A moral obligation bond is a tax-exempt bond issued by a municipality or a state financial intermediary and backed by the moral obligation pledge of a state government. While the state's pledge is not legally binding, it carries significant weight.
A Moral Obligation Bond is a type of tax-exempt bond issued by a municipality or a state financial intermediary. These bonds are supported by the moral pledge of a state government to appropriate funds necessary for debt service in case the issuing entity defaults. However, it should be noted that this pledge is not legally enforceable, as future state legislatures cannot be legally mandated to appropriate funds.
Tax-Exempt Status: Typically, interest income from moral obligation bonds is exempt from federal income tax, potentially making them attractive to investors in higher tax brackets.
Backing: Unlike legally binding guarantees, moral obligation bonds rely on the moral or ethical promise of the state government.
Intermediary Issuance: These bonds are usually issued by either municipalities or state financial intermediaries.
Although the state may pledge a moral obligation to support the bond, this does not legally bind it. Future legislative bodies are free to decide not to appropriate the funds, making the support only a morally persuasive argument.
The concept emerged in the 1970s when state entities started using moral obligation bonds to back certain debt issues in order to make them more attractive to investors. This structure allowed states to finance various public projects without dedicating legally binding general funds.
Suppose a city wants to build a new school. The municipality issues a moral obligation bond backed by the state’s moral obligation, meaning if the city defaults, the state legislature is morally committed to providing the funds, albeit not legally obligated.