Moral Obligation Bond: Understanding Municipal and State Financial Intermediary Backing

August 25, 2024 4 min read Finance Investment Bonds Municipal Bonds Tax-Exempt Bonds State Government Moral Obligation

A moral obligation bond is a tax-exempt bond issued by a municipality or a state financial intermediary and backed by the moral obligation pledge of a state government. While the state's pledge is not legally binding, it carries significant weight.

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Definition

A Moral Obligation Bond is a type of tax-exempt bond issued by a municipality or a state financial intermediary. These bonds are supported by the moral pledge of a state government to appropriate funds necessary for debt service in case the issuing entity defaults. However, it should be noted that this pledge is not legally enforceable, as future state legislatures cannot be legally mandated to appropriate funds.

Key Characteristics

Tax-Exempt Status: Typically, interest income from moral obligation bonds is exempt from federal income tax, potentially making them attractive to investors in higher tax brackets.
Backing: Unlike legally binding guarantees, moral obligation bonds rely on the moral or ethical promise of the state government.
Intermediary Issuance: These bonds are usually issued by either municipalities or state financial intermediaries.

Structure and Issuance

Types of Moral Obligation Bonds

General Obligation Bonds: Where the municipality uses general tax revenues to repay the debt.
Revenue Bonds: Supported primarily by the revenue generated from specific projects or sources, such as tolls from a bridge or fees from a public utility.

Legal Framework

Although the state may pledge a moral obligation to support the bond, this does not legally bind it. Future legislative bodies are free to decide not to appropriate the funds, making the support only a morally persuasive argument.

Issue Process

Proposal and Approval: The need for a project is identified, and a proposal for bond issuance is prepared.
Legislative Approval: Legislatures often need to approve the moral obligation backing.
Issuance and Sale: Bonds are issued and sold to investors, with disclosure of the nature of the backing.

Historical Context

Evolution of Moral Obligation Bonds

The concept emerged in the 1970s when state entities started using moral obligation bonds to back certain debt issues in order to make them more attractive to investors. This structure allowed states to finance various public projects without dedicating legally binding general funds.

Applicability

Use Cases

Public Infrastructure Projects: Financing for roads, bridges, schools, and other public facilities.
Economic Development Initiatives: Supporting job creation and business development programs.

Example

Suppose a city wants to build a new school. The municipality issues a moral obligation bond backed by the state’s moral obligation, meaning if the city defaults, the state legislature is morally committed to providing the funds, albeit not legally obligated.

General Obligation Bond: A bond backed by the full faith and credit of the issuing municipality.
Revenue Bond: A bond repaid from specific revenue sources.
Taxable Bond: Unlike tax-exempt bonds, the interest income is subject to federal income tax.

Distinctions

Moral Obligation Bond vs General Obligation Bond: The former relies on a moral pledge, while the latter is a full legal commitment.
Moral Obligation Bond vs Revenue Bond: The state’s moral obligation as backing differentiates it from solely revenue-based support.

FAQs

Are moral obligation bonds riskier than general obligation bonds?

Yes, they carry more risk because the state’s support is moral rather than legally binding, adding an element of uncertainty.

Why would an investor choose moral obligation bonds?

Despite the higher risk, potential tax-exempt interest income and relatively higher yields can be attractive to certain investors.

Can a state refuse to honor its moral obligation?

Legally, yes. Future legislatures are not bound to honor past moral pledges, although doing so could affect the state’s reputation and future borrowing costs.

References

“Municipal Bonds: The Basics,” Municipal Securities Rulemaking Board.
“The Handbook of Municipal Bonds,” edited by Sylvan Feldstein and Frank Fabozzi.

Summary

Moral obligation bonds offer a unique investment opportunity, blending the appeal of tax-exempt income with the moral backing of state governments. While they are not without risk, their structured reliance on the ethical commitment of states plays a crucial role in financing public projects. Understanding the nuances and historical context of these bonds helps investors make informed decisions.

This structured entry provides a detailed insight into moral obligation bonds, from their definition and structure to historical context and practical examples.