General obligation (G.O.) bonds are a common type of municipal bond. They fund important city, state, or local projects that don’t generate revenue. These are called non-self-supporting projects, and they include public school systems, non-toll roads, parks, and government buildings.
When a G.O. bond is issued, the municipality borrows money from investors and repays it over time. Because these projects don’t produce revenue that can be used for repayment, the municipality must use taxes to repay the borrowed funds. Specifically, G.O. bonds are repaid with property taxes.
Property (real estate) owners receive a tax bill from their local government each year. Municipalities can also collect additional assessment costs and fines for late payment. Property taxes - also called ad valorem taxes - support many public services, including school districts, police departments, park maintenance, and city libraries. When a municipality wants to fund a new non-self-supporting project, it can raise money by issuing a G.O. bond, pay for the project, and then use property taxes to repay investors over time.
G.O. bonds are backed by the full faith, credit, and taxing power of the municipality. In many cases, secured bonds are considered safer than full faith and credit bonds, but a municipality’s taxing authority is a major strength. If a state or local government doesn’t have enough funds to pay debt service on a G.O. bond, it may be able to raise property taxes with voter approval. However, raising taxes can’t always solve a funding problem. Other factors - such as population growth, economic diversity, and existing municipal obligations - also affect an issuer’s ability to repay debt. For example, the city of Detroit filed for bankruptcy in 2013, which remains the largest municipal bankruptcy filing in U.S. history. Contributing factors included a declining population, reliance on a single dominant industry (the auto industry), and significant pension obligations.
Even so, the vast majority of G.O. bonds are considered safe and do not default.
Municipal issuers follow specific protocols and procedures when offering G.O. bonds in the primary market. Municipal securities are exempt from registration with the Securities and Exchange Commission (SEC) and therefore avoid some regulatory oversight* during their initial sale to the public. Even so, municipalities still complete a set of key steps before issuing a G.O. bond.
*Most securities are subject to registration, which requires significant disclosures to both the SEC and potential investors. Registration is covered in the primary markets unit.
Here’s the general process municipalities follow when issuing G.O. bonds.
First, the municipality identifies a need. For example, suppose a city needs to build a new high school because its population has increased significantly. Schools are expensive to construct, and larger projects can cost well over $100 million. Once the need is established, the city hires a financial (municipal) adviser to help guide the process.
The financial adviser analyzes the municipality’s financial condition, since the city needs to know whether taking on additional debt is realistic. If the city’s population is declining (fewer taxpayers) or it already has significant liabilities (such as other large debts), borrowing more money may not be a good idea. In financially strained municipalities, leaders may face difficult tradeoffs, such as choosing between pension payments to retired employees and funding a much-needed school.
If borrowing appears feasible, the municipal adviser helps structure the bond issue. This includes decisions such as:
Many factors influence the structure, including forecasted tax collections and population growth.
G.O. bonds are typically issued in serial form. As a reminder, a serial issue starts at the same time, but different portions of the issue mature on different future dates. For example, assume a municipality issues 100,000 bonds, each with a $1,000 par value ($100 million total offering). A serial offering may look like this:
All the bonds are issued on one day, but four separate cohorts mature in five-year increments. This structure fits G.O. bonds well because tax collections occur annually. With multiple maturity dates, the issuer doesn’t have to make one large principal payment on a single day (as it would with a term issuance). Instead, principal repayment is spread across the various maturity dates. Once the financial adviser has created the bond structure, their role is essentially complete.
Next, the issuer hires bond counsel, a group of specialized lawyers who analyze the legal aspects of the bond. Their job is to provide a legal opinion on the bond’s validity, legality, and tax-free status.
To determine whether a municipal bond is valid, bond counsel confirms that it has been properly authorized. G.O. bonds typically require voter approval to be issued. You may have seen these questions on a local ballot. Because G.O. bond debt is repaid with taxpayer funds, municipalities generally must obtain approval by vote.
A bond issuance is legal if no constitutional law or regulation prohibits it. For example, a city’s constitution might require new high schools to be powered by solar panels. In addition, constitutional debt limits may restrict how much debt a municipality can issue. These limits are designed to prevent overspending of taxpayer money. If a municipality has reached its debt limit, it may request a vote to raise that limit. Bond counsel helps confirm compliance with all legal requirements, whether they relate to the project itself or to the borrowing.
Finally, bond counsel determines whether the bond will be tax-free for residents who purchase it. Taxes can significantly affect a bond’s return, so tax status is an important investment consideration. If local residents are expected to receive tax-free interest on the high school bond, bond counsel must confirm that the bond qualifies.
After reviewing validity, legality, and tax status, bond counsel issues a legal opinion. The municipality is hoping for an unqualified legal opinion. Despite the name, an unqualified opinion is the best outcome: it means the bond is valid, legal, and tax-free without conditions. A condition would be something like: “this bond is tax-free, but only for persons not subject to Alternative Minimum Tax*.” That added limitation is a qualifier, and it can make the bond less marketable. Ideally, the bond is simply valid, legal, and tax-free.
*Alternative minimum tax (AMT) is an assessment only some investors (typically those with higher incomes) are subject to.
After the legal opinion is issued, the municipality hires an underwriter. Under MSRB* rules, the municipality’s financial adviser cannot serve as the underwriter. The underwriter’s main job is straightforward: sell the bonds to investors. Municipalities have expertise in governing, but they typically don’t have the resources or experience to distribute securities in the primary market, which is why they hire underwriters.
*The Municipal Securities Rulemaking Board (MSRB) is a self-regulatory organization (a regulator) responsible for creating rules for financial professionals within the municipal securities markets. We’ll discuss this organization in detail later in the Achievable materials.
Because taxpayers ultimately fund municipal costs, the city needs to be cost-sensitive when selecting an underwriter. G.O. bonds are typically sold through a competitive bidding process to help keep borrowing costs low. The city begins by publishing an Official Notice of Sale in the Bond Buyer, an online resource used by the underwriting community. Large underwriters - such as Goldman Sachs and Morgan Stanley - monitor these notices and may submit bids.
Interested underwriters submit bids using bid forms, similar to bidding on items through an online auction. On the bid form, the underwriter specifies:
The municipality awards the issue to the underwriter that offers the lowest interest cost to the issuer (lower interest cost means cheaper debt for the municipality). The winning underwriter purchases the bonds on a firm basis. G.O. bond commitments are always firm, meaning the underwriter pays the municipality for the entire issue up front. Once the sale to the underwriter is complete, the city has the funds needed to build the high school.
Although not required by law, most municipalities prepare official statements and provide them to the winning underwriter. These disclosure documents are designed to inform potential investors about the investment’s benefits and risks, along with key information about the municipality. Official statements typically include:
Once the underwriter is confirmed as the winning bidder, it may begin offering the bonds to investors. If an official statement has been prepared, the underwriter must deliver it* to all investors who purchase the bonds by settlement. The underwriter’s profit comes from selling the bonds to investors at a marked-up (higher) price. After the offering, the bonds trade in the secondary market until they are called (if callable) or mature.
*Underwriters can either send the official statement in writing (including electronic versions) or direct their customers to obtain it on EMMA (Electronic Municipal Market Access). EMMA is an MSRB website containing information relating to municipal securities, including official statements, trade data, and market statistics.
In a typical issuance, each party benefits in a different way. The city raises funds to build the high school. The underwriter earns a profit by reselling the bonds. Investors gain access to an interest-paying investment while helping finance a public project.
As discussed, G.O. bonds typically require voter approval. You might see a proposed G.O. bond to fund a public park on your ballot, but if it passes, your taxes will likely increase. That potential tax increase is a major reason voters reject G.O. bond proposals. Another concern is that the project could end up costing more than expected. If the expected cost (and potential tax impact) could prevent public approval, the municipality may issue a limited tax bond.
A limited tax bond is a type of G.O. bond that can use only a predetermined amount of taxes for repayment. Because the tax amount is capped, the issuer can’t simply increase taxes if it has trouble paying debt service. That limitation adds risk for bondholders. As a result, these bonds generally must be issued with higher coupons and tend to trade at lower prices (higher yields) in the market.
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