Bama vs. Clemson. Nunes vs. Rousey. A Patriots and Packers Super Bowl? These hyped up sports match-ups are only marginally more exciting than general obligation bonds vs revenue bonds in the muni world. OK, so muni bonds are not going to get anyone excited unless you want to earn stable, tax-exempt income.
The first step in analyzing a municipal bond is determining the source of revenue that will pay back your investment. There are two main groups of municipal bonds – general obligation and revenue. Understanding the differences and risks of each type can help you become a better muni investor. Let’s dive into the pros and cons of investing in general obligation bonds vs revenue bonds.
General Obligation Bonds vs Revenue Bonds
General Obligation bonds, also known as GO bonds, are backed by the full faith and credit of the municipality. GO bonds can be issued by a state, a city, a county, or really any municipality with taxing power. These bonds are typically backed by ad valorem (property) taxes on all property within the boundaries of the municipality’s taxing authority.
State GO bonds are usually rated higher than city or county GO bonds within the same state. For one reason, the state has much more taxing power as they are able to tax a much larger group of citizens than a local municipality. Thus, state GO bonds are generally considered a safer investment and trade at a lower yield than that of a city or county.
The section of the official statement that explains the GO taxing power is found under the section titled “SECURITY FOR THE BONDS”. The screenshot below shows the language from a recent bond issue for the City of Oakland, California.
It’s important to note in this section it states the city has “the power, is obligated, and has covenanted” to levy taxes without limitation on all property as long as the bonds are outstanding. This means the city is required to raise property taxes to make sure your bond investment is repaid. At least that’s how it is supposed to work but it’s not always that easy.
Watch out for GO bonds that require voter approval to raise property taxes. Most people don’t want to pay more taxes so if the municipality has to bring a tax increase before voters, this increases your risk as a bondholder. GO bonds with the power to raise taxes without voter approval are preferred.
Understanding the financials of a GO can be much more complicated than analyzing a revenue bond. I plan to address detailed GO analysis in upcoming articles.
Here are a few pros and cons of investing in GO municipal bonds.
Pros of Investing in General Obligation Bonds
- Highest level of municipal guarantee: “Full faith and credit”
- Usually has unlimited ad valorem (property) taxing authority
- Can use other available sources of revenue in addition to property taxes to pay debt
- Typically is the highest rated debt of an issuer
Cons of Investing in General Obligation Bonds
- Analysis requires knowledge of fund/governmental accounting
- More impacted by economic downturns and property value declines
- Changes in management can be a risk
- Underfunded pensions can be a huge credit risk to the GO
In summary, GO bonds require quite a bit more analysis than revenue bonds but can be a highly rated source of tax-exempt income. Now we turn to revenue bonds to continue our comparison of general obligation bonds vs revenue bonds.
Revenue bonds can be easier to understand and analyze than GO bonds which is why I like them. These types of bonds are backed by a specific revenue stream which can come from a wide range of fees or taxes including: sales tax, income tax, water and sewer fees, toll road fees, and university tuition fees. I have already covered in-depth how to analyze water/sewer bonds.
Let’s use a city sales tax revenue bond as an example.
Many cities use sales tax revenue bonds to finance their transit systems for light rail or buses. Sales tax bonds are issued to extend a section of track, purchase new buses or trains, or any other use needed to run or expand the public transit system. To borrow money from investors, the city will pledge a percentage of the sales tax collection in order to repay the bondholders. This can be pledged through gross revenue (before expenses) or net revenue (after expenses).
When a consumer buys something, the sales tax is collected by the store or the seller at the point of sale. The seller then submits the sales tax to the taxing authority. The money then flows from the municipality to a fund to be held for debt service on the bonds.
If the city is collecting enough revenue to cover the payments on the debt there should be no problems. It is simply analyzing how much money is coming in against how much money must go out to pay debt. This is measured through the debt service coverage ratio.
This is a bit of simplification but is generally how revenue bonds work. Things can become more complicated when the municipality can transfer sales tax revenue to use for other purposes other than paying back sales tax bonds.
Here are some of the pros and cons of investing in revenue bonds.
Pros of Investing in Revenue Bonds
- Easy to analyze – money in vs. money out
- Debt service coverage ratio is important but easy to measure
- Include “essential service” revenue bonds such as water/sewer
- Pensions have a lower impact on credit risk
Cons of Investing in Revenue Bonds
- Revenue stream can be very narrow such as football ticket sales at a University
- The project the bonds are financing can be a risk (stadium for a pro sports team that could relocate)
- Revenue can be used for other spending needs of the municipality
There is not a clear winner in comparing general obligation bonds vs revenue bonds. Both types of municipal bonds can provide a high-quality source of tax-exempt income. I currently prefer revenue bonds over GO bonds given the funding status of many pension funds is much lower than they should be. Over the next 5 to 10 years the Chicago debt situation is going to get much worse. The pensions will weigh heavily on any losses the Chicago GO bondholders will take. Recently, the Dallas police and fire pensions have been in the news. I also recently posted an article on Seeking Alpha describing the crisis in Puerto Rico and their pension system.
There are very good GO’s out there you just have to know what to look for. Building a balanced muni bond portfolio includes investing in a mix of GO and revenue bonds from a diversified group of issuers.