The tax-free municipal bond market is massive. It provides the funding through which cities, counties, and states build their roads, schools, hospitals, airports, sewage facilities, water lines, and much more. But not all municipal bonds are created equally.
There are two types of municipal bonds: general obligation (GO) bonds and revenue bonds. They differ in the sources of cash flows that repay the investors who provide the capital when the bonds are issued.
- General obligation (GO) municipal bonds are guaranteed to fulfill the promise of returns or value by the entities that issue them.
- Revenue municipal bonds are issued with a source of revenue guaranteeing returns or value.
- Both types of bonds can be good investments as long as they fit your goals and you're certain that there's a low risk of default and low inflation rate risk.
General Obligation Municipal Bonds
The general obligation bond is the broadest and often most secure type of municipal bond. These bonds are backed by the full faith and credit of the issuer. This includes the power of the municipality to tax its citizens.
From tiny towns in the middle of the country to massive cities in states like New York, municipal bonds vary a great deal in strength based on the population, demographics, and economic diversity of those who live and work there. The debt levels and budgets of the entity that's issuing the bonds also play a role.
Many analysts divide general obligation municipal bonds into two subcategories: unlimited tax and limited tax obligation bonds.
Unlimited Tax General Obligation Bonds
These bonds are backed by the total taxing power of the issuer. It can use property taxes, sales taxes, special taxes, and other sources of income to repay the bonds, as well as the interest owed on them.
The key difference between the two is how much the municipality can tax the population to repay the bondholders.
Limited Tax General Obligation Bonds
These bonds are backed by narrow taxing power. A town might pass a bond to build a bridge to pay for the debt. It then agrees to a $.01 increase in sales tax for every $1.00 generated within the city limits for five years.
General obligation municipal bonds have been among the safest bonds issued in the world for years. The population of an area is committed to the expenditure through work and taxes. There are often plenty of assets or taxing power to repay the investors.
Revenue Municipal Bonds
A revenue bond is backed by a certain stream of revenue. A city may build a stadium or a convention center. Then it requires usage fees when it's booked for major concerts, meetings, or sporting events. These fees might support the bonds.
A city might build an airport. Then it levies fees on the airlines that fly into it. It also levies fees on the stores that are located in the terminal. It might also charge fees for the parking garages that passengers use and to flight tickets purchased by consumers.
Municipalities issue sewage bonds to build water lines and sewage treatment facilities. The bonds are repaid through usage fees and assessment fees.
Bond Safety Varies by Issuer
The safety of bonds can depend on the municipal bond issue you're thinking about buying or selling. It can also depend on the price at which you enter into a transaction. But general obligation bonds are safer. They're less likely to default than revenue bonds.
The safety of general obligation bonds lies in taxes. Revenues are never guaranteed. Still, taxes will always be collected.
A municipality has a broader source of potential cash sources. It can dip into these sources if it finds itself unable to make the interest payments or repay the money it was loaned.
But inflation can be a major enemy of your municipal bond portfolio. You might want to make use of a municipal bond laddering strategy if you're concerned about the future of interest rates. This is a method of splitting an investment amount into smaller portions with a series of bond purchases. Each bond has a maturity date after the prior bond.