Market Sector

There are basically two types of municipal bonds issued by state and local governments: 1) General Obligation Bonds and 2) Revenue Bonds. These are defined in detail below.

Each type of bond has a higher or lower risk of default, that is, non-payment of interest or principal, based on the way the debt is supported.

While a bond's status can change from good to bad due to a credit downgrade, it can also change due to positive market events like a refinancing which results in the best of status of all, the gold plated Pre Refunded bond.

Pre-Refunded bonds are the safest of all since they are not backed by their issuer, but are backed by U.S. Treasury bonds.

Pre-refunded municipal bonds are created when municipalities issue new debt to refinance debt issued when interest rates were higher. This is analogous to a consumer refinancing their home mortgage when interest rates drop. Once the refinancing is completed the issuer uses the proceeds of the new issue to purchase collateral, such as U.S. Treasury securities, and places these securities in an escrow account. The income from the collateral is then used to pay interest and principal on the original debt until the bond is called. The call date and price are set when the refinancing is completed.

Since they are backed by Treasury instruments, they are as safe as but generally pay a higher premium than Treasuries. An additional advantage over other bond types is that they are generally exempt from federal and state taxes, which, in effect, increases their return.

Next in order of default risk are General Obligation (GO) bonds. These bonds are backed by the full faith and credit of the states and localities that issue them.

While the issuers in theory have "unlimited" taxing authority, in reality, it may be a problem to enact these taxing powers and defaults while rare have occurred. For example, New York in 1975 defaulted on its GO Bonds, as did Orange County in California which declared bankruptcy in 1994.
GO bonds give municipalities a tool to raise funds for projects that will not provide direct sources of revenue, such as roads and bridges, parks and equipment. As a result, GO bonds are typically used to fund projects that will serve the entire community.
Next in order of default risk are Revenue bonds which are used to fund projects that will serve specific populations who provide revenue to repay the debt through user fees and use taxes, such as hospitals, universities, airports, toll roads, and public utilities.
These bonds are considered riskier than GO bonds since they depend on the revenues from the projects they fund to repay the bond debt, rather than the taxing authority of state or local government.
Revenue bonds are backed can be categorized into:

A) Basic infrastructure such as gas & electricity production and transmission, water & sewer infrastructure, or transportation infrastructure (i.e. toll roads, tunnels and bridges).

B) Specific purposes such as higher education, multifamily housing, hospitals, nursing homes, congregate care retirement communities, assisted living facilities, sales tax revenue, cigarette/liquor tax ("sin tax" collections), tobacco settlement proceeds, or for-profit entities using conduit financing to encourage local economic or environmental improvements.
Because they are not backed by the full faith and credit of a municipality, the way GO bonds are, they carry a somewhat higher default risk, but pay higher yields in return. To evaluate a revenue bond, it is important to understand the type and cash flow of the project that will be providing the revenue.