Municipal Bond Definitions
Municipal bonds are issued in the form of a general obligation of a state or local government, or as a revenue bond of a particular facility or project.
I. General Obligation Bonds
General obligation bonds are backed by the full faith and credit of the issuer and are considered a general credit obligation of the state or local government which issued them. General obligation bonds are issued as unlimited or limited obligations.
A. Limited-Tax General Obligation Bonds
Limited-tax bonds are secured by the pledge of a tax which is limited in the amount or rate, such as a maximum property tax. Before the decision is reached to purchase the bond, a determination must be made of how much of the limited taxing power remains unused. If the limited taxation power of the state or local government has already been completely utilized, there is no extra margin of safety to protect the bondholder.
B. Unlimited-Tax General Obligation Bonds
Unlimited-tax bonds carry the backing of all the taxing power of the issuer. For this reason, unlimited-tax bonds usually sell at a higher price (lower yield) than limited-tax bonds with the same quality and maturity. Both limited and unlimited-tax bonds are judged according to the strength of the tax base of the area being taxed to payoff the bonds.
II. Revenue Bonds
A. Traditional Revenue Bonds
There are several types of revenue bonds all of which have one feature in common: they are generally secured primarily by payments from some special source of income. The source of income backing revenue bonds is typically derived from the operation of specific income-producing facilities. Traditionally, these facilities have included water, electrical, toll bridges, expressways, and tunnels. Because of constitutional and statutory debt limitation provisions on general obligation bonds, revenue bond-finance facilities now include higher education projects, airports, hospitals, and rapid transit systems. Often, a special agency or authority is established by a subdivision of, or directly by, a state or local government. One must be aware of the various fundamental changes which can cause particular types of revenue bonds to be affected favorably or adversely in price relative to other similar issues.
If a situation arises where the revenue derived from a specific project or facility was not sufficient to pay back interest and principal, in most cases the bonds would go into arrears and trade at a substantial discount to the market. In some cases there may be a commitment of aid from a state or local government to provide the additional funds needed to meet the debt service payments. The commitment may be in the form of a legally binding contract or a moral obligation. Under the moral obligation the government does not guarantee to aid the project but will provide funds only if the appropriation is approved.
B. Industrial Revenue Bonds
Industrial revenue bonds were originally created by state and local governments to attract industry to their communities through the benefit of interest cost savings. Since the bonds pay interest on a tax-free basis they usually carry a coupon lower than fully taxable bonds. This security involves the issuance of bonds by a municipality or authority, the proceeds of which are used to construct facilities or to purchase equipment by a corporation. The authority acts only as a conduit by which the financing is secured. The source of repayment will always be with the corporation. To a certain extent the companies who utilize the IDR financing option, are termed middle market companies. Since the credit evaluation for an IDR is similar to a straight corporate debt issue most underwriters have encouraged the use of a bank letter of credit, or municipal bond insurance to increase the marketability of the issue in both the private and public markets.