Municipal Bond

Municipal Bond: Definition, Types, Risks, and Tax Benefits

What is a municipal bond?

A municipal bond (muni) is a debt security issued by state, county, or local governments—or by agencies acting on their behalf—to raise capital for public projects such as schools, highways, water and sewer systems, and parks. Investors who buy municipal bonds are lending money to the issuer in exchange for periodic interest payments and repayment of principal at maturity.

How municipal bonds work

• Issuer borrows capital and promises interest (coupon) payments to bondholders.
• Principal is repaid at the bond’s maturity date.
• Interest rates on many municipal bonds are lower than on taxable bonds because interest may be exempt from federal—and sometimes state and local—income taxes for qualified investors.

Main types of municipal bonds

• General obligation (GO) bonds: Backed by the issuer’s taxing power or general funds. Considered relatively secure because repayment is supported by broad revenue sources (e.g., property taxes).
• Revenue bonds: Repaid from revenues generated by a specific project or source (e.g., tolls, utility charges, hotel occupancy taxes). Risk depends on the project’s ability to generate consistent cash flows.
• Conduit bonds: Issued by a government entity on behalf of a private borrower (e.g., nonprofit hospital or developer); the third party is responsible for payments.

Note: Some municipal issues are not tax-exempt (taxable munis), depending on purpose and structure.

Tax treatment

• Interest from many municipal bonds is exempt from federal income tax.
• Interest may also be exempt from state and local taxes if issued within the investor’s state of residence.
• Tax status varies by bond; some munis are taxable. Always confirm an issue’s tax treatment before investing.

Risks

• Credit/default risk: Generally lower than corporate bonds, but varies by issuer and bond type. Revenue bonds tied to discretionary activities or niche projects carry higher risk.
• Interest rate risk: Bond prices fall when interest rates rise. Longer maturities typically experience greater price sensitivity.
• Liquidity risk: Many municipal bonds trade infrequently, which can make selling quickly difficult or costly.
• Call risk: Many munis include call provisions allowing issuers to redeem bonds early, often when rates fall. Investors may face reinvestment at lower yields.
• Taxability risk: Changes in tax law or the bond’s tax qualification can affect after-tax return.

Typical terms and minimums

• Term lengths range from short-term (a few years) to long-term (several decades).
• New-issue municipals are commonly sold in $5,000 increments.
• Investors can also access municipal exposure via mutual funds and exchange-traded funds (ETFs), which allow for smaller investments and greater diversification.

Benefits

• Potentially tax-advantaged income (especially valuable for investors in higher tax brackets).
• Generally lower default rates and relative stability compared with many corporate bonds.
• Useful to diversify fixed-income portfolios and match tax-sensitive income goals.

When municipal bonds make sense

• Investors seeking tax-efficient, stable income—particularly those in higher marginal tax brackets.
• Investors willing to accept lower yields in exchange for tax benefits and relative safety.
• As part of a diversified fixed-income allocation, or when matching long-term liabilities for tax-aware investors.

Key takeaways

• Municipal bonds finance public projects and provide fixed income with possible tax advantages.
• GO bonds rely on taxing power or general funds; revenue bonds rely on project-generated income.
• Evaluate credit quality, tax treatment, term, liquidity, and call features before investing.
• For small investors or those seeking diversification, muni funds and ETFs offer a practical alternative to buying individual bonds.

Municipal bonds can be a tax-efficient, lower-risk component of a conservative income strategy, but they carry distinct risks and structural features that should be understood before investing.