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Traditionally, state and local governments (as well as certain other nonprofit organizations such as universities and hospitals) have had the ability to issue debt, in the form of bonds, to finance construction and/or improvements to public infrastructure. Bonds issued by state and local governments—often referred to as municipal or public bonds—can also be used, under certain circumstances for private activities.
Public bonds vary by tax liability, as well as the form of security used to back the bonds. These options can be mixed and matched—for example, tax-exempt bonds could be general obligation, revenue, or asset backed.
Public bonds can differ by their tax liability—that is, what taxes the purchaser of a bond (e.g., an investor or a bank) will have to pay on the interest payments received from the issuer (e.g., state or local government). This is important for issuers, because the amount of taxes a purchaser expects to pay will influence the interest rate they offer in the terms of the bond sale. Tax liability for public bonds is largely determined by the types of activities that are funded through the proceeds.
Tax-Exempt Bonds: If the bonds are issued for a specified public purpose, the bond purchasers do not have to pay federal income tax on the interest income received from those bonds, as long as certain tax rules are met. Such bonds are referred to as tax-exempt bonds. Interest on the bond may also be exempt from state and local income taxes. As a result, tax-exempt bonds historically carry an interest rate to the borrower that is lower than comparable taxable debt. Tax-exempt bonds could be used by a government entity to fund the capital expenditures for energy efficiency improvements in public buildings, but could not, in most cases, be used to fund privately owned energy efficiency upgrades on private residences or businesses.
Private Activity Bonds: Although tax-exempt bonds typically may not be issued for the benefit of private parties (i.e., the proceeds may not be loaned to private parties or used for a private purpose), there are limited exemptions to this rule. Exemptions include various "exempt facilities" that may be owned by private parties, including solid waste disposal and recycling facilities undertaking a public function, even if privately owned. Such bonds are referred to as private activity bonds, or PABs.
Taxable Bonds: The same entities that may issue tax-exempt bonds for capital expenditures for public purposes may also issue taxable debt for private purposes. For example, a municipality could issue bonds to provide funds that are then lent to private individuals to fund energy efficiency improvements to private property. In such a case, the bond purchasers would be subject to the payment of federal income tax on the interest income received from those bonds.
Public bonds may also vary by what the bondholder's recourse is, should the issuer fail to make debt service payments — that is, the underlying bond security.
General Obligation Bonds: General obligation (GO) bonds are secured by the full faith and credit of the issuing entity. The government (or authorized entity) commits its entire asset portfolio and its taxing powers to repay the debt obligation—that is, issuers agree to use the full extent of their taxing powers to collect funds sufficient to pay the annual debt service. Because of this commitment, GO bonds often require voter approval and there are statutory caps (local and/or state) on the total amount of outstanding debt. GO bonds are one of the most commonly used bond options, because they are typically the most secure debt instrument available for financing public projects, and so offer the longest terms and most attractive interest rates.
Revenue Bonds: Revenue bonds are secured by a specific revenue stream. While the revenue stream need not be directly related to the financed project, capital lease revenue bonds entail a third party guaranteeing an energy savings revenue stream, and that guaranteed revenue stream being used as bond security.
Asset-Backed Bonds: Asset-backed bonds are secured by specific assets. These assets need not be directly related to the financed project. A school building could be used as the underlying security for a bond. To the extent that debt service payments were not made, the bondholder would have the right to foreclose on the property.
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