Public Purpose Bond: What It Is, How It Works

What Is a Public Purpose Bond?

A public purpose bond is a type of debt security that municipalities use to finance public works facilities and improvements. A public purpose bond must fund a project that benefits the public at large and not private individuals.

Public purpose bonds enjoy mostly tax-exempt status. Their income is tax-free at the federal level, and often at the state level if the individual resides in the state of bond issuance.

How a Public Purpose Bond Works

A public purpose bond is a specific kind of municipal bond that funds a public project. They finance public work projects that do not attract private investment or produce revenue. These bonds are generally employed to fund such projects as road construction and maintenance, libraries, swimming pools, and other municipal facilities.

Public purpose bonds are exempt from federal income taxes and were first defined by the Tax Reform Act of 1986 which requires the categorization as either public purpose or private purpose bonds. In order to issue a public purpose bond, a municipality must be able to tax its residents, plus have the ability to exert eminent domain or police power.

Public purpose bonds are a kind of municipal bond classified as a general obligation bond (GO). GO bonds receive backing from the credit and taxing power of the issuing jurisdiction as opposed to a bond backed by the revenue derived from any given project. As general obligation bonds, public purpose bonds do not require assets for collateral; instead, the municipalities issue the bonds with the belief that they will be able to repay their debt obligation through taxation or revenue from projects.

Oversight of Public Purpose Bond Issues

The Municipal Securities Rulemaking Board, (MSRB), is a regulating body that creates rules and policies for investment firms and banks in the issuing and sale of municipal bonds, notes, and other municipal securities. States, cities, and counties issue municipal securities for a variety of reasons. MSRB is the official source of data and disclosure statements for all available municipal debt securities. Issuers agree to provide specific information to MSRB. This information includes annual financial reports and notices about events such as delinquencies, defaults, unscheduled draws on debt service reserves, and any activities that would affect the tax-exempt status of the security.

Public Purpose vs. Private Purpose Bonds

Public purpose bonds require the majority of the funded project to benefit the public at large. In contrast, a private purpose bond finances a project for which at least 10% of the benefit will go to a private sector entity.

For example, a city is hoping to attract economic investment and wants a corporation to open a new headquarter in the town. To entice the corporation the city issues a municipal bond lending the corporation the funds to build its new headquarters. The municipality hopes the office will create jobs and stimulate the city’s economy. 

By issuing the bonds, the corporation can borrow funds at a lower interest rate than a bank would offer. The city benefits from economic growth. The income any investors make off of this bond, however, is taxable because a private entity generates the revenue.