What is a GO bond anyway?
This question from a novice during the first session of Introductory Bond School earlier this year triggered unexpected pangs of anxiety. After fully appreciating the profundity of the question from the new recruit to the municipal market, I had to lament that the person asking could not fully appreciate in the very first class just how difficult the answer has become.
When I started in the business, General Obligation bonds were the bedrock credits. All other credits in one way or another have been compared and contrasted with the flagship GO from both a credit and market perspective. As they did back then, most Issuers still hold to their conviction and believe that their GO is worth fighting for in order to protect from turbulence of all kinds. Doing so also preserves the all-important market access.
If one were to ask any recently minted attorney who just passed the bar what is the best definition for a GO bond, with the response would be: an unsecured obligation. I understand the need to respond in this manner. However, even though most GOs do not have a lien on specific revenue sources, the “Full Faith & Credit” pledge has been intended to signify more. If there are sums in various funds and accounts that are not pledged specifically to other purposes under law, at least theoretically, these same sums may be applied to the repayment of GO bonds.
Most market participants are now acutely aware that a GO in one state is not exactly the same as in another. We always have known that GO Warrants in Alabama were different. It is just now we fully appreciate and are apprised of many more differences across the nation. In spite of these subtleties, $179 billion of GOs were successfully placed in the market last year.
We have now learned that when the natural order of the municipal market is disturbed, the belief that all available funds may be tapped in order to pay a GO is not always forthcoming. This predicament has even taken place when the provision for GO bonds is written into the Constitution of that governmental entity.
The lessons of the last few bankruptcies and defaults have instructed us to favor Revenue bonds due to the clarity of the pledge and the clearer treatment under bankruptcy. Then why do Revenue bonds have higher yields than GOs?
There are no easy answers to this question either. Under “normal” market conditions, GOs are rated on average much higher than revenue bonds due to the recalibration actions by some of the rating agencies some years ago.
The most common rating category for a GO on a precalibration basis approximated an “A” level. Today, the most common rating category for a GO is in the “AA” category. Many seasoned Revenue bonds can reach the “AA’” range or better, though a somewhat lower rating is more pervasive. As we know, many more factors go into determining coupons and yields, however, ratings or the lack thereof remain an important factor.
These considerations compel us to contemplate the “cliff risk” in the GO segment of the market. When GOs encounter financial difficulties, the implications can be more vexing. My yardstick for true challenges on the GO side is the diminishment in cash flow. The latter is more difficult to gauge these days with so few notes being sold. Cash flows are not always readily available.
What is a new market participant to do? How can they become learned in the ways of the Municipal Market? I urge them to study the well-worn cases of municipal defaults and bankruptcies for patterns and for the truths. A heavy supplement of asking for lessons from those who have come before has no substitute.
We do appreciate that no two cases are the same and it is the nuances of the cases that brings the true depth of understanding.