General-obligation bonds, or GO bonds, are a common financial instrument issued by state and local governments, and have features that make them different from corporate bonds and U.S. Treasury securities. General-obligation bonds can be a useful addition to your trading or retirement portfolio, if you understand the pros and cons and pick the ones that suit your objectives.
A general-obligation bond is a borrowing instrument issued by a state or local government that pays its holder a periodic interest over a specific period of time and a lump sum payment at the time of its expiration. A GO bond, for example, may have semi-annual payments, 10-percent interest and a five-year duration, with a face value of $1,000. Such a bond will pay 10 percent of $1,000, or $100 per year. Since interest payments are semi-annual, there will be two payments per year of $50 each. At the end of the the fifth year, the bond will expire, at which time you return the bond and get your original $1,000 back.
General obligation bonds are the safest type of municipal bonds. They are backed by the full faith of the issuing municipality or state. The local government can raise taxes or resort to additional borrowing to honor obligations associated with GO bonds. Revenue bonds, on the other hand, are dependent on income generated by a single project, which may fail even if the local government as a whole is doing well financially.
Potential Tax Savings
The income from a GO bond is generally exempt from federal taxes. Especially if you are in a high or top tax bracket, the resulting savings can be substantial; because of this you must be careful when comparing the potential income from a GO bond to other taxable financial instruments. Depending on your tax bracket and filing status, a GO bond paying 4 percent may result in a higher after-tax income than a taxable bond such as a Treasury or corporate security paying 5 percent; however, also depending on your tax bracket and filing status, income from a GO bond may be subject to the federal alternative minimum tax or state and local taxation.
Since GO bonds are both quite safe and promise tax savings, the issuing governmental entity can often attract investors with a relatively low interest rate. In many instances, GO bonds issued by a financially healthy municipality can carry a lower interest rate than a U.S. Treasury bond. GO bonds are generally not a good choice for those who need to grow their investments at a brisk pace to achieve their retirement goals. GO bonds are for investors whose primary aim is capital preservation and tax savings.
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