State and Local Governments

Classifying State and Local Debt Instruments

Security: General Obligation, Revenue, and Lease Rental Bonds

Another important characteristic of tax-exempt bonds is the security provided to the bondholder. General obligation (GO) bonds pledge the full faith and credit of the issuing government. The issuing government makes an unconditional pledge to use its powers of taxation to honor its liability for interest and principal repayment. Revenue bonds, or non-guaranteed debt, pledge only the revenue from a specific tax or the earnings from the project financed with the bonds. Should these revenues or earnings prove to be inadequate to honor these commitments, the issuing government is under no obligation to use its taxing powers to finance the shortfall. Some revenue bonds are issued with credit enhancements provided by insurance or bank letters of credit that guarantee payment upon such a revenue shortfall.

Figure 2 displays the breakdown between long-term GO and revenue bonds since 1992. The long-term market has been and continues to be dominated by revenue bonds. The revenue bond share has fluctuated between 60% and 72% from 1992 through 2016.

All tax-exempt interest income attributable to state and local governments does not appear in the form of bonds. Governments may enter into installment purchase contracts and finance leases for which the portion of the installment or lease payment to a vendor is tax exempt. For example, computer equipment or road building equipment could be leased from a vendor using a rental agreement or an installment sales contract. Under this type of agreement, the monthly payments to the vendor are large enough to cover the vendor's interest expense on the funds borrowed to purchase the equipment which was leased to the government. The portion that is attributable to interest income is not included in the vendor's taxable income. Such transactions are often referred to as municipal leasing.

Figure 2. Volume of Long-Term Tax-Exempt Debt: General Obligation (GO) and Revenue Bonds, 1992 to 2016

Lease rental revenue bonds and certificates are variations on revenue bonds. An authority or nonprofit corporation issues bonds, builds a facility with the proceeds, and leases the facility to a municipality. Security for the bonds or certificates is based on the lease payments from the municipalities. When the bonds are retired, the facility belongs to the lessee (the municipality). An advantage to this type of arrangement is that many states' constitutional and statutory definitions do not consider this type of financing to be debt because the lease payments are annual operating expenses based upon appropriated monies.

The leasing technique has also been used to provide tax-exempt funds to nonprofit organizations. A municipality issues the bonds for the construction of a facility that is leased to a nonprofit hospital or university. Again, security for the bonds is based on the lease payments.