What it means
Local governments borrow by issuing bonds to pay for schools, roads, water systems and other public projects. Investors lend the money and receive interest and repayment of principal over time.
In a general obligation bond, repayment is backed by the full faith and credit of the issuer, which means a legal promise to use all its available resources. An unlimited tax general obligation bond goes a step further by allowing the issuer to raise property tax rates as high as needed to meet the debt payments.
A limited tax bond, by contrast, is backed by taxes that cannot exceed a legal cap. The absence of a cap on the pledge means bondholders have a stronger claim, and the bonds typically carry lower yields than weaker credits.
The taxes are usually levied on the assessed value of property, and are often expressed as a rate per $1,000 of value, called a mill rate. In many places, voters must approve the issue of such a bond at an election.
The tax raised for debt service is generally kept separate from the money used for ordinary running costs. For investors, strength of the pledge is only one part of the analysis.
They also look at the size and growth of the local tax base, the level of existing debt, the economy and the history of tax collection. A very high tax burden on residents can eventually drive people and businesses away, even if the legal power to tax is unlimited.
Interest on many municipal bonds is exempt from federal income tax, and sometimes state tax for residents of the issuing state, which makes them attractive to investors in high tax brackets. The details depend on the bond and on current law.
Businesses with surplus cash sometimes buy short-dated municipal bonds for the tax advantage, but they should check how the rules apply to them. Rating agencies look beyond the legal pledge when they judge these bonds.
They examine whether the tax base is diversified, how large local employers are and whether pension and other long-term obligations of the issuer are growing. A bond with an unlimited pledge from a shrinking community can be riskier than one with a limited pledge from a thriving one.
In practice
Real-world examples.
Example
A school district asks voters to approve $50,000,000 of unlimited tax bonds to rebuild two schools. If the measure passes, property owners will pay a dedicated tax each year until the bonds are repaid.
Example
A bond fund manager compares an unlimited tax bond with a limited tax bond from a similar city. She accepts a slightly lower yield on the unlimited tax issue because the pledge is stronger.
Example
A county with a falling property tax base finds its debt service per household rising. Analysts keep the unlimited tax pledge in mind but watch whether residents' ability to pay is weakening.
Formula
Calculation
Required tax rate = annual debt service / total assessed value of taxable property
A school district must pay $1,200,000 a year in principal and interest on its unlimited tax bonds. The taxable property in the district has an assessed value of $400,000,000. Required rate = 1,200,000 / 400,000,000 = 0.003, which is 3 mills or $3 per $1,000 of value. A home assessed at $300,000 would therefore pay 300,000 x 0.003 = $900 a year towards the debt.Case study
Seen in the real world.
Ridgemont County is an illustrative, fictional local authority that issued $30,000,000 of unlimited tax bonds to build a water treatment plant. Each year the county levied a dedicated tax rate to produce around $2,400,000 of debt service.
A downturn lowered property values by 12%, so the county raised the tax rate by about 14% to collect the same $2,400,000. Bondholders were paid in full and on time, because the legal pledge allowed the rate to adjust.
Homeowners complained about the higher bills and the county's credit rating agency noted the pressure on the tax base. The illustrative lesson is that the pledge protects bondholders, but taxpayers and the economy bear the strain when values fall. The county kept its rating and refinanced part of the debt two years later at a lower interest rate, which reduced the annual tax needed.
Watch out
Common mistakes.
- Assuming unlimited means risk free, when a weak local economy can still strain repayment.
- Confusing unlimited tax bonds with revenue bonds, which are repaid from the income of a specific project rather than from taxes.
- Ignoring the issuer's total debt, because many bonds paid from the same tax base add to the burden.
Questions
People also ask.
What is the difference between an unlimited and a limited tax bond?
An unlimited tax bond can be repaid from taxes raised without a rate cap, while a limited tax bond relies on taxes that are subject to a legal ceiling.
Who approves these bonds?
Often voters must approve them, though the rules vary by state and by type of issuer.
Why do investors accept lower yields on them?
Because the unlimited taxing pledge makes default less likely, so they demand less compensation for risk.
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