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Municipal Bonds

Definition of 'Municipal Bonds'

Municipal bonds -- munis to the investors who love them -- are bonds issued by states and local governments.

Their key feature is exemption from federal income tax. And, if you live in a state with an income tax, chances are that muni bonds issued in your state are exempt from the state tax as well. As a result, muni yields are typically lower than yields on taxable bonds like Treasuries and corporates. Investors settle for lower yields on munis because they are also getting a tax benefit.

Not all investors can benefit from munis, though. Depending on your tax bracket, you might be able to find a taxable bond with an after-tax yield higher than the yield on a muni.

There are two main types of municipal bonds: general obligation bonds and revenue bonds. Like Treasuries, GOs are backed by the issuer's taxing power. Revenue bonds, on the other hand, are repaid from a specified revenue stream. The revenue stream can be generated by either a project (a bridge, for example) or a tax (some bondholders have a claim on state sales tax receipts).

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