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.
Both types of bonds are sold to raise money for income-producing projects, such as toll roads, bridges, or parks. The key difference between the two types of municipal bonds (also known as muni) is the source of the revenue used to make the bond's interest and principal payments.
- General obligation bonds are issued by municipalities are backed by the full faith and credit of the issuer.
- Revenue bonds are issued by municipalities and fund projects; they are backed by the revenues the projects bring in.
- Other types of municipal bonds are essential service bonds, anticipation notes, pre-refunded bonds, and insured bonds.
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 to repay the bond obligation.
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 a specific municipal project to fail to generate its anticipated income. Investors can buy GO bonds directly, but several mutual funds and exchange-traded funds (ETFs) make the process easier by specializing in general obligation securities. For example, Vanguard's Tax-Exempt Bond ETF (VTEB) is 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 of investors.
What Are Revenue Bonds?
Revenue bonds are another type of muni bond. They are backed by the revenue generated by a specific project being financed by the bond issuer. In other words, the money raised by the bond offering directly finances the project, and the project—once complete—generates the revenues to pay back the interest and principal on the bonds to investors.
Projects could include hospitals, airports, toll roads, housing projects, convention centers, bridges, and similar endeavors. Revenue bonds are generally of higher risk than general obligation bonds, and as a result, they typically offer higher yields.
Essential Services Bonds
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 viewed as having a lower amount of risk than bonds financed by revenue from non-essential services. That perceived lower risk is reflected in the slightly lower-interest-rate 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 offer more details of the investments carried within a specific fund.
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 issuing 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, are generally 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.