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Know What You Own: Why Not All General Obligation Bonds are Created Equal

Know What You Own: Why Not All General Obligation Bonds are Created Equal

Key Points
  • Detroit's bankruptcy illustrates how important it is for municipal bond investors to know what they own.

  • We review some of the most common types of municipal bonds, and explain why some have stronger pledges than others.

  • It’s generally a good idea to focus on general obligation bonds or other essential service revenue bonds as the core of a municipal bond portfolio.

When Detroit declared bankruptcy in 2013, its bondholders questioned how much of their investment they'd recover—if any. The outcome of the nation's largest municipal bankruptcy illustrates how important it is for municipal bond investors to know what they own. Some investors recovered 73 cents on the dollar, others as little as 12 cents on the dollar, and some continued to receive regular interest and principal payments.

Those disparities occurred because Detroit—like most large municipalities—had several different types of debt outstanding, each backed by a different resource or type of pledge. The main types of bonds Detroit had outstanding were:

  • Unlimited tax general obligation (GO) bonds
  • Limited tax GO bonds
  • Certificates of participation (COPs)
  • Water and sewer revenue bonds

The unlimited tax GO bondholders' recovery rate was more than six times higher than that of the COP holders, while the water and sewer bonds continued to make uninterrupted interest payments.

A common mistake some municipal bond investors make is assuming that any bond issued by a state or local government is a general obligation bond. However, GO bonds, or bonds backed by a general pledge of government revenues, account for only about 27% of the municipal bond market.1 They come in several varieties.

What types of bonds do governments issue?

The most common types of municipal bonds issued are:

  • General obligation (GO) bonds backed by a dedicated tax pledge as well as unlimited taxing authority
  • GOs backed by unlimited taxing authority but no dedicated tax
  • GOs backed by limited taxing authority
  • Lease revenue bonds, often known as Certificates of Participation (COPs)
  • Enterprise revenue bonds

The first four are listed in order of the strength of their financial pledges. Enterprise revenue bonds, depending on the issuer, can range from strong to weak.

Historically, municipal bond issuers have rarely missed principal or interest payments. However, munis that do default tend to be non-GO bonds, such as COPs or enterprise revenue bonds. Since 1970, only 95 of the thousands of municipal bonds that Moody's Investors Service rates have ever defaulted. Of that 95, only eight were GO bonds.

Unlimited tax GOs with a dedicated tax are usually the strongest pledge

Unlimited tax GOs with a dedicated tax are usually the strongest pledge

Source: Schwab Center for Financial Research opinion. For illustration only.

Unlimited tax GO, with dedicated tax

These bonds are often backed by a dedicated tax—usually property tax—that the municipality collects. Frequently, these bonds are also backed by a pledge that the issuer will use all other available revenue sources, such as other taxes or state support, if the taxes specifically authorized to repay the bonds aren't sufficient.

In California, for example, school districts often issue bonds backed by a property tax dedicated specifically to debt service on the bonds. Voters within the school district must agree to the tax, and the dedicated property tax cannot be mixed with the school's other revenues. If the school district doesn't have the necessary funds to pay the bonds, it typically must increase property taxes to meet the amount due. In our view, this is one of the strongest security pledges for municipal bonds.

Unlimited tax GO, with no dedicated tax

These bonds are backed by the general revenues of an issuer, including taxes. Unlike dedicated tax GOs, however, they do not have a specific tax pledged to repay them. Instead, bondholders are paid from general revenues, and if those prove insufficient to cover debt service, the issuer typically must raise taxes. In our view, this is a very strong pledge.

Limited tax GO

Like unlimited tax GOs, these bonds are backed by the general revenues of an issuer, including taxes. However, the issuer doesn't have the ability to increase taxes by an unlimited amount to pay the bonds back. The limit on the amount of tax increase allowed is generally described in the bond offering statement, and the bonds are clearly labeled. Although we believe this is still a strong pledge, the limit on the tax lessens the security of the bonds.

Lease revenue bonds, or COPs

Lease revenue bonds are not secured by a municipality's tax revenues. Instead, they are usually backed by the lease revenues paid by a government to use a property, often a building. For example, a local government may issue COPs to finance the construction of a new courthouse. The municipality then sells the building to a trustee and leases the building back from the trustee for an amount sufficient to repay the bonds.

Local governments often issue COPs if they face restrictions on the amount of debt they can incur. The lease obligation is usually not considered a form of long-term debt, and the government's council or board must renew the lease annually. If it does not renew the lease, the trustee can repossess the property and sell it to reimburse bondholders. This rarely occurs in practice, but it's the primary source of security for bonds.

In our view, COPs are among the least secure local government obligations. They are not backed by a specific tax or the issuer's pledge to raise the necessary revenues. Instead, they are often backed only by the government administrator's pledge to put the lease payment into the budget. The local government can opt not to pay and instead turn over the leased facility to the bondholders. If a local government defaults, the recovery rates in bankruptcy rely on the value of the property.

Enterprise revenue bonds

Enterprise revenue bonds—such as water and sewer, sales tax, and airport bonds—constitute a broad array of bonds issued by local governments. The size and diversity of this market makes it difficult to make broad generalizations about the security pledge. They are generally backed by the revenues of the enterprise, not the local government.

What to do now

Focus first on unlimited tax GO bonds, with or without a dedicated tax pledge, and limited tax GO bonds for the core of your municipal bond portfolio. We're more cautious about lease revenue bonds, unless issued by very highly rated issuers and tied to a building or property essential to the municipality. Talk with a Schwab Regional Bond Specialist (RBS) if you'd like help choosing securities.

1 Based on market value of the Barclays Municipal Bond Index and Barclays Municipal Bond GO Index

Talk to Us

  • Call a bond specialist at Schwab anytime at 877-908-1072.
  • Talk to a Schwab Financial Consultant at your local branch.
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Important Disclosures

(1215-AFCB)

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