Municipal bonds can be classified as either revenue bonds or general obligation bonds. The difference relates to the sources of money used to pay interest and principal on the bonds. Revenue bonds receive money from a specific project, and general obligation bonds draw from a broader taxing authority.
Advantage: Full Tax-Power Backing
General obligation bonds can be issued by states, cities or other local governmental units. Money raised by the sale of bonds is typically used to fund local projects. The money to pay back bonds comes from the taxing authority of the issuing government. Payments on the bonds are an obligation of the city or state, and the governmental entity can use any of the tax revenue it receives to pay on the bonds. If more money is needed, the local government has the power to increase taxes to get additional money to cover general obligation bond interest and principal payments.
Advantage: High Level of Safety
The backing of the full taxing power of a government for a general obligation bond provides more security that bond payments will be made when due. This is in contrast to a revenue bond, which receives money only from the specific project funded by the bond proceeds. If the project does not generate revenue as predicted, revenue bond holders may not receive interest or a repayment of principal. General obligation bonds have the same credit rating as the issuing city or state government.
As with all municipal bonds, the interest earned from general obligation bonds is exempt from federal income tax. If you buy bonds issued by the the state or city governments located in your state of residence, the interest earned is also exempt from state income taxes. Tax-free income can result in a higher level of after-tax income for high-tax-bracket investors. For example, if an investor with a combined 40 percent tax bracket buys double tax-exempt municipal bonds yielding 4 percent, the taxable-equivalent yield is 6.67 percent.
Disadvantage: Lower Yields
The higher credit ratings and perceived safety of general obligation bonds make them more attractive than revenue bonds to investors. As a result, the interest rates paid by general obligation bonds are lower than the rates earned from other types of municipal bonds. Municipal bond issuers with the highest credit ratings pay the lowest interest rates on issued general obligation bonds. Investors must decide between the highest level of safety and low yields or a lower level of safety and a higher interest yield.
Disadvantage: Safety Related to Issuer
Although general obligation bonds are backed by the full taxing power of the issuer, investors should be aware that some bond issuers have lower credit ratings. Before buying a bond, an investor should research the tax revenues of the issuer and whether enough taxes are collected to safely cover the issuer's budget and debt obligations. Raising taxes is an easier proposition for some governmental units than others. Local laws and tax rules can affect the overall safety of a specific general obligation bond.
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