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Funds generated from the sale of municipal bonds may go to provide for unspecified, general government financial needs, or they may be specifically designated to fund a public works project. Common projects funded by municipal bonds include roads and bridges, schools, hospitals and even sports stadiums. Municipal bonds are sometimes issued by a government entity such as a housing or port authority.

Municipal Bond Risk

Municipal bonds are regarded as very safe investments because they are issued by government entities that have the power to tax to raise funds to pay off the bond obligations. Overall, default rates on municipal bonds remain lower than the default rate on corporate bonds. Municipal bonds are not considered as risk-free as Treasury bonds (T-bonds) backed by the U.S. Treasury.

The most distinguishing feature of municipal bonds is that, unlike corporate bonds, the interest income they generate is usually exempt from federal income taxes. Additionally, municipal bonds may or may not be exempt from state or local taxes.

Types of Municipal Bonds

Several types of municipal bonds exist. The most common type is a general obligation, or GO, bond. GO bonds are for general purposes, not a specific project. They are considered very low risk and offer relatively lower yields. GO bonds have to receive voter approval before issuance.

Revenue bonds are backed by a designated revenue source and are typically used for funding the construction of a facility. An example of a revenue bond is a bond to fund the construction or expansion of an airport, funded with airport usage fees paid by airlines. Revenue bonds offer higher yields than GO bonds.

Short-term bonds with maturities less than one year, used to fund budget shortfalls or meet cash flow needs, are issued as commercial paper bonds. These bonds are often backed by a bank letter of credit. They offer relatively low yields due to the short time frame to maturity.

Private activity bonds are those used to fund private sector projects that qualify as tax-exempt because they serve a public good. These bonds carry higher risk and offer correspondingly higher yields.

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