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Definition

Moral Obligation Bond

What is Moral Obligation Bond?

Moral Obligation Bond is a tax-free revenue bond in which the government is not lawfully required to provide cash to cover a bond debt, but has a strong motivation to do this to prevent default. This type of bond is issued by a municipality or financial intermediary at a state level that is not backed by the legal obligation but the moral one of the state government to appropriate funds in case of default.

Understanding Moral Obligation Bond

A moral obligation bond also provides stakeholders with the tax incentives of a municipal bond, but also adds a morally neutral guarantee that lenders would be protected in the case of insolvency. This is credible since the granting body's assurance is backed up by a reserve fund set up to cover any debt service bills that the government might be unable to cover. While there is no legal need to avoid insolvency, investors are motivated by a moral imperative.

A non-binding condition secures this sort of bond, allowing the issuer authority to spend funds (appropriation) to cover any shortage in funds required to accommodate the loan. The government's increased security is just morally - and not lawfully - enforceable. Nonetheless, because the issuing authority would incur adverse credit rating consequences if it omitted to follow the commitment, the commitment is widely viewed as being similarly reliable as a legally binding guarantee. As a result, the municipal government has a strong incentive to fulfill its interest payments in terms of avoiding default.

Practical Example

A homeowner’s association may sell bonds for a project, but the estimated income stream is insufficient to meet bond payments due to declining housing prices. The government supervising such a housing association is required to repay the loan payments via other funding methods in order to maintain its excellent rating on Wall Street and cheap borrowing prices.

In a Sentence

  • The term moral obligation bond is basically used in finances and stock markets which is typically issued by the government to borrow money. 
  • The moral obligation bonds may require interest that might be tax-free from federal income.

 

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