General obligation bonds: good track record and here to stay

General obligation (GO) bonds have historically been the most popular means for state and local governments to fund capital improvements, providing a way to raise money for projects that may not directly generate a revenue stream. They offer the lowest borrowing costs among the various types of municipal bonds because of their broad security pledge.

GO bonds are backed either by a pledge of the “full faith and credit” of the issuer or an unlimited ad valorem property tax to pay debt service. What does full faith and credit mean? This term refers to the ability of a court to compel a municipality to increase property taxes to repay the bonds if necessary. This is a legally binding commitment that municipalities make with bondholders that requires municipal issuers to increase property tax levies as needed.

There are two types of GO bonds: the limited-tax GO and the unlimited-tax GO bond. As the names suggest, a limited-tax GO bond allows a municipality to raise property taxes within a specified limit while the unlimited GO has no limit on the increases. The owner of a GO bond may look for repayment from all legally available sources of revenue that the municipality is entitled to receive. In simple terms, the bonds are backed by the state and local governments’ ability to tax constituents and raise taxes in order to pay bondholders. For states this power comes in the ability to raise state income taxes and/or sales tax. At the local level, it normally comes in the form of an ad valorem tax, which is the property tax based on the real value of property.

Investors and other participants have long viewed GO bonds as very safe investments, perhaps second only to United States Treasury securities. Due to their wide pledge of security and traditionally higher credit quality issuers, this type of bond tends to offer less yield when compared to other investment options in the municipal market. Despite the lower yield, GO bonds have a crucial place in a diversified portfolio to manage risk.

Municipal bankruptcies are few and far between in the United States as seen in Figure 1. It’s rare for municipal bonds to default and even rarer for GO bonds to default. The average five-year municipal default rate since 2012 is 0.1% compared to the 7.2% rate that global corporate entities have experienced (including high-yield issuers).¹ Additionally, municipal issuers are on average rated much higher than corporates.

We can also see in Figure 1 that the incidence of municipal default rates was well below that of global corporates, though clearly linked to overall economic cycles. The credit quality of the municipal market has stabilized since the Global Financial Crisis (GFC) and has been further lifted by federal aid and unprecedented economic recovery during the last several years. In addition to low default rates, recovery rates in the municipal market are significantly higher than in the corporate market. Since 1970, Moody’s-rated municipal bonds have had a 66% recovery rate, which is far better than the 47.4% recovery rate of senior unsecured bonds of North American corporate issuers since 1987.² Figures 2 and 3 illustrate the difference in credit quality ratings between municipal bonds and corporate bonds.

Figure 1:  Municipal vs Corporate Defaults (Investment grade and high yield issuers)

Source: S&P Capital IQ. Shown for illustrative purposes only and should not be interpreted as a recommendation to buy or sell.

As previously mentioned, the municipal market is higher rated than the corporate market, which can be seen in Figures 2 and 3 by rating category. Generally speaking, state GO ratings are on the higher end of the investment grade spectrum whereas the distribution of corporate issuers is concentrated in the “B” rating category.

Figure 2: Current state general obligation bond ratings (US only)

Source: S&P Capital IQ. Shown for illustrative purposes only and should not be interpreted as a recommendation to buy or sell.

Figure 3: Current corporate bond ratings (US only)

Source: S&P Capital IQ. Shown for illustrative purposes only and should not be interpreted as a recommendation to buy or sell.

Since the GFC, we have seen home prices and property values steadily increase, which has supported the GO sector. Property values in both cities and counties have exhibited strong growth. Despite the macroenvironment in 2020, cities and counties posted strong growth in market values of 6.8% and 5.5% respectively. Valuation growth helped cities and counties maintain steady property tax revenue collections during a time when other revenue streams were volatile. Whether home price declines actually show up in local tax revenue will depend on a number of factors that can affect assessed property value, which secures bonds at the local level. There is a lag between what happens in the housing market and when assessments are completed. Thus local governments have a year or two before the current movements in the real estate market actually impact property values. This gives local governments the ability to take defensive actions and manage budgets well before they see declines in property tax revenue hit their financial statements. Despite the housing crash in 2008, property tax collections in the following several fiscal years remained strong (Figure 4).

Figure 4: State property tax collections in the wake of the GFC

Source: US Census Bureau. Shown for illustrative purposes only and not a guide to future results.

It remains to be seen how the current housing market dynamics play out but our view is that the housing market is on better footing today than it was during the 2008 housing crisis. As seen in Figure 5, housing prices have been on a steady incline with near-record amounts of equity being built for homeowners, putting them in a stronger position compared to 2008. Additionally, we can see that homeowners today have more fixed rate mortgages relative to 2008, which is beneficial in a rising rate environment (Figure 6). Lastly, the housing market today is in better health thanks to stricter lending standards that resulted from the GFC. Figure 7 shows the credit quality of loans today compared to the time leading up to the GFC. Today more than 70% of home loans go to those with credit scores higher than 720. 

Figure 5: Steep inclines in home value since the GFC (billions)

Source: Federal Reserve Bank of St. Louis. Historical trends may not continue and are not a guide to future results.

Figure 6: Fewer floating rate mortgages (as a % of all mortgages) than pre-GFC

Source: Bloomberg. Shown for illustrative purposes only and should not be interpreted as investment guidance.

Figure 7: Mortgage origination by credit score

Source: Bloomberg. Shown for illustrative purposes only and should not be interpreted as investment guidance.

GO bonds have historically comprised a stable position in the municipal marketplace and we expect them to remain durable in the near term, especially amid the headwinds of slower future economic growth. States have conservatively constructed budgets anticipating lower revenues and the possibility of a recession and have the authority to increase taxes and cut expenditures as needed. Additionally, many states are coming off of record rainy day funds, which will be crucial in the coming fiscal years. Even at the local level, property taxes are not expected to experience widespread declines and have historically offered a stable source of revenue. There are nuances amongst credits due to economic strengths, unique state laws, demographics and budgets, which require careful credit analysis and a prudent investment process. We maintain our high conviction that GO bonds have an important place in a diversified portfolio and are an important risk management tool for fixed income investors.

^1,2Moody’s.