Municipal bonds are loans you make to a state or local government in exchange for regular interest payments and the return of your principal on a set maturity date. The interest is generally exempt from federal income tax under 26 U.S.C. § 103, and it may also escape state and local income tax if you live where the bond was issued.1Office of the Law Revision Counsel. 26 USC 103 – Interest on State and Local Bonds The money raised funds public projects like roads, schools, water systems, and hospitals, and the tax treatment is what makes these bonds popular with investors in higher brackets.
Issuers range from states and counties down to cities and special-purpose districts that run a single school system or utility. Most bond proceeds go to long-term capital projects, though some issues cover operating costs or refinance older debt.
The Two Main Types
Every municipal bond falls into one of two categories, and the difference tells you what actually stands behind the promise to pay you.
General Obligation Bonds
General obligation (GO) bonds are backed by the full faith and credit of the issuing government, which pledges its taxing power to make payments. Most GO debt is secured by property taxes on real estate inside the jurisdiction. Because repayment can require higher taxes, many jurisdictions have to put a GO bond issue to a voter referendum before selling it.
Revenue Bonds
Revenue bonds are tied to the income from a specific project: a toll road, an airport, a public hospital, a water utility. The bond documents identify exactly which revenue streams are pledged. If the project underperforms, the issuer generally has no obligation to reach into general tax revenue to cover the shortfall.2MSRB. Sources of Repayment That project-specific risk is the price of the higher yields revenue bonds often carry.
How Payments Work
Each bond has a par value, or face value, that you receive at maturity. Par is usually $1,000 or $5,000 per bond. The coupon rate sets the interest, typically paid semiannually. What varies is the schedule for returning principal:
- Term bonds pay the entire principal on a single maturity date.
- Serial bonds break the total debt into portions that mature at intervals over several years, giving investors a choice of shorter or longer maturities within one issue.
Many municipal bonds are also callable. That means the issuer can repay your principal ahead of schedule, and they usually do so when rates fall so they can refinance cheaper. If you own a callable bond, look at the yield-to-call, not just the yield-to-maturity, because a call ends your above-market interest stream and forces you to reinvest at whatever the market offers next.3FINRA. Callable Bonds: Be Aware That Your Issuer May Come Calling
The Tax Picture
Section 103 excludes most municipal bond interest from your federal gross income. The exclusion covers governmental bonds and certain qualified private activity bonds; it does not cover arbitrage bonds, unregistered bonds, or private activity bonds that miss the statutory requirements. You still report the tax-exempt interest on your federal return—it is not taxed, but the IRS uses the number in other calculations.4Internal Revenue Service. Instructions for Schedule B (Form 1040)
State and Local Exemption
Many states exempt interest on bonds issued within their borders from state income tax. Buy an in-state bond and you get a double break: federal and state. A few cities with local income taxes push that to a triple exemption on their own bonds. Whether any of this applies depends on your state’s tax code and your residency, so verify before assuming a bond qualifies.
Tax-Equivalent Yield
Comparing a muni’s yield directly against a taxable bond understates the muni. To get a fair comparison, divide the muni yield by one minus your marginal federal rate. A 3.5% muni yield at the 32% bracket equals 3.5% ÷ (1 − 0.32) = 5.15%. You would need a taxable bond yielding at least 5.15% to match it after tax. The higher your bracket, the more the exemption is worth.
Alternative Minimum Tax
Interest on most governmental munis is not subject to AMT. Interest on some private activity bonds, though—typically those funding airports, housing developments, or industrial facilities—counts as an AMT preference item. Qualified 501(c)(3) bonds are an exception and stay AMT-free. If you are near the AMT threshold, confirm a bond’s classification before buying.
Social Security
Tax-exempt interest does not appear in your taxable income, but the IRS folds it in when deciding how much of your Social Security is taxable. The formula adds half your benefits to your other income, including tax-exempt interest. Cross $25,000 as a single filer or $32,000 filing jointly and a portion of your benefits becomes taxable.5Internal Revenue Service. Social Security Income Retirees with sizable muni holdings need to account for this.
Buying at a Discount
When you buy a muni on the secondary market for less than face value, the discount can create ordinary income at sale or maturity. A de minimis rule under 26 U.S.C. § 1278 sets the threshold at 0.25% of face value times the complete years remaining to maturity.6Office of the Law Revision Counsel. 26 USC 1278 – Definitions and Special Rules Under that threshold, any gain is capital gains. Over it, the accrued market discount is ordinary income. A $1,000 face-value bond with 10 years left has a $25 threshold. Buy at $980 and the $20 discount stays in capital-gains territory; buy at $970 and the whole $30 flips to ordinary income at sale or redemption.
Risks to Know
Municipal bonds are widely considered safer than corporate bonds, but they carry real risks.
Credit Risk
Rating agencies grade the likelihood an issuer will pay. Moody’s runs from Aaa down through Aa, A, and Baa for investment grade; S&P uses AAA through BBB-. Anything below is non-investment-grade, sometimes called high yield or junk. Since 1970, investment-grade munis have had a cumulative 10-year default rate of roughly 0.1%, against about 2.2% for investment-grade corporates.
Interest Rate Risk
When market rates rise, existing bond prices fall, because newer bonds pay more. Longer maturities move more on any given rate change. If you hold to maturity you get face value regardless, but selling early into a rising-rate market can mean a loss.
Chapter 9 Bankruptcy
Municipalities rarely file, but they can. In a Chapter 9 case, GO bonds are treated as general unsecured debt, and the issuer can halt payments while the debt is negotiated and possibly restructured. Revenue bonds are treated differently: under 11 U.S.C. § 928 the lien on special revenues survives the filing, and pledged revenue keeps flowing to bondholders during the case, though the project’s operating expenses take priority.7Office of the Law Revision Counsel. 11 USC 928 – Post Petition Effect of Security Interest8United States Courts. Chapter 9 – Bankruptcy Basics
How to Buy Them
You can buy new issues on the primary market or trade existing bonds on the secondary market.
Primary Market
New bonds are sold through an underwriting syndicate at a set offering price. Before the sale, the issuer publishes an Official Statement covering the terms, the issuer’s finances, the use of proceeds, and any call provisions.9Investor.gov. Offering Document (or Official Statement or Prospectus) Read it before you commit.
Secondary Market
After issuance, bonds trade between investors through broker-dealers. There is no centralized exchange, so prices vary between dealers. Buy from a dealer selling out of its own inventory and the price includes a markup; sell and it includes a markdown. These costs typically run 0.5% to 1% of face value, higher on illiquid or small-lot bonds. Dealers must disclose the markup or markdown on your trade confirmation.10MSRB. Resource on Disclosing Mark-ups and Determining Prevailing Market Price
EMMA
The MSRB runs a free site called EMMA (Electronic Municipal Market Access) with real-time trade prices, official statements, credit ratings, and disclosure documents for essentially every outstanding muni.11MSRB. About EMMA Checking recent trades there before you buy tells you whether the price a broker is quoting is in line with the market.
Bond Funds and ETFs
Individual munis usually start at a $5,000 minimum, and building a diversified ladder takes real capital. Municipal bond mutual funds and ETFs pool investor money across hundreds or thousands of bonds, so you get diversification with a smaller stake. In exchange you pay an annual expense ratio, you do not pick the specific holdings, and the fund has no fixed maturity, so your principal moves with the market instead of returning to a set number on a set date.