There are over 80,000 issuers of municipal bonds in the United States. With so many different types of issuers, ranging from states to cities, transportation systems, school districts, hospitals, and housing projects, investors should understand the key differences and nuances associated with the two most basic types of bonds: general obligation bonds and revenue bonds.
When a state, city, hospital or any other issuer issues a bond, the issuer expects to pay back the borrowed money at some point in the future. The issuer guarantees repayment of the money in one of two basic ways:
- Taxation: such as income taxes, property taxes, sales taxes, etc.
- Revenues: by collecting revenues from the project financed with the bonds.
General Obligation Bonds (GO bonds)
When a state, city or other issuer issues general obligation bonds, this means that the issuer is guaranteeing repayment of the bonds using any means necessary. The full faith, credit, and taxing power of the issuer are backing the bonds. The issuer is going to use any taxation power in its authority to make sure you get paid back, putting the revenues from every type of tax on the hook to guarantee the bonds: income taxes, corporate taxes, property taxes, sales taxes, excise taxes, gas taxes, any tax that can be levied by the issuer. This is why it is called a general obligation bond: the issuer is generally obligated. If the issuer has any problems paying you back, they must raise taxes or come up with the money somehow, some way. The issuer may even have to sell assets to do it. If they miss a payment, known as a “default”, a judge can order the issuer to take corrective action to raise money to satisfy the bondholders.
The most common issuers of general obligation (GO) bonds are:
- Cities and towns
- School districts (school districts rely on the local town, city, or a group of municipalities that belong to the district to guarantee repayment.)
Revenue bonds distinguish themselves from general obligation bonds through their method of repayment; unlike GOs which rely on taxation, revenue bonds are guaranteed by the specific revenues generated by the issuer.
The most common issuers of revenue bonds are:
- Transportation systems
- Power systems
- Sewer systems
- Water systems
- Other local authorities that generate revenues from providing services to the public
For instance, the Bay Area Rapid Transit Authority (BART) and New York City’s Metropolitan Transportation Authority are public transportation systems: they operate metro buses, light rail and subways. BART and MTA generate revenues from selling train tickets and bus tickets to the public. When BART or MTA wants to buy new trains or buses, improve tracks, or build new train stations, they issue bonds to make capital investments. The bonds issued are then guaranteed to be paid back from the revenues that the transport systems receive from selling tickets to the public. This is why it is called a revenue bond.
Another example: Water districts can issue revenue bonds with the revenues from people’s water bills guaranteeing the repayment of the bonds. Water, power, and sewer services are considered essential services. This means that bondholders can generally feel secure in knowing that people will pay their water, sewer, and electric bills as the services are essential to living in a modern society. People may skip out on other bills before they stop paying for electricity, water, or sewer services.
For comparison purposes, hospitals can also issue bonds that get paid back from the revenues generated from providing medical services. The problem with hospital bonds is that if the revenues are not sufficient to make interest payments or pay back the bonds, the prices of the hospital’s services cannot necessarily be increased without resulting in even fewer patients. With water, sewer, and power, there is usually only one provider for a given locality (a natural monopoly); this means that the prices can be increased without too much risk of people shutting off the water or power in their homes. Certain types of revenue bonds have much better track records of repayment than other types.
If you are looking to invest in the municipal bond market, it’s important to understand where the guaranteed repayment money comes from. Taxation and revenue backed munis each carry various risk levels dependent on the economic health of the issuer. Be wary of default risk and track records but keep in mind that when invested in wisely, muni bonds can prove to be a great and profitable tax shield for investors in higher tax brackets.