Municipal bonds, also known as “munis,” are debt securities issued by state, city, or local governments and their agencies to raise funds for public projects such as building schools, roads, bridges, water systems, and hospitals. When you purchase a municipal bond, you effectively lend money to the government, which promises to pay you interest regularly until the bond matures, at which point your principal is repaid.
How Do Municipal Bonds Work?
Municipal bonds work like loans to local governments for funding essential public works. The issuer—the state, city, or agency—sets the bond’s face value, interest rate (coupon), and maturity date. Investors buy the bond, providing capital upfront.
Interest payments are typically distributed semi-annually, and one of the key advantages is that this income is often exempt from federal income tax. Additionally, if you invest in bonds issued by your state or local government, interest may also be exempt from state and local income taxes, increasing its attractiveness.
At maturity, the government repays the bond’s face value to the investor. The primary purpose is to provide governments with financing that does not require immediate tax hikes while giving investors a relatively stable, tax-advantaged income stream.
Types of Municipal Bonds
Munis come mainly in two types:
General Obligation (GO) Bonds
GO bonds are backed by the issuer’s ability to tax residents and businesses broadly. They represent a “full faith and credit” obligation, meaning the government pledges its taxing power to repay bondholders. Because of this backing, GO bonds are generally considered safer.
Revenue Bonds
Revenue bonds are repaid from the revenue generated by the specific project financed by the bond. Examples include toll roads, airports, or utility systems. These bonds carry somewhat higher risks because repayment depends on the project’s success, but they may offer higher interest rates.
For more details on bond types, see our Revenue Recovery Bonds for Municipalities article and the Bonds glossary page.
Why Invest in Municipal Bonds?
Investors choose municipal bonds for several reasons:
- Tax Benefits: Interest income from most municipal bonds is exempt from federal income tax under IRS rules (see IRS Publication 550). Many states also exempt interest for bonds issued within their borders. This is especially advantageous for investors in higher tax brackets.
- Safety: Munis have a historically low default rate, making them relatively safe investments.
- Diversification: Municipal bonds often behave differently than stocks or corporate bonds, providing portfolio balance. To learn more about diversification, visit our Diversification glossary entry.
- Community Support: Investing in munis means your money funds local infrastructure projects that benefit your community.
Considerations and Risks
Though municipal bonds are generally safe, investors should be aware of certain risks:
- Credit Risk: There’s always a small chance of default. Rating agencies such as Moody’s, S&P, and Fitch provide credit ratings to help assess issuer risk.
- Interest Rate Risk: Rising market interest rates can reduce the market value of existing bonds. See our Interest Rate Risk page for more.
- Tax Considerations: Many municipal bonds’ interest is exempt from federal income tax, but some private activity bonds may be subject to the Alternative Minimum Tax (AMT). Also, interest income from bonds issued outside your state may be subject to state and local taxes.
How to Invest in Municipal Bonds
You can invest in individual bonds through brokerage firms or gain diversification by investing in municipal bond mutual funds or ETFs.
Before investing, review the issuer’s credit rating and the bond’s maturity date. Shorter maturities reduce interest rate risk but provide lower yields, whereas longer maturities offer higher yields but greater price sensitivity.
Common Questions
Are municipal bonds liquid? Generally, yes, but liquidity varies. Larger issues tend to be more liquid.
What if the issuer defaults? Defaults are rare but can lead to reduced payments or restructuring.
Where to buy? Bonds can be purchased via brokers or through municipal bond funds and ETFs.
For deeper tax details, check IRS Publication 550 here.
Summary
Municipal bonds provide a tax-advantaged way to support local governments while earning steady interest income. By understanding the types, risks, and tax implications, investors can effectively incorporate munis into a diversified portfolio aligned with their financial goals.
