General Obligation Bonds: Repaid by the Taxpayer

Investing doesn’t have to be as complicated as you might think it is. The biggest thing to remember is the tradeoff between risk and reward. I explain it in depth here. Today, let’s talk about the most conservative end of the risk/return spectrum, general obligation bonds (also known as GO bonds).

What is a GO Bond?

A GO bond is a bond issued by a municipality, state, or government entity that is backed by the “full faith and credit” of that entity. Typically they are issued by municipalities.

The purpose of the money that the bond earns is not to necessarily make a profit for that municipality, although that can certainly happen. There can be a lot of purposes for GO bonds. However, the two most popular uses of GO bonds are to construct new schools and highway systems.

So the question is, if the municipality is borrowing money from people to build schools, highway systems, etc. how do they pay it back if those schools and highways don’t earn money directly?

The answer: Taxes.

A GO bond is backed by the “full faith and credit” of the municipality who issues them. That means that your taxes are going to repay these. That is why, in a lot of communities, there is a bond proposal that needs to be voted on in an election.

The bond proposal that you would vote on in an election is usually for something like building a new school. The government entity needs to ask permission from the voters to raise their taxes to pay for a new school (or whatever the bond is being used for).

What Types of GO Bonds Are There?

There are four primary types of go bonds. Before I get into them, just remember that these bonds are repaid by the taxpayer.

1. Unlimited Tax General Obligation Bonds: This is the strongest and most secure of the GO bonds. That is because the municipality says that they will tax the taxpayer as much as they need to (without limit) to repay the bonds. Of course, the municipality won’t want to raise taxes too high because they will be all thrown out of office and there would be rioting in the streets. But in theory, the municipality could tax the taxpayer as much as they need to repay these bonds. That is why they are considered the most secure (from an investor perspective).
2. Limited Tax General Obligation Bonds: This is similar to the unlimited tax GO bonds but there is a limit to how much the municipality could tax. There might be a cap of 2% of income, 5% of income, etc.
3. General Fund General Obligation Bonds: This makes no promise to raise taxes to pay for the bond. It doesn’t mean that the taxes won’t be raised, but there is no promise to do so.

From an investor perspective, the safest (and thus lowest interest rate) would be the Unlimited Tax GO Bond. The second safest (and middle interest rate) would be the Limited Tax GO Bond. And the leas safe (and highest interest rate) would be the General Fund GO Bond.

It’s also important to remember that all of these investments are generally going to be extremely low risk. Of course, not zero risk. But in a general investment sense, municipal bonds (GO bonds and Revenue bonds) are very low risk and very low reward.

What are the Benefits and Drawbacks of GO Bonds?

There are several benefits of investing in these products.

• Since the risk of default is so low, these can serve as a very safe investment if that is what you are seeking in your investment portfolio.
• GO bonds are generally federally tax exempt.
• Raising money for public projects in a municipality can be rewarding and help to improve communities by providing community projects the money needed to complete them.

Some of the drawbacks of these products include:

• The rate of return of these bonds is generally really low given the safe nature of them. So if you are looking for a high rate of return, these are probably not what you need.
• You might want to consider extra investigating of these bonds since they are being repaid by the taxing authority of a particular municipality. Does the municipality have one large employer that employs most of the town? What happens if that employer leaves? The tax base will be far less. Just some things to consider.

Final Thoughts

GO bonds are an interesting animal. They aren’t bad nor good. Just like any other investment. It’s important to know how they work and what security you will have when you invest with them and how they will be treated from a tax perspective.

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Until next time!