Special Assessment Obligations
What are Special Assessment Obligations?
Special assessment obligations (also called special assessment bonds) are municipal bonds that are repaid with taxes assessed on the property that benefits from the improvements financed by the bonds.
How Do Special Assessment Obligations 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 it needs to do so. To finance the project, ABC Town could issue special assessment obligations. Because only people that live in the district will benefit from the improvement, ABC Town might levy a tax (i.e. a special assessment) on the property owners in the district. It would then use those tax revenues to make the interest and principal payments on the bonds.
In general, issuers can only collect special assessments equal to or less than the cost of the project. So in our example, ABC Town could not collect more than $10 million in assessments for the project.
Why Do Special Assessment Obligations Matter?
It is important to note that special assessment bonds are like revenue bonds in that if taxes collected from the assessments is insufficient, 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 obligations is that the interest is usually exempt from federal taxes and most state and local taxes (if the investor lives in the state or municipality issuing the debt). Generally speaking, this exemption means that investors in high federal tax brackets can benefit from special assessment obligations and other municipal bonds. Because of this relationship, there is usually stronger demand for special assessment obligations in high-tax states.
In addition to the interest rate risk that all bonds are exposed to, pending or suspected tax legislation can dramatically affect the value of special assessment obligations. 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 valuable.