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What Are Municipal Bonds and How Do They Work?

Municipal bonds are issued by city, county, and state governments, and the interest income they generate is exempt from federal taxes.
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Darkened photo of a city hall building with text overlay that reads "What Is a Municipal Bond?"Darryl Brooks

Municipal bonds are often called "munis" for short. 

What Is a Municipal Bond?

Put simply, a municipal bond (or “muni” for short) is essentially a loan from an individual investor to a city, county, or state government to help fund a specific infrastructure project or general, day-to-day operations.

In exchange for the temporary use of the investor’s money, the state or municipality provides them with periodic interest payments before eventually paying back the principal loan amount in full when the bond matures. In many cases, municipal bond interest payments are exempt from federal and/or state income taxes.

In financial terms, a municipal bond is a fixed-income debt security issued by a local or state government that pays interest to its holder at an annual rate known as its coupon. Municipal bonds—like corporate and treasury bonds—are tradable, so they can change hands any number of times before they reach maturity, and their market value may change over time, fluctuating above and/or below their face or “par” value.

What Are the 2 Main Types of Municipal Bonds?

Most municipal bonds fall into one of two categories—general obligation and revenue—based on how repayment funds are to be sourced.

1. General Obligation

General obligation bonds are so called because there isn’t one particular source of funds from which investors are to be paid. Instead, they are backed by the “full faith and credit” of the governmental entity that issued them, as that government has the right to tax its residents in order to make interest and principal payments to bondholders.

2. Revenue

Revenue bonds, unlike G.O. bonds, are used to fund income-generating projects (like toll roads or parking meters) that can then be used to provide the funds necessary to make interest payments and eventually pay back bondholders’ principal.

What Do Municipal Bonds Pay For?

In some cases, municipal bonds may be used simply to raise money for the day-to-day operations and expenses of a governmental entity. More often, however, the funds generated from the sales of municipal bonds are used to pay for specific projects intended to benefit the residents of the issuing state or municipality. Some of the more common project-specific destinations for muni bond funds include schools, roads, bridges, libraries, parks, and other infrastructural public works.

How Is Municipal Bond Income Taxed?

Interest income generated by holding municipal bonds is not taxed federally. In many cases, it is not taxed at a state or local level either, but this varies depending on the nature of the bond and whether its buyer lives in the issuing city, county, or state. Interest income from treasury and corporate bonds, on the other hand, is taxed federally.

For this reason, an investor may prefer a municipal bond over a treasury bond—even if the treasury bond has a higher yield—because the municipal bond ends up having a higher after-tax yield. It’s important for investors to keep their tax brackets in mind and consider post-tax yields when comparing municipal bonds with other debt securities.

For example, let’s say there was a 10-year, $10,000 municipal bond with a yield of 3.5%, and a 10-year, $10,000 treasury bond with a yield of 4%. An investor in the 20% federal income tax bracket would prefer the municipal bond because it would earn them $350 per year, whereas the treasury bond would earn them only $320 ($400 minus $80 for taxes).

How Safe/Risky Are Municipal Bonds?

In general, debt securities like bonds are significantly less risky than equity securities (like stocks) and most derivative securities (like options). But how do munis compare to other types of bonds?

Because municipal bonds are backed either by income-generating projects (in the case of revenue bonds) or income tax (in the case of general obligation bonds), they have a very low default risk compared to corporate bonds. That being said, governmental entities at local, county, and state levels are not totally immune from default risk. The City of Detroit, Michigan, for instance, filed for bankruptcy in 2013. Events like this are rare, but they can happen.

One other thing to keep in mind—although it does not directly render munis “risky,” per say—is that individual municipal bonds are nowhere near as liquid as stocks or exchange-traded funds that include bonds. This means that trading them isn’t usually as easy as pressing a button in a trading app. Buyers and sellers are fewer and farther between, so trades can take time, and bid-ask spreads can be larger than anticipated.

How to Buy Municipal Bonds

The easiest way to buy many municipal bonds at once while avoiding liquidity risk is to invest in a muni-focused ETF. ETFs trade on stock exchanges, so buying shares is easy, and aside from expense ratios (a percentage of each investor’s invested balance paid to the fund’s management annually), there are no fees to worry about. Muni-focused mutual funds also exist, but these may come with additional fees, balance minimums, and other complicating factors.

Those interested in buying munis individually can do so via their bank, a brokerage, or even directly from a state, county, or local government. 

What Are the Advantages and Disadvantages of Municipal Bonds?

ProsCons

Regular interest payments

Low gain potential compared to equities

Low default risk

Inflation risk

Federal tax-free

Relatively low liquidity

Municipal Bonds vs. Treasury Bonds: What Are the Differences?

Municipal bonds and treasury bonds are both interest-paying debt securities issued by governments, but while treasury bond interest income is subject to federal tax, municipal bond interest income is not.