General Obligation Bonds and Revenue Bonds
The Relative Risks of General Obligation Bonds and Revenue Bonds
Municipal bonds – or the debt issued by states, cities, and counties to fund projects – fall into several categories. The most important types to know are general obligation bonds and revenue bonds. The key difference between these two types of municipal (also known as muni) bonds is the source of the revenue used to make interest and principal payments.
What Are General Obligation Bonds?
General obligation bonds, also called GOs, are bonds that are backed by the “full faith and credit” of the issuer, with no specific project identified as the source of funds. In other words, the municipal issuer can make interest and principal payments using any source of revenue available to them, such as tax revenues, fees, or the issuance of new securities. This means that if the municipality encounters fiscal difficulty, it can raise taxes to offset the shortfall. GOs are therefore seen as being relatively safe, and defaults are rare.
It is far less likely that an entire municipal government will face serious financial difficulty than for specific municipal project to fail to generate its anticipated income. Investors can buy general obligation bonds directly, but there are several mutual funds and exchange-traded funds (ETFs) that specialize in general obligation securities, among them is Vanguard's Tax-Exempt Bond ETF (symbol VTEB), a passively-managed municipal bond index security. Investing in a municipal bond fund or ETF offers a degree of diversification unavailable to all but the most affluent investors.
What Are Revenue Bonds?
Revenue bonds are bonds that are backed by the revenue generated by the specific project being financed by the bond issue. In other words, the money raised by the bond offering finances the project, and the project – once complete – generates the revenues to pay the interest and principal on the bonds. Projects could include hospitals, airports, toll roads, housing projects, convention centers, bridges, and similar endeavors. Revenue bonds are generally higher risk than general obligation bonds, and as a result, they typically offer higher yields.
Within the revenue bond category, there are also “essential services” revenue bonds, which include projects related to water, sewer, and power systems. Since the revenue from such projects is seen as being more reliable, essential services revenue bonds are seen as being lower risk than bonds financed by revenue from non-essential services. That perceived lower risk is reflected in the slightly lower returns of essential services bonds compared with the returns of other revenue bonds.
Typically, most bond fund managers will invest in a combination of general obligation and revenue bonds. Literature provided by the fund company will provide an idea of how a specific fund is invested.
Other Types of Municipal Bonds
Revenue and general obligation bonds aren’t the only type of municipal securities. Investors also can choose from:
- Anticipation notes, which are short-term bonds municipalities may offer in anticipation of a larger, longer-term bond offering for the same project, generally issued later in the project's development.
- Pre-refunded bonds. The term "pre-refunded" refers to callable bonds that have been effectively paid off by issuance of another lower-interest bond before the original bond's call date. Until the original bond's call date, funds from the new bond are held in escrow and invested in U.S. Treasuries. As such, pre-refunded bonds represent a low risk to investors similar to the risk of Treasury Notes while still offering the tax-free advantage of a municipal bond.
- Insured bonds, often those issued by smaller municipalities, which have been guaranteed by a third party. The process usually consists of the third-party guarantor purchasing the entire bond issuance, insuring or otherwise guaranteeing it, then issuing the insured bonds to investors. Because of the guarantee, they offer lower interest rates than other, similar uninsured bonds.
To learn more about these types of municipal bonds, read Types of Municipal Bonds.
About Money does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.