Given all the municipal bonds to choose from, how do you decide which ones should make up the core of your portfolio? With $3.7 trillion of muni debt outstanding1 spread among tens of thousands of issuers, the choice may seem daunting, but we’ll help you break it down.

Municipal bonds are sold by local and state governments to help fund public projects or municipal government operations, like building new schools or repairing city sewer systems. Their interest payments are usually exempt from federal income taxes, and may be exempt from state income taxes if the bond issuer is located in the investor’s home state. For these reasons munis are often attractive to income-oriented investors looking to reduce income tax bills.

Munis can generally be classified into two camps—general obligation bonds and revenue bonds. General obligation, or GO, bonds are backed by the general revenue of the issuing municipality, while revenue bonds are supported by a specific revenue source, such as income from a toll road.

In this article, we’ll focus on GO bonds. They account for 28% of the investment-grade muni market and are usually backed by the taxing authority of the bond issuer. Most states and local governments issue GO bonds to help fund operations or specific projects. The dollar value of GOs issued by states compared to local governments is roughly equal, even though there are fewer states than local governments. In other words, the amount of debt issued per state is much larger than the amount of debt issued per local government.

General obligation bonds make up about a quarter of the muni market

Source: Bloomberg Barclays Municipal Bond Index, as of 12/1/2020.

The market’s perception of GOs has changed

Although general obligation bonds account for only about a quarter of the muni bond market, they tend to get the most attention. Historically, GO bonds were considered the more secure of the two options, because they are backed by the full faith and credit of the municipal government. Given GO bonds’ perceived security advantage, revenue bonds used to yield more than GO bonds on average—but that has changed in recent years, as illustrated in the chart below. The change can be partly attributed to Detroit’s bankruptcy in 2013. Initially, Detroit tried to treat its GO bondholders as “unsecured” creditors,2 which would have gone against the market’s longstanding belief of the security pledge of GOs. Detroit’s bankruptcy was settled outside the court, so there was no legal opinion on its security pledge. The result was that muni market participants began to scrutinize GO bonds more closely.

Revenue bonds used to yield much more than GO bonds

Bloomberg Barclays Indices, as of 12/1/2020. Differences in yields may be attributable to certain features such as call maturities, durations, call features, average credit ratings, or other factors. Past performance is no guarantee of future results.