When a General Obligation is not a General Obligation

Last week, the Bond Buyer published a piece discussing the differentforms of legal security that can back payments to bondholders of general obligation debt.  The piece highlights the importance of conducting thorough credit analysis because, as the article points out, there are stronger and weaker forms of a security pledge that many investors implicitly assume is always the same.  The strongest form is an ad valorem property tax pledge, which is approved by voters of a district and requires the issuer to levy property taxes without limit as to rate or amount in order make good on bond payments.  This type of pledge contrasts to a general obligation pledge that does not require any specific taxation but offers the full faith and credit of the issuer and is generally thought to be quite strong due to the state's flexibility in raising various forms of taxes.  Another type of the full faith and credit pledge comes in the form of limited tax general obligations of local government entities such as cities, counties and school districts.  These have become very popular for issuers in the state of Oregon and to a lesser degree Washington, and are secured by the same “promise to pay” as at the state level because the pledge does not have any taxing requirement or authority.  The problem with this structure is that local issuers do not enjoy the same tax-raising flexibility as states, thus requiring much more judicious budget management and/or carrying a greater risk of default.  There is another form of limited tax general obligation that is voter-approved, and does require property taxes to be levied to ensure payment of the bonds but places a limit on the maximum amount of the levy rate.  These are common in Texas and Illinois, among other places, but a significant difference in the credit quality between these bonds is the room between the current levy rate and the cap, which in Texas is generally quite generous but in Illinois is considerably smaller.  These variations are all outlined in the issuing document for the bonds called the Official Statement (OS).  Understanding the security pledge in addition to the underlying credit fundamentals of what you own is of paramount importance, especially as the economic recovery continues to be modest at best and local issuers are pressured by pension obligations and funding cuts from their respective states.