Advantages and Disadvantages of General Obligation Bonds

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Advantages and Disadvantages of General Obligation Bonds

General obligation bonds are often prized for their relative safety as investments. Because the credit of a municipality stands behind them, GOs typically have high bond ratings, higher than revenue bonds tend to. The reason is the municipality’s power of taxation: a city or town always has the option of raising tax rates or levying new taxes in order to meet its obligation to bondholders. As a result, it is rare for a municipality to default on its GO bonds. GO bonds typically rate with US Treasury securities and high-grade corporate bonds for investor confidence. With revenue bonds, by contrast, if the project the bonds fund does not raise sufficient revenue, there is at least the possibility that the municipality may default on the bond issue.

Safety brings a downside

As with other examples of low-risk investments, the tradeoff for safety is lower returns. GO bonds typically pay lower interest than revenue bonds, precisely because the credit behind them makes the possibility of default so remote. However, many GO bonds offer federal-income-tax-free returns, which can make up for lower interest rates, especially for investors in higher tax brackets. For example, if you were in a 28 percent tax bracket, a 4 percent yield from a tax-free municipal issue would be equivalent to a 5.56 percent yield from a taxable bond issue. Keep in mind that general obligation bonds and other municipal securities may indeed be subject to state and local taxes, as well as the federal alternative minimum tax.