Municipal bonds - or the debt issued by states, cities, and counties to fund projects – fall into several categories. The most important types to know are general obligation bonds and revenue bonds. The key difference between these two types of muni bonds is the source of the revenue used to make interest and principal payments.
What are General Obligation Bonds?
General obligation bonds, also called GOs, are bonds that are backed by the “full faith and credit” of the issuer, with no specific project identified as the source of funds. In other words, the issuer can make interest and principal payments using any source of revenue, such as tax revenues, fees, or the issuance of new securities, and if it encounters fiscal difficulty it can raise taxes to offset the shortfall. GOs are therefore seen as being relatively safe, and default are rare. After all, an entire government is less likely to face serious financial difficulty than a specific project. Investors can buy general obligation bonds directly, but there are also a number of mutual funds that specialize in general obligation securities.
Learn more: How risky are municipal bonds?
What are Revenue Bonds?
Revenue bonds are bonds that are backed by the revenue generated by the specific project being financed by the bond issue. In other words, the money raised by the bond offering finances the project, and the project – once complete – generates the revenues to pay the interest and principal on the bonds. Projects could include hospitals, airports, toll roads, housing projects, convention centers, bridges, and similar endeavors. Revenue bonds are generally higher risk than general obligation bonds, an they typically offer higher yields.
Within the revenue bond category, there are “essential services” revenue bonds, which include projects related to water, sewer, and power systems. Since the revenue from such projects is seen as being more reliable, essential-services revenue bonds are seen as being lower-risk than bonds financed by revenue from non-essential services.
Typically, most bond fund managers will invest in a combination of general obligation and revenue bonds. Literature provided by the fund company will provide an idea of how a specific fund is invested.
Other Types of Municipal Bonds
Revenue and general obligation bonds aren’t the only type of municipal securities. Investors also can choose from:
- Anticipation notes
- Pre-refunded bonds
- Insured bonds
To learn more about these securities, click here.