State, county and local government entities issue municipal bonds to raise capital for projects such as highways, bridges and buildings. When an investor purchases a municipal bond, he is lending money to governmental authorities that undertake the projects. In exchange for the loan, the entity promises to repay interest to the municipal bond buyer until the bond either reaches maturity or is called. At maturity, the principal of the bond is returned to the investor at par, the original dollar value of the debt security.

As with most other debt issues, municipal maturities vary. Terms range from seven days to 30 years and, also like other debt issues, coupon payments increase as maturities extend. For example, a three-year bond may have a 1% coupon, while a 20-year issue may carry a coupon rate of 3%. Monetary policy and macroeconomic conditions dictate yields that generally parallel the rates of U.S. government issues, with one notable exception: Unlike U.S. Treasurys, the vast majority of municipal securities are free from federal income tax, and nominal yields for similar municipal maturities will always run lower than federal issues, due to tax treatment.

Municipal Bond Mutual Funds

Municipal bond mutual funds are a diversified portfolio of individual municipal bonds that vary in maturity, coupon rates and credit rating. Investors pool their money with other investors to create assets with which a fund manager uses discretion to purchase numerous municipal issues that fulfill the fund's investment objectives. Municipal bond fund objectives primarily seek tax-free income, with preservation of capital as a secondary objective.

Bond funds, through diversification, offer some advantages over individual bonds. While rare in the municipal market, individual bondholders face default risk. If the issuer of the municipal bond is in a weakened financial condition, as seen in Puerto Rico in May 2016, the authority may not be able to meet principal and interest payments owed to the bond investor. Thus, bond funds offer diversification that spreads credit risk across a spectrum of debt issues with varying credit ratings.

Active management allows the fund to buy and sell issues in the market as interest rates rise or fall. The recent Fed commitment to cyclically increase the target funds rate allows fund managers to purchase issues with higher coupon rates. Monetary tightening also presents the challenge of preserving principal as bond values move inversely to interest rates. With a long maturity and high coupon, the value of an individual municipal bond will decrease as rates move higher.

If the investor needs to liquidate the security, the bond may need to be sold at a discount, causing the investor to lose principal. Municipal bond funds, with the ability to ladder maturities, limit interest rate risk assumed by the individual bond investor.

Municipal Bond Tax Treatment

High-income investors are drawn to individual municipal bonds and municipal bond funds because the securities are free from federal income tax. Therefore, tax-equivalent yield is used to compare tax-free and taxable bond yields. Consider an investor purchasing a 10-year AAA-rated corporate bond at par value with a 4% coupon. The buyer's tax rate is 33%. The purchaser compares the corporate issue to an AAA-rated municipal bond with the same maturity, at par, with a 3% coupon. Using the formula (tax-equivalent yield = tax-free yield/1- tax rate), the investor would need a corporate yield of 4.48% or greater to equal or exceed the 3% tax-free rate. Thus, the higher the tax bracket, the higher the tax equivalent yield is for a municipal security.

Although municipal bond funds are free from federal income taxes, some municipal funds contain private activity bonds that may be subject to the alternative minimum tax (AMT). A further tax advantage emerges when a resident of a state invests in a bond issued by or in that investor's state of residence. The municipal security is exempt from state taxes as well, boosting the tax-equivalent yield of the municipal bond or bond fund. The investor receives triple tax-free status when the issue or portfolio is exempt from federal, state and local taxes.