Municipal bonds is debt that is issued by state or local governments to finance capital expenditures. Income from these bonds is usually tax-exempt at the federal, state and local levels. (See also: Weighing the Tax Benefits of Municipal Securities.)
When you buy a municipal bond, you are loaning money to the municipality, which agrees to pay you back with interest. (See also: The Basics of Municipal Bonds.)
Money Market Funds
Money market funds are fixed income mutual funds that invest in debt securities, usually with short maturities and low credit risk. Money market mutual funds are among the lowest-volatility types of investments. Income generated by a money market fund is either taxable or tax-exempt, depending on the types of securities the fund invests in. (See also: Getting to Know the Money Market.)
There are some money market funds that are primarily invested in municipal bonds, thus creating municipal money market funds. These funds bring together the tax benefits of municipal bonds with the stability, liquidity and diversification qualities of money market funds. All of these benefits tend to attract high-income investors seeking a tax shelter. (See also: Introduction to Money Market Mutual Funds.)
Municipal Bonds: One of the major risks associated with municipal bonds is the possibility that short-term yields will rise. This means other bonds coming on the market will pay a higher rate to bond owners, and your bond will be seen as less valuable. This can cause the price of your bond to drop. This is only a problem if you decide to sell the bond. You will still receive your interest payments.
Another risk is that municipal bond returns may not keep pace with inflation. If inflation rises, your bond yield will stay the same. Eventually, you may be making less in interest than the inflation rate. If inflation is at 5% and you are earning 3%, you are losing money. Your interest income won't have as much buying power. Though extremely rare, default is also a risk to investors in municipal bonds. (See also: Can Puerto Rico Default on Its Debt?)
Money Market Funds: This is one of the safest investments you can find. These funds very rarely lose value, and the interest they pay is reliable. Because of this safety, they also pay very low interest. Risk and reward are always related: Low risk means low reward.
The Bottom Line
If you are investing for income, either municipal bonds or money market funds will pay you interest. Just know that bonds can lose value and money market funds most likely won't. Note also that since municipal bonds are income-tax free, you are actually making more than the interest rate would indicate. You can factor in your tax savings as part of the value of buying such a bond.