The tax-free municipal bond market is massive. After all, it is the mechanism through which cities, counties, and states build roads, schools, hospitals, airports, sewage facilities, water lines, and much more.
Yet, when examining bond listings and their information, it quickly becomes apparent that not all municipal bonds are created equally. Generally speaking, there are two categories of municipal bonds. The first is known as general obligation bonds (GO), and the second is known as revenue bonds.
General obligation and revenue bonds differ in the sources of cash flows that are responsible for repaying the investors who provide the capital when the bonds are issued.
- General obligation municipal bonds are bonds guaranteed by the entity that issued them to fulfill the promise of returns or value.
- Revenue municipal bonds are bonds issued with a source of revenue providing the guarantee of returns or value.
- Both types can be good investments as long as they fit your investing strategy and that you're certain that there is a low risk of default and low inflation rate risk.
General Obligation Municipal Bonds
The broadest and often most secure type of municipal bond is known as general obligation bonds. These bonds 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 cities in 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. The debt levels and budgetary outlook of the government entity issuing the bonds also play a role.
Many investment analysts divide general obligation municipal bonds into two subcategories; unlimited tax and limited tax obligation bonds.
Unlimited Tax General Obligation Bonds
These municipal bonds are backed by the total taxing power of the issuer. Therefore, it can use property taxes, sales taxes, special taxes, and other sources of income to repay the bonds, as well as the interest owed to investors.
The key difference between the two is how much the municipality can tax the population to repay the bond holders.
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 $.01 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. This is because the population of an area is committed to the expenditure (through work and taxes), and there are often sufficient assets or taxing power to repay the investors.
Revenue Municipal Bonds
A revenue bond issued by a municipality is backed by a specific stream of revenue. Some examples could be:
- 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; the fees might support 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.
- Municipalities issue sewage bonds to build water lines and sewage treatment facilities. The bonds are repaid using usage fees and assessment fees.
Bond Safety Varies by Issuer
As is the answer with most things in life, it depends. In this case, 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, all other things being equal, general obligation municipal bonds are safer and less likely to default than revenue municipal bonds.
The safety of general obligation municipals lies in taxes. Revenues are never guaranteed, but taxes will always be collected.
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.
Beyond this, don't forget that inflation can be a major enemy of your municipal bond portfolio. You might want to utilize a municipal bond laddering strategy if you are worried about the future of interest rates. Laddering is a method of splitting an investment amount into smaller portions with a series of bond purchases. Each bond has a maturity occurring after the previous bond.
Remember that when added to a well-rounded investment portfolio—known as a diversified portfolio—stuffed with stocks, real estate, and other cash-generating assets, municipal bonds can be a good source of passive income for retirement and often are available tax-free.