Moral Obligation Bond: What It is, How It Works

What Is Moral Obligation Bond?

Moral obligation bond is a tax exempt revenue bond issued by a municipality, or similar government body, that carries with it a moral, though not legal, commitment to avoid defaulting on payments, even it means appropriating funds from elsewhere.

Understanding Moral Obligation Bonds

A moral obligation bond not only gives investors the tax exemption benefits inherent in a municipal bond, but also provides an additional moral pledge of protecting lenders against default. This has credibility as the issuing body's commitment is supported by a reserve fund established to meet any debt service costs the government may be unable to make. So, while they is not the legal obligation to avoid default, the moral imperative does hold sway with investors.

A municipal authority may issue debt in the form of bonds to raise capital to finance projects. The two types of municipal bonds are general obligation bonds (GO) and revenue bonds. The interest payment and principal repayment of a general obligation (GO) bond are funded from the state or local government’s financial coffers. These bonds are backed by the full faith and credit of the municipal government which may have the authority to increase taxes in order to fulfill its payment obligations on the GO bond. On the other hand, payment obligations on a revenue bond are backed by the projected revenue stream of the project for which the bond was issued. One form of a revenue bond is the moral obligation bond.

Special Considerations

A moral obligation bond is secured by a non-binding covenant which permits the issuing government to appropriate funds (appropriation) to make up for any shortfall in funds needed to service the debt. This additional security provided by the government is only morally - and not legally - binding. However, the pledge is generally regarded as being as credible as a legally binding promise because the issuing government would face negative credit rating effects if it failed to honor the pledge. Thus, the municipal body has great incentive to make good on its interest obligations in order to avoid default.

For example, a bond is issued to finance the construction of an airport in a major city. The revenue generated by the airport is the source of income stated to service the bond and repay the principal when the bond matures. However, if the revenue generated from airport services falls short of the required amount needed to fulfill the municipality’s interest payments, the issuer cannot increase taxes on its residents to make up for this shortfall. With a moral obligation bond, the issuer is obligated to make a concerted effort to seek other financing routes in other to make its interest and principal payments to investors.

Since moral obligation bonds are not secured by the full faith and credit of the issuer, bondholders face the risk of losing all their investments if the issuer defaults on its payments. Due to the higher risk, these bonds typically have a higher yield than general obligation bonds to compensate for the added risk. In addition to the higher yield earned, interest income from moral obligation bonds is exempt from federal taxes and most state taxes if the investor lives in the state or municipality issuing the debt.