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

What Is a Municipal Bond?

The term municipal bond refers to a type of debt security issued by local, county, and state governments. They are commonly offered to pay for capital expenditures, including the construction of highways, bridges, or schools. Municipal bonds act like loans, with bondholders becoming creditors. In exchange for borrowed capital, bondholders/investors are promised interest on their principal balance—the latter being repaid by the maturity date. Municipal bonds are often exempt from most taxes, which makes them attractive to people in higher income tax brackets. Types of municipal bonds include government obligations and revenue bonds.

Key Takeaways

  • Municipal bonds (“munis”) are debt securities issued by state and local governments.
  • These can be thought of as loans that investors make to local governments, and are used to fund public works such as parks, libraries, bridges and roads, and other infrastructure.
  • Interest paid on municipal bonds is often tax free, making them an attractive investment option for individuals in high tax brackets.
  • General obligation (GO) munis provide cash flows generated from taxes collected on a project.
  • Revenue munis return cash flows generated from the project itself.
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What Is A Municipal Bond?

Understanding Municipal Bonds

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.

Municipal bonds, which are also known as muni bonds or munis, can generate tax-free income for qualified residents but pay lower coupon (interest) rates as a result compared with taxable bonds.

Types of Municipal Bonds

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 via sales, fuel, hotel occupancy, or other taxes. When a municipality is a conduit issuer of bonds, a third party covers interest and principal payments.

$4 trillion

In 2021, the municipal bond market constituted about $4 trillion in assets outstanding.

Municipal Bond Risks

Default risk is low for municipal bonds compared with 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.

What's the Minimum Amount You Need to Invest in Municipal Bonds?

Most municipal bonds are issued in $5,000 increments. Municipal bonds may be included in some exchange-traded funds (ETFs) as well as mutual funds, allowing investors to purchase bond fractions.

What Term Lengths Are Available for Municipal Bonds?

Municipal bonds are available in a variety of terms ranging from two to 30 years.

What Are the Benefits of a Municipal Bond?

Although municipal bonds may have lower interest rates than riskier investments like corporate bonds or stocks, they offer stability for your capital with low default rates. Interest from munis is also federally tax-exempt, making it an attractive investment.

Article Sources
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  1. SIFMA. “US Municipal Bonds Statistics.”

  2. Vanguard. "Municipal Bonds."

  3. Finra. "Municipal Bonds."

  4. Municipal Bonds For America. "What Is A Municipal Bond?"

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