Municipal Bonds
Municipal bonds are debt issued by US states, cities, counties and other public bodies to fund projects like schools and roads. Their interest is generally exempt from federal income tax, which makes them attractive to investors in high tax brackets.
When a city builds a bridge or a state funds a hospital, it often borrows from investors by issuing municipal bonds. In exchange, investors receive interest that is usually free of federal income tax. That tax break makes "munis" a staple for wealthy US investors. This entry explains the types, the tax-equivalent yield and the risks.
- Category
- Bonds and Interest Rates
- Reading time
- 3 min
- Also called
- Munis, Muni bonds, Municipal securities
- Updated
Municipal bonds in plain words
Municipal bonds, or munis, are debt securities issued by states, cities, counties and other government entities.1
Their interest is generally exempt from federal income tax and may also be exempt from state and local tax for residents of the issuing state.1
That tax advantage makes munis especially attractive to people in high tax brackets.2
How munis work, step by step
A public body needs funding
For schools, highways, hospitals and more.
It issues bonds
General obligation or revenue bonds.
Investors lend money
Receiving interest. See Coupon Rate.
Interest is tax-advantaged
Usually federal tax-free.
Principal is repaid
At maturity. See Bond.
Check disclosures
Issuer filings are free on MSRB's EMMA site.
Worked examples
Example 1 — Tax-equivalent yield
≈ 5.38% equivalentA muni yields 3.5%. You are in the 35% federal bracket.
| Formula | 3.5% ÷ (1 − 0.35) |
| Taxable-equivalent yield | ≈ 5.38% |
Because muni interest is generally federal tax-exempt, a lower yield can match a higher taxable one.1
Example 2 — Low tax bracket
Taxable bond winsSame 3.5% muni, but you are in the 12% bracket. A taxable bond pays 4.5%.
| Muni equivalent | 3.5% ÷ 0.88 ≈ 3.98% |
| Taxable bond | 4.5% |
The tax break matters most for high earners; for others a taxable bond may pay more.2
Example 3 — Rates rise
≈ −7%You hold a muni with 8 years left; market rates jump 1 point.
| Rough price change | ≈ −1% × 7 (duration) = −7% |
Bond prices fall when market interest rates rise.2 See Interest Rate.
General obligation vs revenue bonds
| Aspect | General obligation | Revenue bond |
|---|---|---|
| Repaid from | Taxing power of the issuer | A specific project's income |
| Example | State school bonds | Toll road, utility |
| Risk | Usually lower | Depends on the project |
| See also | Credit ratings | Credit Rating |
Who uses municipal bonds
High-income investors
Maximising after-tax income. See Capital Gains Tax.
Retirees
Steady, tax-advantaged income.
Bond ladders
Staggered maturities. See Bond Ladder and Barbell.
Muni funds
Diversified exposure. See Mutual Fund.
Advantages and disadvantages
Advantages
- Interest usually free of federal tax.
- Often state tax-free for residents.
- Historically low default rates.
Disadvantages
- Lower yields than taxable bonds.
- Many issues trade rarely and are illiquid.
- Interest rate and credit risk remain.
Going deeper
Read as far as you need. Each level builds on the one before it.
Who issues them
Beginner
Munis can be issued by states, cities, counties, towns and many public authorities to fund their obligations.3
Liquidity
Intermediate
Conduit bonds
Advanced
Governments sometimes issue munis for private entities such as non-profit hospitals, which agree to repay the issuer — so credit depends on that borrower.1
Common mistakes
Ignoring your tax bracket
The benefit depends on it.
Holding munis in tax-free accounts
The tax break is wasted.
Skipping credit research
Some issuers do default.
Expecting easy resale
Many munis trade thinly.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- Munis are bonds issued by US state and local governments.
- Interest is generally exempt from federal income tax.
- Tax-equivalent yield shows their real value.
- They suit high-bracket investors best.
- Liquidity and credit vary by issue.
Frequently asked questions
Are municipal bonds completely tax-free?
Are munis safe?
Where can I research munis?
Further learning
- Bond
Bond basics.
- Credit Rating
Judging issuer quality.
- Treasury Bills, Notes and Bonds
Federal government bonds.
- Yield to Maturity
Measuring a bond's return.
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- Investor.gov (SEC). Bonds – FAQs (opens in a new tab) Checked .
- Corporate Finance Institute. Municipal Bond (opens in a new tab) Checked .
- FINRA. Bonds (opens in a new tab) Checked .
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. We are not affiliated with any publisher linked above. Last reviewed . Report an error or request a source credit.