WHAT IS AN 'Obligation Bond'

An obligation bond is a type of municipal bond that secures a mortgage on property or another physical asset. The face value of an obligation bond exceeds the value of its collateral.

BREAKING DOWN 'Obligation Bond'

An obligation bond is a specific type of municipal bond. An obligation bond creates a personal obligation on the part of the borrower to compensate the lender for costs in excess of the value of the mortgaged property or assets, such as closing costs or transaction costs.

Obligation bonds are a subset of municipal bonds, which are debt securities issued by a state, municipality or county to finance capital expenditures, including the construction of highways, bridges or schools. Obligation bonds, like all municipal bonds, are exempt from federal taxes and most state and local taxes, making them especially attractive to people in high-income tax brackets. Issued by a nonprofit organization, a private-sector corporation or another public entity using the loan for public projects, a municipal bond gets categorized based on the source of its interest payments and principal repayments. Municipal bonds fall into one of two categories: obligation bonds or revenue bonds.

A revenue bond, unlike an obligation bond, secures principal and interest payments through the issuer or sales, fuel, hotel occupancy or other taxes.

Investing in Municipal Bonds

Default risk is low for municipal bonds when compared to corporate bonds. However, revenue bonds are more vulnerable to changes in consumer tastes or general economic downturns than general obligation bonds. For example, a facility delivering water, treating sewage or providing other fundamental services has more dependable revenue than a park's rentable shelter area.

A municipal bond’s funds are favored by investors, as municipal bonds are one of a few investments in the market that offer tax exemption. For investors, they offer yield and can be a good fixed-income option for conservative portfolio allocations. Equally sought after by high-net-worth investors in higher tax brackets for their tax exemption advantages and more conservative fixed-income portfolios, these bonds can be managed with varying objectives that are often based on location, credit quality and duration.

As a fixed-income security, the market price of a municipal bond fluctuates with changes in interest rates: when interest rates rise, bond prices decline; when interest rates decline, bond prices rise. In addition, a bond with a longer maturity is more susceptible to interest rate changes than a bond with a shorter maturity, causing even greater changes in the municipal bond investor’s income. Furthermore, the majority of municipal bonds are illiquid; an investor needing immediate cash has to sell other securities instead.

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