Obligation bond

Obligation bond

Obligation bonds, also called revenue bonds, are essential components of municipal finance. They act as a tool for governments to raise money and finance vital community-benefitting projects. Obligation bonds are more potent than general obligation bonds, which rely on a municipality’s taxing power because they are funded by revenue from specific projects.  

Due to this quality, they become a unique and strategic tool for governments to carry out projects like infrastructure development, public utilities, transit networks, and more. Understanding how obligation bonds function is essential for investors, decision-makers, and the general public because it clarifies the financial underpinnings of these investments and their effects on society. 

What is an obligation bond? 

An obligation bond is a municipal bond not backed by the proceeds from a specific project but rather by the credit and taxing power of the jurisdiction issuing it. Municipalities issue general obligation bonds to repay the debt through taxes or project revenues. There are no assets pledged as security.  

Local and state governments can finance public projects by issuing general obligation bonds, which are debt securities. They are supported by the issuing government’s full faith and credit, guaranteeing it will utilise its taxing authority to pay back investors.  

Bonds with a general obligation serve as a crucial source of finance for infrastructure initiatives, including building roads, schools, and public utilities. Governments can spread the expense of expensive projects over a more extended period by issuing these bonds, making them more affordable and manageable. 

Understanding an obligation bond 

Obligation bonds are essential to public finance because they allow governments to finance critical infrastructure projects. They provide many advantages, including reduced borrowing rates, excellent credit scores, and tax advantages.  

Investors buy obligation bonds when released, lending money to the government. The government uses the money to pay for the project, such as building a stadium, a bridge, or a better utility system. The bondholders are repaid using the project’s earnings, such as tolls, fees, or user charges.  

The project’s success is essential to the bonds’ repayment. If the project makes enough money, bondholders will get regular interest payments and their principal investment back at maturity. However, the bondholders can be at risk of missed or reduced payments if the project needs to bring in more money. 

Types of obligation bonds 

The following are the types of obligation bonds: 

• Limited tax general obligation bonds 

A specified, constrained tax revenue source supports limited tax general obligation bonds. The amount of tax that can be imposed is capped, but the issuer promises to utilise a specific tax, such as property tax, to pay back the bonds. 

• Unlimited tax general obligation bonds 

General obligation bonds with unlimited taxation have no restriction on the amount of taxes that can be collected to pay off the bond. Taxes may be raised by the issuer if necessary to guarantee prompt bond repayment. 

• Double-barrelled general obligation bonds  

General obligation bonds with double barrels combine aspects of revenue and general obligation bonds. They offer additional protection to bondholders by carrying the full faith and credit of the issuer and are primarily backed by a specified revenue source. 

Benefits of obligation bond 

The following are the benefits of obligation bonds: 

• It is regarded as a very safe investment choice by investors. 
• It encourages investors to put money into these kinds of bonds because it is tax-exempt. 
• Since municipalities can request higher taxes than usual to pay the dues, the investors will receive total repayments from the tax authorities in the event of any default. 
• Investors are encouraged to purchase general obligation bonds since these bonds are publicly issued and substantially increase capital. 

• Issuing bonds in the market aids the towns in finishing the project. 
• The municipality must pay off the debts with the proceeds when a project fails in the worst-case scenario or due to a financial shortfall. 

Example of an obligation bond 

Municipal bonds are an example of an obligation bond. State and local governments issue municipal bonds to finance public infrastructure projects like building schools, hospitals, roads, or bridges.  

 As a result of the issuing government’s legal requirement to repay the borrowed money to the bondholders with regular interest payments, these bonds are regarded as obligations. Investors effectively lend money to the government organisation issuing the bond when they buy municipal bonds. In exchange, the government guarantees to pay the bondholders interest regularly and to repay the principal sum when the bond matures. 

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