The basics

General obligation (G.O.) bonds are a common type of municipal bond. They support important projects for the city, state, or local area that don’t create revenue. G.O. bonds fund non-self-supporting projects, which include schools, roads, parks, and government buildings. A non-self-supporting project is one that does not make the required revenue to pay for itself.

When a G.O. bond is issued, the municipal government borrows from investors and pays them back over time. Because the bonds can’t be paid off with revenue obtained from the project, the municipality must use taxes to repay their borrowed funds. Specifically, G.O. bonds are paid off with property taxes.

Every year, property owners receive a tax bill from their local government based on how much and what type of property they own. Property taxes, also known as ad valorem taxes, are used to support many things, including school districts, police departments, park maintenance, and city libraries. If a municipality wants to fund a new non-self-supporting project, they raise money through a G.O. bond issuance, pay for the project, and use property taxes to pay back the borrowed funds over time.

G.O. bonds are typically not backed by a specific form of collateral. Instead, they are backed by the full faith, credit, and taxing power of the municipality. Normally, full faith and credit bonds are not as safe as secured bonds, but the taxing power of municipalities is a significant factor. If the state or local government is short of funds necessary to pay off a G.O. bond, they can raise property taxes with voter approval.

Raising taxes can’t always be a fix for a lack of money, though. Many other components, like population growth, economic diversity, and municipal obligations can affect a municipal issuer’s ability to pay off its G.O. bonds. For example, the city of Detroit filed for bankruptcy in 2013, which is still the largest municipal bankruptcy filing in US history. Contributing factors included a declining population, a single dominant industry (auto industry), and significant pension obligations.

When a municipality’s population declines, the local government loses taxpayers. This is why local politicians encourage people and businesses to move to their city. The more people that live in the city, the more taxes the government can assess.

A single, dominant industry within a municipality can be a recipe for disaster. In Detroit, the entire city grew around the automobile industry. When the industry took off, it created a booming city full of opportunities. Workers knew their jobs were stable, made good wages, and were able to live comfortably.

Fast forward to the Great Recession of 2008, things were different. The economy experienced the largest financial collapse since the Great Depression in the 1920s and 1930s. When the economy is rough, people generally avoid buying durable goods like automobiles.

Auto sales plunged in 2008 and 2009, which created big problems for Detroit. With the entire city built around the industry, there were numerous business closings and layoffs that affected significant portions of the population. These problems contributed to a dwindling tax base over the next several years as many people left Detroit to seek better opportunities outside the city.

Municipalities also face challenges when they have significant payout obligations, like pensions. Pensions are retirement plans which are generally only offered by government entities today. If your job provided a retirement pension, you would be paid an ongoing benefit until death (after retirement). Most employers require at least 20 years of service to be eligible for a pension. When the pension requirements are met, employers typically match their worker’s average earnings at a specific percentage (for example, paying 80% of the worker’s highest year of earnings) throughout their retirement (until death).

Pensions are great for workers as they provide retirement income for life, but they are burdens for employers. Organizations offering pensions know they are on the hook for making a lifetime of payments, regardless of their financial situation. Even if a municipality is experiencing significant financial problems, payments still must be made to pension retirees. When Detroit was financially challenged in the late 2000s / early 2010s, pension payouts strained them further.

In summary, G.O. bonds provide funding to state and local governments for all of the important projects that don’t make their own revenue. The success of a G.O. bond hinges on the municipality’s ability to pay back borrowed funds, which are collected through property taxes. Other obligations, like pensions, may hinder their ability to make required payments. We’ll discuss analyzing general obligation bonds in further detail later in this unit.