Municipalities and Special Districts issue bonds to finance civic oriented projects ranging from municipal parking lots, hospitals, water and sewer facilities, aviation, recreation facilities, and many more ideas, both good and farfetched, that citizens want or politicians think they can promote in hopes to have a building named after them.
In general, bonds are either Revenue Bonds or General Obligation bonds.
Bonds that have the financial backing of the taxpayer base within a district are General Obligation or GO Bonds. The municipality or special district issuer raises taxes and creates a special account for such tax receipts to pay principal and interest to the bondholders. Taxes used for GO Bonds include property, income, sales and others. Usually these bonds generate federally tax-free interest income to the bondholders.
Bonds that use non-tax dollars to pay bond principal and interest are Revenue Bonds. Revenue Bonds secure payment from the revenue flow from the projects for which the bond was issued such as water payments, parking lot receipts, stadium receipts and many more. The yield on Revenue Bonds usually is higher because the revenue source for repayment (taxpayers pay GO Bonds v. users pay Revenue Bonds) is riskier than with GO Bonds.
Most municipal bonds are callable earlier than the stated maturity date thus changing the overall yield to maturity. The call provisions usually favor a municipality or special district during eras when interest rates are falling and the issuer can re-fund the bonds at lower rates. Re-funding bonds can happen only once or the IRS may recharacterize the tax-favored treatment.
The post-2008 financial era in the USA has risks above and beyond cyclical interest rate fluctuations. Ratings on GO and Revenue Bonds by the major rating firms are in flux in a never-before-seen manner due to the downgrade of sovereign debt worldwide and due to taxpayer inability to pay. Debt risk is higher than ever.
Risk is an ethereal subject. More on risk later…..