Moral Obligation Bond: What It is, How It Works

Cierra Murry is an experienced writer in banking and finance with over 15 years of expertise in financial analysis, underwriting, loan documentation, loan review, banking compliance, and credit risk management.

What Is Moral Obligation Bond?

A moral obligation bond is a tax-exempt revenue bond issued by a municipality or similar government body. It carries a moral commitment to avoid defaulting on payments, even if it means appropriating funds from elsewhere.

Key Takeaways

• A moral obligation bond is a tax-exempt revenue bond issued by a municipality or similar government body. It carries a moral commitment to avoid defaulting on payments, even if it means appropriating funds from elsewhere.
• Moral obligation bonds are not secured by the full faith and credit of the issuer, putting bondholders at risk of losing their investments if the issuer defaults on payments.
• Moral obligation bonds typically have a higher yield than general obligation bonds to compensate for the added risk.

Understanding Moral Obligation Bonds

A moral obligation bond provides investors with tax exemption benefits and a moral pledge of protecting lenders against default. 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. While there is no legal obligation to avoid default, the moral imperative does hold sway with investors.

A municipal authority may issue bonds to raise capital for projects. The two types of municipal bonds are general obligation bonds (GO) and revenue bonds. General obligation bonds are backed by the full faith and credit of the municipal government and can increase taxes to fulfill payment obligations. On the other hand, payment obligations on revenue bonds are backed by the projected revenue stream of the project. Moral obligation bonds fall under the category of revenue bonds.

Special Considerations

A moral obligation bond is secured by a non-binding covenant that permits the issuing government to appropriate funds to service the debt. This additional security serves as a credible promise, as the issuing government would face negative credit rating effects if it failed to honor the pledge. The municipal body has great incentive to make good on its interest obligations to avoid default.

For example, if a bond is issued to finance the construction of an airport and the revenue generated falls short of the required amount to fulfill interest payments, the issuer cannot increase taxes to make up for the shortfall. With a moral obligation bond, the issuer is obligated to seek alternative financing routes to fulfill its obligations to investors.

Moral obligation bonds are not secured by the full faith and credit of the issuer, putting bondholders at risk of losing their investments if the issuer defaults. Due to the higher risk, these bonds typically have a higher yield than general obligation bonds. Additionally, interest income from moral obligation bonds is exempt from federal and most state taxes for investors living in the state or municipality issuing the bond.