General Obligation Bonds Term Paper

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Obligation Bonds

Two types of municipal bonds exist, revenue bonds and general obligation (GO) bonds. General obligation bonds offer investors a relatively safe investment opportunity while providing states and local governments with funds for community improvement. These bonds are debt instruments issued by states and local governments to raise funds for public works. General obligation bonds are backed by the full faith and credit of the issuing municipality. That is, the municipality commits its full resources to paying bondholders, including general taxation and the ability to raise more funds through credit. The ability to back up bond payments with tax funds is what makes GO bonds distinct from revenue bonds, which are repaid using the revenue generated by the specific project the bonds are issued to fund.

General obligation bonds give municipalities a means to raise funds for projects that do not provide direct sources of revenue such as roads, bridges, and parks. As a result, GO bonds are typically used to fund projects that serve the entire community.

The primary reason municipal GO bonds are such low-risk investments is that they are backed by the full faith and credit of the municipalities that issue them. The municipalities can apply funds raised from various kinds of taxes. The default risk of GO bonds is low since the municipality has the option of raising taxes to meet its obligations.

States and local municipalities that levy income or sales taxes may apply the revenue they generate to pay principal and interest on GO bonds. Various kinds of fees, such as license fees, can be used as well. Most cities, towns and villages, however, typically rely on various kinds of taxes based on the value of private and business holdings within the municipality. Property and real estate taxes are the most common types of taxes available to municipalities.

Municipalities may also repay bondholders by borrowing more money. When interest rates decrease, municipalities may call a bond issue, which means the bond issuer repays the principal before the bond matures. The municipality may then re-fund the debt by making a new bond issue at a lower interest rate.

Because the credit of a municipality stands behind them, GO bonds typically have high bond ratings because of the municipality's power of taxation. A city always has the option of raising tax rates or levying new taxes in order to meet its obligation to bondholders. As a result, municipalities rarely default on GO bonds. GO bonds typically rate with U.S. Treasury securities and high-grade corporate bonds for investor confidence. However, the trade-off for safety is lower returns. General obligation bonds typically pay lower interest than revenue bonds because the credit behind them makes the possibility of default low. However, many GO bonds offer tax-free returns, which can make up for lower interest rates, especially for investors in higher tax brackets. For example, if one were in the 28% tax bracket, a 5% yield from a tax-free municipal issue would be equivalent to a 6.9% yield from a taxable bond issue.

General obligation bonds, like most municipal bonds, are typically sold in denominations of $5,000. While it is sometimes possible to buy directly from the municipality, most GO bonds are purchased on the secondary market. If GO bonds are bought through secondary dealers such as brokers, a minimum purchase of $25,000 or more may be required.

Several opportunities exist to buy into pools of GO bonds for investors who want the benefits of GO bonds without the high purchase prices. A number of mutual fund companies offer shares in managed open-end or closed-end municipal security funds. Another alternative is a unit investment trust, an unmanaged pool of GO bonds. These pooled funds give investors a chance to participate in a diversified portfolio of municipal bonds without the need to lay out a large initial sum of money. A typical minimum purchase for these pooled investments is $1,000.

Credit Consequences of General Obligation Bonds

The major rating agencies examine four primary credit areas when reviewing GO bonds and providing a rating. These areas include an issuer's debt position, financial performance, the quality of its management, and the local economy strength. Typical debt analysis begins with a review of debt structure, including amortization, and key ratios. Trends in debt levels and the impact of future capital needs and plans are considered. The existence of clear policies and practices relating to debt management, affordability, and planning is viewed positively. Analysis of finances focuses on consistency of operating results over time, as well as fund balances levels relative to expenditures or revenues.

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Financial performance is closely related to an entity's debt, economic, and management quality. The economic activity in the surrounding area provides the foundation for a government's debt and fiscal patterns. Economic activity as a generator of tax revenue is the primary basis from which a government's entity is able to pay debt. Finally, a government entity's ability to manage its resources optimally is reflected in its debt's credit rating in numerous ways.

To properly assess local debt properly, all borrowing supported by the same tax base must be included. The types and proportions of debt utilized and the payment structure should be noted. The overall debt structure is broken down into direct debt and overlapping debt. Direct debt is debt for which the government itself is responsible for and is backed directly by tax revenue minus any debt that is self-supporting from enterprise operations. Direct tax-supported debt is all obligations of an entity paid from tax sources, including GO bonds, special tax bonds, lease-secured obligations, and capital leases. Overlapping tax-support debt is the debt of other jurisdictions having the same tax base. Debt is treated as self-supporting if debt service has been paid from an enterprise-operation. Such debt generally is deducted in the calculation of net tax-supported debt only if the user-charged supported system has been paying all its expenditures, including debt service, from non-tax sources for at least three consecutive years.

Most local tax-supported debt is from GO bonds, payable from either limited or unlimited property taxes. Where the debt service is to be paid from a limited tax, one must determine how much debt capacity remains within the legal limitation, what other expenditures the tax supports, and the entity's overall financial flexibility. Generally, where significant additional margin exists or where the entity has demonstrated a historical financial flexibility to operate within the limitation.

Debt structure is reviewed to ensure that the length of outstanding bonds is approximately matched to the useful life of the assets being financed. A debt maturity schedule that is average in its amortization rate is a 25% principal payout in 5 years and 50% in 10 years; rapid amortization is more than 35% in 5 years and 60% in 10 years. The structure of any refunding bond issue should be analyzed to determine the impact on the issuer's overall amortization and payment structure, particularly if current debt obligations are deferred to the future to achieve short-term budget relief.

The level of debt service as a percentage of a borrower's budget affects overall financial flexibility. All things being equal, limited and single-purpose governments have higher debt service levels proportionate to their budgets than governments who offer a broader array of services. If debt service is above 10% of expenditures or revenues, this may constitute a budgetary concern. This concern is mitigated to the extent that amortization is above average and the debt service structure is declining as opposed to back loaded or level.

The trend in debt in relation to resources is often analyzed. Sustained growth in debt may ultimately overburden a tax base and reduce economic viability. Similarly, rapid growth in an entity's debt service obligation may strain budget and tax resources and reduce flexibility. Conversely, debt reduction generates tax and economic capacity to the extent that infrastructure necessary for economic growth is not under funded. Also, variable rate debt should not make up more than 15%-20% of total direct debt.

Analysis of debt burden focuses on overall ratios that include the debt of overlapping and underlying units. Various ratios are used to measure the burden of debt on a community. These measures are direct tax-supported debt per capita and as a percentage of market value of taxable property, and overall tax-supported debt per capita and as a percentage of market value of taxable property and overall debt per capita and as a percentage of market value. Direct debt ratios look solely at the entity's debt, while overall ratios include the debt of overlapping or underlying units, as these ratios best reflect the overall burden to a community.

While direct debt ratios indicate the burden on the entity of its own capital costs, overall ratios best measure the debt that must be serviced by the community's tax base. Debt per capita is a good initial indicator of local debt burden and the ability of local residents to support such debt through taxes. However, the use of this financial ratio has limitations.….....

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