Portfolio Manager & Managing Director John Bonnell argues that the true risk-return profile of GO versus revenue bonds may surprise some investors.
Not all investors know that municipal bonds are debt instruments issued by states, cities and counties to fund various projects: for instance, construction of roads, schools, hospitals, sewage facilities, water lines and much more. Muni bonds are typically classified into two camps — general obligation and revenue bonds. In this article, we provide an overview on the main differences between the two and clarify misconceptions that can lead investors to miscalculate the risk-return potential of these bonds.
What’s the Difference?
General obligation (or GO) bonds are issued by state and local governments and are backed by the full faith and credit of the issuer, which in turn uses its taxing authority — that is, collection of income, property and sales tax — to repay the bond obligation. In other words, a GO issuer can repay its debt using any funds that are legally available to it. That includes, for example, money from a municipality’s “general fund,” which may be sourced from a variety of taxes and fees that it has collected.
Revenue bonds, on the other hand, are backed by a dedicated revenue stream produced by a specific project that the bond was issued for. For example, a utility authority might issue a revenue bond in order to obtain the capital needed to build or expand an electric utility plant or water treatment facility. The revenues collected from these projects (e.g., from users electric or water bills) are then used to support the revenue bond. Other projects supported by revenue bond issuance might also include hospitals, toll bridges and roads, or housing projects.
The Great Fallacy of GO Bonds vs. Revenue Bonds
Many investors believe GO bonds tend to have lower credit risk than revenue bonds do, as GO bond payments are funded by much broader and more diversified sources of potential income streams than revenue bonds. This is a common myth, and we believe it can lead investors astray when they are evaluating the true risks of GO vs. revenue bonds. There have been a number of instances in the past where municipalities or governments have filed for bankruptcy and defaulted on their GO bonds, even as they remained willing and able to pay their revenue bond debt. The following are two recent such cases:
Lessons from Detroit’s Bankruptcy
The Detroit bankruptcy story serves as an invaluable lesson for municipal bond market participants. In July 2013, Detroit filed the largest municipal bankruptcy in U.S. history, defaulting on several hundred million dollars of its GO bonds. Not only was the city skipping on these bond payments, but they were also unable to sufficiently pay their pension debt holders. Throughout this same period, the city continued to keep essential services running and was able to make 100% of its payments on water and sewer revenue bonds. The resulting payout structure helps disprove the long-held belief that GO bonds are the safest municipal security out there.
Lessons from Puerto Rico’s Default
The Puerto Rico debt crisis serves as another example when payment to GO bond holders are not as certain as one thinks. In 2016, the Puerto Rico government decidedly told its creditors it would not fulfill its GO debt obligations of roughly $800 million, even though these bonds were explicitly backed with a “constitutional priority” when issued. The government believed it instead needed to safeguard the essential needs of its residents and continued to pay its teachers, emergency responders, police officers and so on. In this case, the unfortunate outcome for GO bondholders was significant haircuts in their recovery.
Both of these recent examples demonstrate that when governments are faced with insolvency and hard choices, many will likely choose maintenance of basic services before making bondholder payments, even when there is a strong legal pledge to prioritize the latter. Thus, the differential in risks and income stability between GO and revenue bonds can vary greatly depending on the legal status of what is pledged for repayment, and the values and priorities of those in charge at the time the bond is due. We believe each bond, whether GO or revenue, must be carefully examined on a case-by-case basis with a discriminating eye.
Not All Defaults Create Equal Damage
While GO defaults have been rare historically, when governments do go into bankruptcy, the dollar volume of debt defaulted on can be quite large in comparison to revenue bonds. The table below reveals a sharp difference between the “default count” and the “dollar volume” of all the municipal defaults from 1970 to 2020. Based on this Moody’s study, while the competitive enterprises (i.e., revenue bonds) made up over 75% of defaults, the underlying projects that issued these revenue bonds were relatively small, resulting in a much smaller default volume than that of GO bonds. In contrast, while GO bonds only comprised 25% of the total defaults, they accounted for approximately 75% of the total default volume.
In other words, although GO bonds tend to have higher credit ratings and default less, when they do default, the damage is far greater than that of revenue bonds. Revenue bonds are not without their risks as they make up the larger percent of defaults. However, despite their higher frequency of default, the total default loss is usually less severe.
Frequency versus severity of municipal bond defaults, 1970–2020
| SECTOR | DEFAULT COUNT | DEFAULT VOLUME | ||
|---|---|---|---|---|
| COUNT | SHARE | MLN USD | SHARE | |
| General Governments | Total: 29 | 25.5% | $53,455 | 72.5% |
| City GO | 5 | 4.4% | $916 | 1.3% |
| City Lease | 3 | 2.6% | $1,767 | 2.5% |
| County GO | 3 | 2.6% | $326 | 0.5% |
| County Lease | 2 | 1.8% | $117 | 0.2% |
| K-12 GO School District | 2 | 1.8% | $10 | <0.1% |
| Special District | 2 | 1.8% | $48 | 0.1% |
| State Governments | 11 | 9.6% | $50,220 | 69.6% |
| Tax Increment | 1 | 0.9% | $51 | 0.1% |
| Municipal Utilities | Total: 8 | 7.1% | $15,107 | 20.9% |
| Electric Utility | 3 | 2.6% | $11,343 | 15.7% |
| Mass Transit | 1 | 0.9% | $439 | 0.6% |
| Toll Facility | 2 | 1.8% | $216 | 0.3% |
| Water/Sewer Utility | 2 | 1.8% | $3,109 | 4.3% |
| Competitive Enterprises | Total: 77 | 67.8% | $3,564 | 4.9% |
| Charter School | 2 | 1.8% | $28 | <0.1% |
| Higher Education | 1 | 0.9% | $47 | 0.1% |
| Hospitals & Health Service Providers | 23 | 20.2% | $2,455 | 3.4% |
| Hotel | 2 | 1.8% | $139 | 0.2% |
| Housing | 45 | 39.5% | $764 | 1.1% |
| Not-for- Profit | 2 | 1.8% | $86 | 0.1% |
| Private Colleges & Universities | 1 | 0.9% | $35 | <0.1% |
| Private K-12 | 1 | 0.9% | $10 | <0.1% |
Source: Moody’s Investor Service
Putting it all together, the municipal bond market is a highly complex and heavily nuanced space in which there is often more than meets the eye — so investors cannot solely rely on credit ratings in their decision-making. Given what has transpired in Detroit, Puerto Rico and other cases, we believe successful municipal bond investing requires a discerning bottom-up research process in an effort to select both GO and revenue bonds that will yield durable income and returns for investors over the longer term.
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