General obligation (G.O.) bonds

General characteristics

General obligation (G.O.) bonds are a common type of municipal bond. They support important city, state, or local projects that don’t generate revenue. These are known as non-self-supporting projects, which include public school systems, non-toll roads, parks, and government buildings.

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

Property (real estate) owners receive a tax bill from their local government every year. Additional assessment costs and fines for not paying taxes promptly can also be collected by municipalities. Property taxes, also known as ad valorem taxes, support many things, including school districts, police departments, park maintenance, and city libraries. When a municipality wants to fund a new non-self-supporting project, it raises money through a G.O. bond issuance, pays for the project, and uses property taxes to repay the borrowed funds over time.

G.O. bonds are backed by the full faith, credit, and taxing power of the municipality. Usually, secured bonds are safer than full faith and credit bonds, but the taxing authority is a significant factor. If the state or local government lacks the funds to pay off a G.O. bond, they can raise property taxes with voter approval. Raising taxes can only sometimes fix a lack of money, though. Many other components, like population growth, economic diversity, and municipal obligations can impact a municipal issuer’s ability to pay off debt. For example, the city of Detroit filed for bankruptcy in 2013, which is still the largest municipal bankruptcy filing in U.S. history. Contributing factors included a declining population, a single dominant industry (auto industry), and significant pension obligations.

Regardless, the vast majority of G.O. bonds are safe and do not default.

Issuance

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. Regardless, a checklist of items must be accomplished 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.

Let’s walk through the general process municipalities follow when issuing G.O. bonds. First, the municipality will become aware of a need. For example, assume a city needs to build a new high school as its population has increased significantly. Schools are costly to construct; larger projects can run well over $100 million. Once the need is established, the city will hire a financial (municipal) adviser to help them navigate the project.

The financial adviser analyzes the municipality’s financial situation as it’s essential to determine if borrowing more money is feasible. If the city’s population is in decline (fewer taxpayers) or maintains significant liabilities on its books (e.g., other large debts), it may not be wise to borrow more money. Poorer municipalities may be forced to make tough decisions, like choosing between making pension payments to retired employees or opening a much-needed school.

If borrowing more money seems feasible, the municipal adviser creates the new high school bond structure. They help determine how long the bond should last, the expected interest cost (how much interest the issuer will likely pay to investors), and other bond features (e.g., if the bond will be callable). Many factors influence the bond structure, including forecasted tax collections and population growth.

G.O. bonds are typically issued in serial form. As a reminder, this type of offering involves the entire offering starting simultaneously, with specific cohorts maturing on different days in the future. 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:

• 100,000 bonds issued on January 1, 2023
• 25,000 bonds mature on January 1, 2028
• 25,000 bonds mature on January 1, 2033
• 25,000 bonds mature on January 1, 2038
• 25,000 bonds mature on January 1, 2043

As you can see, all the bonds were issued on one day, but four separate cohorts are set to mature in five year increments. This structure works well with G.O. bonds as annual tax collections occur. With sets of bonds maturing on different days, the issuer isn’t required to make one substantial principal payment on a single day, as they would with a term issuance. Instead, the principal payments at maturity are divided between the various maturity dates. Once the financial adviser creates the bond structure, their job is essentially done.

Next, the issuer hires the bond counsel, a group of specialized lawyers responsible for analyzing the legal aspects of a bond. Specifically, their job is to provide a legal opinion on the validity, legality, and tax-free status of the bonds to be issued.

To determine if a municipal bond is valid, the bond counsel must confirm if it has been legally mandated. G.O. bonds typically require voter approval to be issued. You may have noticed this type of municipal bond on your last voter ballot. Because G.O. bond debt is paid off with taxpayer funds, municipalities must obtain approval by vote.

A bond issuance is legal if no constitutional law or regulation prevents it. For example, your city’s constitution may require all new high schools to be powered by solar panels. Also, constitutional debt limits may prevent a bond from being issued. Municipalities are typically subject to debt limits to prevent overspending taxpayer money. Even if the debt limit is reached, the municipality could request a vote to raise its debt limits. The bond counsel will help determine if there’s full compliance with legal requirements, whether it pertains to the project or the borrowed money.

Last, the bond counsel determines if the bond will be tax-free if purchased by residents. Taxes can significantly impact the return of a bond and are an essential investment consideration. Local residents should receive tax-free interest if they buy the high school bond, and the bond counsel must confirm that this will occur.

Once the bond counsel analyzes the high school bond’s validity, legality, and tax status, they issue a legal opinion. The municipality is hoping for an unqualified legal opinion. Although it sounds bizarre, an unqualified opinion means the bond is valid, legal, and tax-free without qualifiers. An example of a qualifier would be, “this bond is tax-free, but only for persons not subject to Alternative Minimum Tax*.” The last part of the previous sentence is a qualifier, which is undesirable and makes the bond less marketable. It’s always best if 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.

An underwriter is hired after the legal opinion is issued. The municipality’s financial adviser is prohibited from filling this role according to MSRB* rules. The underwriter’s primary responsibility is simple - sell the bond to investors. Municipalities know how to govern but don’t have the resources or experience offering securities in the primary market. That’s 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.

The city needs to be cost-sensitive when hiring an underwriter because its taxpayers fund everything. How would you feel if your city spent millions hiring the most expensive financial firm and paid them with your tax dollars? G.O. bonds are sold through a competitive bidding process to keep costs as low as possible. First, the city publishes an Official Notice of Sale in the Bond Buyer, an online resource the underwriting community utilizes. You’ve probably heard of some of the more prominent underwriters, including Goldman Sachs and Morgan Stanley. Financial institutions like these access the Bond Buyer and, if interested in underwriting a bond, will consider submitting a bid.

Potential underwriters submit bids through bid forms, similar to how people bid on items through eBay. On the bid form, the underwriter specifies the price they are willing to pay for the bonds and the yield they’ll publicly offer to their investors. The municipality awards the bond to the underwriter with the lowest interest cost to the issuer (the less interest the issuer pays, the cheaper the debt is to pay off). The underwriter with the winning bid purchases the bond on a firm basis. G.O. bonds commitments are always firm, meaning the underwriter pays the municipality for the entire bond issuance up-front. Once the sale to the underwriter occurs, the city has the necessary funds to build the high school.

Although not required by law, most municipalities create official statements and provide them to the winning underwriter. These are disclosure documents intended to inform potential investors of the benefits and risks of the investment, along with information about the municipality. The following details are typically offered in official statements:

• The bond’s interest rate
• Timing of interest payments
• Length of the bond (maturity)
• Specific features of the bond (e.g., call features)
• Source of repayment funds (e.g., property taxes)
• The municipality’s finances
• Legal matters, including the legal opinion

The underwriter may begin offering the bond to investors once they are confirmed to win the bid. If an official statement has been created, the underwriter must deliver it* to all investors buying the bond by the settlement of the transaction. To make a profit, the underwriter aims to sell the bonds at a marked-up (higher) price. Once the offering concludes, 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.

At this point, everyone should be satisfied. The city raised the necessary funds to build the new high school by selling the bond to the underwriter. The underwriter made a profit when they re-sold the bonds to the public. The investing public gained access to another interest-paying investment and funded the construction of a new high school. G.O. bonds can benefit many parties and help facilitate necessary municipal projects when it works as they should.

Limited tax bonds

As we’ve discussed, G.O. bonds require voter approval to be issued. You might see a favorable G.O. public park bond on your voting ballot, but your taxes will likely increase if it passes. This is the primary reason people vote against G.O. bonds. Also, the public park may cost more than expected. If costs could prevent public approval of the project, the municipality may issue a limited tax bond.

A limited tax bond is a type of G.O. bond that only has access to a predetermined amount of taxes. Therefore, the issuer has no incentive to raise taxes if they face challenges paying off the bond. These bonds come with additional risk to bondholders as the issuer can’t increase taxes if they face financial difficulties. The added risk requires these securities to be issued with higher coupons, plus they tend to trade at lower prices (higher yields) in the market.