Sources of Repayment
Payment of principal and interest on a municipal security may be backed by various types of pledges and forms of security. Below is a general description of some of the more common sources of security for payment of principal and interest. For detailed information about a specific bond, refer to its official statement, which will typically be available on the MSRB's EMMA website.
General Obligation Bonds
Typically “general obligation” bonds are issued by a state or local government that pledges its full faith, credit and taxing power to pay principal and interest. General obligation bonds may be payable from general funds including income taxes or property taxes of the issuer, although the precise source and priority of payment for general obligation bonds may vary considerably from issuer to issuer depending on applicable state or local law. General obligation bonds issued by local units of government often are payable from (and in some cases solely from) the issuer’s ad valorem taxes, while general obligation bonds issued by states often are payable from appropriations made by the state legislature.
General obligation bonds may require approval by voters prior to issuance. In the event of default in required payments of interest or principal, general obligation bondholders typically have certain rights to compel a tax levy or a legislative appropriation.
“Revenue bond” is the term used generally to describe a bond that is payable from a specific source of revenue and to which the full faith and credit of an issuer with taxing power is not pledged. The issuer of a revenue bond is not obligated to pay principal and interest on its bonds using any source other than the source(s) specifically pledged to the bond. Revenue bonds are payable from identified sources of revenue and do not permit the bondholders to compel taxation or legislative appropriation of funds not pledged for payment of debt service. Pledged revenues may be derived from operation of the financed project, grants or excise or other specified non-ad-valorem taxes. Generally, no voter approval is required prior to issuance of such obligations. If the specified source(s) of revenue become inadequate, a default in payment of principal or interest may occur. Various types of pledges of revenue may be used to secure interest and principal payments on revenue bonds. The nature of these pledges may differ widely based on the type of issuer, type of revenue stream and other factors.
Some revenue bonds are issued by governmental agencies to fund facilities for essential public services. A bond issued by a municipal water and sewer authority, for example, typically would involve revenues obtained through local water and sewer assessments. The pledge of revenue would identify specific assessments that can be used to pay principal and interest on the bonds, the authority’s responsibility and ability (if any) to raise water and sewer assessments, and any superior claim on the assessments, for example.
Conduit Revenue Bonds
Another type of revenue bond may be issued by a governmental issuer acting as conduit for the benefit of a private sector entity or a 501(c)(3) organization. In these cases, the governmental issuer is seeking to advance specific public purposes within its mission, with such conduit bonds commonly issued for not-for-profit hospitals, single and multi-family housing, industrial or economic development, student loan programs or waste disposal facilities. Principal and interest on such bonds normally are paid exclusively from revenues pledged by the entity receiving financing (the “obligor”). Unless otherwise specified under the terms of the bonds, the issuer is not required to make payments of principal or interest if the obligor defaults.
The term “double-barreled bond” is used to describe bonds secured by a defined revenue source as well as the full faith and credit of an issuer that has taxing power. It has both general obligation and revenue pledges.
Moral Obligation Bonds
The term “moral obligation bond” refers to a bond, usually issued by a state or agency, that is secured by a non-binding covenant that any amount necessary to make up any deficiency in pledged revenues available for debt service will be included in the budget recommendation made to the state legislature or other legislative body, which may appropriate funds to make up the shortfall. The legislature or other legislative body, however, is not legally obligated to make such an appropriation. Unlike a general obligation pledge, the moral obligation bond does not require voter approval and does not have the state’s official pledge of its full faith and credit.
Some municipal securities are backed by a third-party credit enhancement, which backstops the primary pledge to pay principal and interest. Forms of credit enhancement include bond insurance, bank letters of credit, state school guarantees and credit programs of federal or state governments or federal agencies. Credit enhancement serves as a secondary source of payment if the primary source of payment is insufficient. Investors should take care to note the current credit quality of the guaranty or letter of credit bank but should also consider carefully the credit of the issuer or the obligor since the financial strength of credit enhancers can change over time and in some cases could decline.
Insured bonds and bonds backed by letters of credit often carry two separate ratings, one of which is based on the financial strength of the insurer or bank and the other underlying rating is based on the financial strength of the issuer or obligor making the primary pledge for payment of principal and interest. However, in other cases, a guarantee may be provided by a different type of related third party, such as another unit of government, or in the case of conduit revenue bonds, a parent corporation or other entity related to the private beneficiary of the bonds.