What a municipal bond actually is

A municipal bond is a loan you make to a city, county, school district, or other local government. When you buy a bond, you give that government money upfront. In return, they promise to pay you back the full amount on a set date, plus interest along the way. You are not buying a piece of ownership in anything — you are a creditor, the same way a bank is a creditor when you take out a mortgage.

The government uses the money you lend for a specific project: building a bridge, fixing water pipes, constructing a school, or funding a hospital. Because the project itself will eventually generate revenue or serve the public for decades, the government can afford to repay you. The interest rate you receive is usually lower than you would get from a corporate bond or a savings account, but municipal bonds come with a tax advantage that makes up for it in many cases.

Key Takeaways

  • When you buy a municipal bond, you lend money to a local government that promises to repay you with interest on a specific date.
  • The interest you earn on most municipal bonds is not subject to federal income tax, and often not subject to state or local income tax either if you live in the issuing state.
  • Municipal bonds are backed by the taxing power or revenue of the government that issued them, not by collateral you can seize.
  • The longer you hold a bond before it matures, the more interest rate risk you take on, because bond prices fall when interest rates rise.
  • You can sell a municipal bond before maturity on the secondary market, but the price you receive depends on current interest rates and the bond's credit quality.

How the tax advantage works

Interest paid on most municipal bonds is exempt from federal income tax. This means if a municipal bond pays you 3 percent per year, you do not report that 3 percent as income on your federal tax return. For many people, this makes a 3 percent municipal bond more valuable than a 4 percent corporate bond, because the corporate bond interest is taxable.

The tax benefit varies by bond type and your location. Interest on bonds issued to fund schools, roads, water systems, and other public purposes is almost always federally tax-free. Interest on bonds issued to fund private activities — like a stadium built for a professional sports team — may be subject to the federal Alternative Minimum Tax. If you live in the state that issued the bond, the interest is usually exempt from that state's income tax as well. Some states also exempt municipal bond interest from local income tax.

The tax-free status is why municipal bonds pay lower interest rates than similar corporate bonds. Investors are willing to accept lower interest because they keep more of what they earn. If you are in a high tax bracket, the tax savings can be substantial. If you are in a low tax bracket or have little other income, a taxable bond might actually return more money after taxes.

How bonds are repaid: General obligation versus revenue bonds

Municipal bonds fall into two main categories based on how the government promises to repay you. A general obligation bond is backed by the full taxing power of the government. If a city issues a general obligation bond to build a library, the city promises to repay you from tax revenue — property taxes, sales taxes, or whatever other sources it collects. The city is legally obligated to raise taxes if necessary to make the payment.

A revenue bond is backed only by the revenue from a specific project or service. If a city issues a revenue bond to build a parking garage, the city promises to repay you from parking fees collected at that garage. If the garage does not generate enough revenue, the city is not obligated to use tax money to make up the difference. Revenue bonds carry more risk than general obligation bonds because they depend on the project succeeding financially.

Both types are still backed by a government entity, not by collateral you can seize. If a city defaults on a bond, you cannot take possession of the bridge or the parking garage. You would have to pursue a legal claim against the city, which is slow and uncertain. This is why the credit quality of the issuing government matters: a city with strong finances and a history of paying on time is a safer investment than a city with budget problems.

How interest rates and bond prices move together

When you buy a municipal bond, you lock in an interest rate. If you hold the bond until maturity, you receive that rate for the entire life of the bond, regardless of what happens to interest rates in the broader economy. But if you want to sell the bond before maturity, the price you receive depends on current interest rates.

Here is the mechanism: suppose you buy a municipal bond that pays 3 percent per year, and you hold it for five years. Then interest rates rise, and newly issued municipal bonds now pay 4 percent. Your old 3 percent bond is less attractive to a buyer, so if you want to sell it, you have to accept a lower price. The buyer is paying less upfront so that the 3 percent interest rate becomes competitive with the new 4 percent bonds available. Conversely, if interest rates fall to 2 percent, your 3 percent bond becomes more attractive, and you can sell it for more than you paid.

This is called interest rate risk. The longer the time until a bond matures, the more its price can swing when interest rates change. A bond maturing in one year is barely affected by interest rate changes. A bond maturing in 20 years can see large price swings. If you plan to hold a bond until maturity, interest rate risk does not matter — you will get your full principal back. If you might need to sell early, interest rate risk is something to consider.

The secondary market: Selling before maturity

You can buy and sell municipal bonds on the secondary market, which is a network of brokers and dealers who trade bonds that have already been issued. If you own a municipal bond and need cash before it matures, you can sell it to another investor through a broker. The price you receive depends on current interest rates, the bond's credit quality, and how much time remains until maturity.

The secondary market for municipal bonds is less liquid than the stock market. This means fewer buyers and sellers are active at any given moment, and the bid-ask spread — the difference between what a buyer will pay and what a seller is asking — can be wider. For popular bonds issued by large cities or states, the spread is usually small. For bonds issued by smaller municipalities, the spread can be significant, and you might have to wait days or weeks to find a buyer.

If you sell a bond for more than you paid for it, you have a capital gain, which is subject to capital gains tax. If you sell for less, you have a capital loss, which you can use to offset other capital gains or, in some cases, ordinary income. The tax treatment of gains and losses is the same as for stocks.

Credit ratings and default risk

Before you buy a municipal bond, you should know the credit quality of the issuer. Three major rating agencies — Moody's, Standard & Poor's, and Fitch — assign letter grades to municipal bonds based on the issuer's financial health, debt levels, and history of paying on time. Bonds rated AAA or Aaa are considered the safest. Bonds rated BBB or Baa are considered investment-grade but carry more risk. Bonds rated below BBB are considered speculative and carry significant default risk.

Default is rare among municipal bonds, especially general obligation bonds backed by taxing power. Since 1970, the default rate on municipal bonds has been less than 1 percent. But default does happen, particularly with revenue bonds that depend on a specific project succeeding. Before buying a bond, check its rating and read the official statement issued by the municipality, which discloses the issuer's finances and the specific use of the bond proceeds.

You can find municipal bond ratings and official statements on the Municipal Securities Rulemaking Board's Electronic Municipal Market Access database, which is free and open to the public. This database also shows the trade history of each bond, so you can see what price other investors have paid recently.

How to buy municipal bonds

You can buy municipal bonds through a brokerage account at a bank or investment firm. You place an order for a specific bond, and the broker finds a seller and executes the trade. You pay the purchase price plus any commission or markup the broker charges. Some brokers charge a flat fee; others mark up the price of the bond itself. Ask your broker how they are compensated before you buy.

You can also buy municipal bonds through a mutual fund or exchange-traded fund that holds a portfolio of many bonds. This approach gives you when ready diversification and professional management, but you pay an annual fee for the fund. The fee is usually between 0.2 and 1 percent of your investment per year, depending on the fund.

If you want to buy newly issued bonds directly from the municipality, you can sometimes do so through a competitive or negotiated offering. New issue bonds are often available at a lower cost than secondary market bonds because there is no markup from a dealer. Your broker can tell you about upcoming new issues in your area.

Frequently Asked Questions

What happens if the city or county that issued my bond goes bankrupt?

Municipal bankruptcy is rare, but it does happen. If a municipality files for bankruptcy, a court decides how to distribute available funds among creditors. Bondholders are usually paid before other unsecured creditors, but after secured creditors and employees. You may receive less than the full amount owed, or receive it later than promised. The bankruptcy process can take years.

Can I lose money on a municipal bond if I hold it to maturity?

If you hold a bond to maturity, you will receive the full principal amount you paid, plus all promised interest payments. You cannot lose principal if the bond does not default. However, if the bond does default, you may lose some or all of your investment. Default is uncommon but possible, especially with revenue bonds.

Are municipal bonds a good investment for someone in a low tax bracket?

The tax-free interest on municipal bonds is most valuable to people in high tax brackets. If you are in a low tax bracket, a taxable bond or savings account might return more money after taxes. Compare the after-tax yield of a municipal bond to the after-tax yield of alternatives before deciding. Your broker or financial advisor can help you calculate this.

What is the difference between a bond fund and buying individual bonds?

When you buy individual bonds, you know exactly when you will receive your principal back and how much interest you will earn. When you own a bond fund, the fund manager buys and sells bonds constantly, so your principal amount fluctuates with the market. Bond funds offer diversification and professional management but charge annual fees. Individual bonds offer certainty but require more capital upfront.

Can I use municipal bonds in a retirement account?

Yes, you can hold municipal bonds in an IRA, 401(k), or other retirement account. However, the tax-free status of municipal bond interest does not matter inside a retirement account, because all income in a retirement account is tax-deferred anyway. For this reason, municipal bonds are usually a better choice for taxable accounts, where the tax benefit actually saves you money.