State and federal governments issue debt under various authorities,agencies, localities, and special purposes. State debt issued and secured only by the state’s good name is called general obligation debt.
The Nature of General Obligation Debt
State general obligation or g.o. debt represents debt issuance secured and supported by the full faith and credit of the issuing state. State debt is commonly called g.o. debt. State debt is commonly separated by purpose and creditworthiness. Typical debt issuance is for water and sewer projects, state construction projects of state facilities, roads, jails, and important education projects.
The Expected Life of State Created Debt
Debt service, the payment of principal and interest, is usually paid on a level debt basis. This is similar to the amortizing payment plan of a home mortgage. The total payment of principal and interest is in equal amounts but in inverse proportion every year until debt is extinguished. The life of the bond issuance is determined by the useful life of the project being underwritten.
The Types of Bond Issuance
General obligation debt is the most important, strongest form of state debt. However, special taxing authorities or sales tax income may be earmarked for special purposes. This debt is tax-exempt from federal taxes but may or may not be deductible for state income tax purposes. Special project finance does not normally include a general obligation guarantee. Other projects, particularly port, airline, and transportation facilities are supported by the individual cash flow of the project. They may be supported by contracts and tax advantaged inducements but do not carry the general obligation of the state.
The Rating of a State’s Municipal Bond Debt
The rating of the bond issue by the major rating agencies has important consequences for the issuer. Rating agencies examine the total debt picture of the state including contingent liabilities, the long term outlook for the state, the per capital income and demographic data. The difference between a AAA rating and an A rating on a $200,000,000 bond issue can easily mean 25 percent more in extra interest costs or over $1,500,000 per year for the average life of the issue. Revenue bond issues without general obligation backing trade specifically on the outlook for the project in question.
The Tax Exemption is on the Income Only
Bonds purchased at a discount at the time of the original bond issuance are called ‘original discount issue bonds.’ As they accrue over the life of the bond issue that discount is considered tax exempt income. A bond issued at par and later bought at a discount because of higher interest rates or credit deterioration would create an annual taxable capital gains event if the bond is sold at a higher price or kept to maturity. Lastly, certain types of revenue municipal bonds, never general obligation credits, can create alternative minimum tax situations.