General Obligation Bond

General Obligation Bonds are municipal bonds that are backed by the full faith and credit of the issuing government entity, typically a state or local government. These bonds are used to fund public projects and are secured by the government’s power to tax its residents.

Definition

General Obligation Bonds (GOs) are bonds issued by a government that are secured by the government’s pledge to use tax revenues, typically property taxes, to repay bondholders. They represent a commitment to repay debt through taxation, making them a relatively low-risk investment option.

Key Features of General Obligation Bonds

• Backing by Government: GOs are backed by the full taxing power of the issuing authority, which means they are considered less risky than revenue bonds that depend on specific revenue streams.
• Voter Approval: In many cases, the issuance of GOs requires approval from the electorate, ensuring public support for the projects funded by the bonds.
• Tax-Exempt Status: Interest earned on GOs is typically exempt from federal income tax, and in some cases state and local taxes, making them attractive to investors in higher tax brackets.

Calculation of Debt Service

The debt service on General Obligation Bonds is determined by the amount of principal and interest that must be paid over the life of the bond.

Calculating Annual Debt Service

1. Identify the Total Bond Principal: This is the total amount issued in bonds.
2. Determine the Interest Rate: This is the coupon rate that will be paid to bondholders.
3. Calculate the Total Annual Payment: Use the formula for the annual payment on an amortizing loan.

The formula can be calculated as follows:

\[
PMT = P \times \frac{r(1+r)^n}{(1+r)^n – 1}
\]

Where:
– \( PMT \) = Annual payment
– \( P \) = Principal (amount of bonds issued)
– \( r \) = Annual interest rate (in decimal form)
– \( n \) = Number of payments (years until maturity)

Example of General Obligation Bond

Consider a city that issues $1,000,000 in General Obligation Bonds with a 5% annual interest rate, maturing in 10 years.

To calculate the annual debt service:

1. Principal (P): $1,000,000
2. Interest Rate (r): 5% or 0.05
3. Number of payments (n): 10

Using the formula:

\[
PMT = 1,000,000 \times \frac{0.05(1+0.05)^{10}}{(1+0.05)^{10} – 1}
\]

Calculating the values:

\[
PMT = 1,000,000 \times \frac{0.05(1.62889)}{(1.62889 – 1)} \approx 129,506.57
\]

Thus, the city would need to budget approximately $129,506.57 annually for debt service to repay the bondholders.

General Obligation Bonds serve as a pivotal tool for financing public projects while ensuring that investors have confidence in the government’s ability to repay its debts through taxation.