Municipal bonds, also known as muni bonds, are debt issued by states, cities, and counties to fund projects. They fall into many categories. Two key types are general obligation bonds and revenue bonds.
Both are sold to raise money for income-producing projects, such as toll roads, bridges, or parks. The key difference is the source of the revenue used to make the bond's interest and principal payments. Here's what you need to know if you're thinking of investing in this type of bond.
- General obligation bonds are issued by municipalities. They're backed by the full faith and credit of the issuer.
- Revenue bonds are issued by municipalities and fund projects. They're backed by the revenues the projects bring in.
- Other types of municipal bonds include essential service bonds, anticipation notes, pre-refunded bonds, and insured bonds.
What Are General Obligation Bonds?
General obligation bonds are also referred to as GOs. They're bonds that are backed by the “full faith and credit” of the issuer, with no project cited as the source of funds with which to repay the bond obligation.
In other words, the municipal issuer can make interest and principal payments using any source of revenue that's available to them. It might be tax revenues, fees, or the issuance of new securities. The municipality can raise taxes to offset the shortfall if it encounters fiscal troubles. GOs are seen as being relatively safe for this reason. Defaults are rare.
It's far less likely that an entire municipal government will face serious financial hardship than it is that a municipal project to fail to produce its anticipated income. You can buy GO bonds directly. But many mutual funds and exchange-traded funds (ETFs) make the process easier by specializing in general obligation securities.
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 investors.
What Are Revenue Bonds?
Revenue bonds are backed by the revenue produced by a project being financed by the bond issuer. In other words, the money raised by the bond offering directly finances the project. Once complete, the project produces the revenues to pay back the interest and principal on the bonds to investors.
Projects might include hospitals, airports, toll roads, housing projects, convention centers, bridges, and similar endeavors. Revenue bonds are often higher risk than general obligation bonds. They tend to offer higher yields as a result.
What Are Essential Services Bonds?
“Essential services” revenue bonds include projects related to water, sewer, and power systems. The revenue from such projects is seen as being more reliable, so these bonds are seen as having a lower amount of risk than bonds that are financed by revenue from non-essential services. Perceived lower risk is reflected in the slightly lower-interest-rate returns of essential services bonds compared with the returns of other revenue bonds.
Most bond fund managers will invest in a combination of general obligation and revenue bonds. The fund company will offer more details of the investments carried within a fund.
Other Types of Municipal Bonds
Revenue and general obligation bonds aren’t the only type of municipal securities out there. You can choose from a few other options as well.
Anticipation notes are short-term bonds that municipalities may offer in anticipation of a larger, longer-term bond offering for the same project. They're often issued later in the project's development.
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. Funds from the new bond are held in escrow and invested in U.S. Treasuries until the original bond's call date. As such, these bonds provide you with a low risk similar to Treasury Notes while still offering the tax-free advantage of a municipal bond.
Insured bonds are those issued by smaller municipalities. They're often guaranteed by a third party. The process consists of the guarantor buying the entire bond issuance and insuring or otherwise guaranteeing it. It then issues the insured bonds to investors. They offer lower interest rates than other, similar uninsured bonds because of the guarantee.