The principal reason municipal general obligation bonds are such low-risk investments is that they are backed by the full faith and credit of the municipalities that issue them. This means that municipalities can apply funds raised from various kinds of taxes; the default risk of GO bonds is low, since the municipality has the option of raising taxes to meet its obligations.
Most cities, towns, and villages typically rely on various kinds of ad valorem taxes to pay GO bond interest.
States and local municipalities that levy income or sales taxes may apply the revenue they generate to pay principal and interest on GO bonds. Various kinds of fees, such as license fees, can be used as well. Most cities, towns, and villages, however, typically rely on various kinds of ad valorem taxes--taxes based on the value of private and business holdings within the municipality. Property and real estate taxes are the most common types of ad valorem taxes available to municipalities. For example, if a town creates a bond issue to fund a new school building, it may increase the property tax rate in order to ensure that it will have sufficient income to meet its obligations to bondholders.
It is also possible for municipalities to repay bondholders by borrowing more money. When interest rates fall, municipalities may call a bond issue--i.e., repay the principal before the bonds mature. The municipality may then re-fund the debt by making a new bond issue at a lower rate of interest, saving itself some money in the process.
Advantages and Disadvantages of General Obligation Bonds >>