is generated even exempt from the state income tax.

This sort of investment opportunity is specifically viable for the individuals paying taxes in the higher bracket.

As the effective rate of the interest after tax increases for the investor. Hence, it can be an excellent opportunity for the people paying higher taxes.

Disadvantages of General Obligation Bonds

Lower yield

The General obligation bonds carry a lower rate of interest due to higher safety and lower risk. The problem with general obligation bonds is that they even pay lower interest than other municipal bonds like revenue bonds.

So, the investors need to decide between the rate of the return and their ability to presume the risk from the investment.

In addition to this, the investment is made to earn the return. So, it should be if the investment can be made in the corporate bonds that yield higher profits.

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Credit risk

Although it’s rare sometimes, local Government bodies go bankrupt. So, the investors must assess credit risk before making investments in the General Obligation Bonds. The assessment can ensure that the bond issuing authority is competent enough to collect the taxes.

There are no obligations that restrict the Government’s authority to pay off the interest and principal for the bonds.

Other types of the Municipal loan

Municipal loans are not limited to revenue bonds and general obligation bonds. Several other types of bonds issued by the municipal include anticipation loans, pre-refunded loans and, insurance bonds, etc.

However, all of these bonds carry a lower interest rate than corporate bonds because of the lower risk as the Government backs it.

In conclusion, general obligation bonds can be an excellent investment opportunity for investors looking for higher security and exemptions from the tax. Further, these bonds can be used to balance the risk profile of the investment portfolio.