What are Special Assessment Bonds?
Special assessment bonds (also known as special assessment obligations) are municipal bonds that are repaid with taxes assessed on the land that benefits from the improvements financed by the bonds.
How Do Special Assessment Bonds Work?
For example, let's assume ABC Town wants to revamp the sewer system in the XYZ neighborhood, but it does not have the $10 million necessary to do so. To finance the project, ABC Town issues special assessment bonds. Because only people that live in the district will benefit from the upgrading, ABC Town might put a tax (i.e. a special assessment) on the property owners in the district. It would then use the tax revenues for making the interest and principal payments on the bonds.
Usually, issuers are only allowed to collect special assessments totaling to an equal or lesser value of the cost of the project. Therefore, in our example, ABC Town could not collect more than $10 million in assessments for the project.
Why Do Special Assessment Bonds Matter?
It is important to note that special assessment bonds are like revenue bonds in that if taxes collected from the assessments are not enough, ABC Town might not be able to make timely interest and principal payments on the bonds.
Like most municipal bonds, one of the largest advantages of investing in special assessment bonds is that the interest is generally exempt from federal, most state and local taxes (if the investor lives in the state or municipality issuing the debt). This exemption means that investors in high federal tax brackets can benefit from special assessment bonds and other municipal bonds. Because of this relationship, there is usually stronger demand for special assessment bonds in states with high tax rates.
In addition to the interest rate risk that all bonds are exposed to, pending or suspected tax legislation can significantly affect the value of special assessment bonds. Remember, the higher the marginal tax rate, the more valuable the bond's tax exemption is. If a state or the federal government reduces tax rates, the bonds lose some of their advantage for high-tax-bracket individuals, and thus become less desirable and valuable.