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What is a 'Municipal Bond'

A municipal bond is a debt security issued by a state, municipality or county to finance its capital expenditures, including the construction of highways, bridges or schools. Municipal bonds are exempt from federal taxes and from most state and local taxes, making them especially attractive to people in high income tax brackets.

BREAKING DOWN 'Municipal Bond'

A municipal bond is a debt obligation issued by a nonprofit organization, a private-sector corporation or another public entity using the loan for public projects such as constructing schools, hospitals and highways.

Types of Municipal Bond

A municipal bond is categorized based on the source of its interest payments and principal repayments. A bond can be structured in different ways offering various benefits, risks and tax treatments. Income generated by a municipal bond may be taxable. For example, a municipality may issue a bond not qualified for federal tax exemption, resulting in the generated income being subject to federal taxes.

A general obligation bond (GO) is issued by governmental entities and not backed by revenue from a specific project, such as a toll road. Some GO bonds are backed by dedicated property taxes; others are payable from general funds.

A revenue bond secures principal and interest payments through the issuer or sales, fuel, hotel occupancy or other taxes. When a municipality is a conduit issuer of bonds, a third party covers interest and principal payments.

Municipal Bond Risks

Default risk is low for municipal bonds when compared to corporate bonds. However, revenue bonds are more vulnerable to changes in consumer tastes or general economic downturns than GO bonds. For example, a facility delivering water, treating sewage or providing other fundamental services has more dependable revenue than a park's rentable shelter area.

As a fixed-income security, the market price of a municipal bond fluctuates with changes in interest rates: When interest rates rise, bond prices decline; when interest rates decline, bond prices rise. In addition, a bond with a longer maturity is more susceptible to interest rate changes than a bond with a shorter maturity, causing even greater changes in the municipal bond investor’s income. Furthermore, the majority of municipal bonds are illiquid; an investor needing immediate cash has to sell other securities instead.

Many municipal bonds carry call provisions, allowing the issuer to redeem the bond prior to the maturity date. An issuer typically calls a bond when interest rates drop and reissues municipal bonds at a lower interest rate. When a bond is called, investors lose income from interest payments and face reinvesting in a bond with a lower return.

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