What a municipal bond is

A municipal bond is a debt security issued by a state, city, county, or other local government to raise money for public projects. When you buy a municipal bond, you are lending money to that government entity. In return, the issuer promises to pay you interest on a set schedule and return your principal at a specific maturity date.

The issuer uses the money raised from selling bonds to pay for infrastructure like roads, schools, water systems, hospitals, or public transit. Instead of raising funds through taxes or grants, the government borrows from investors like you and repays the loan over time, typically 10 to 30 years.

Municipal bonds differ from corporate bonds because the issuer is a government body, not a business. They also differ from U.S. Treasury bonds because the issuer is local or state government, not the federal government.

Key Takeaways

  • Municipal bonds are issued by state, city, county, and other local governments to fund public infrastructure projects like schools, roads, and water systems.
  • When you buy a municipal bond, you lend money to the issuer and receive interest payments at regular intervals until the bond matures.
  • The interest income from most municipal bonds is exempt from federal income tax, and sometimes from state and local taxes as well.
  • Municipal bonds carry credit risk — the issuer may struggle to repay — so bond ratings help you assess the risk before you invest.
  • The secondary market allows you to sell a municipal bond before maturity, though the price may be higher or lower than what you paid.

General obligation bonds versus revenue bonds

Municipal bonds fall into two main categories based on how the issuer promises to repay you.

General obligation bonds are backed by the full taxing power of the issuer. The government pledges to use tax revenue — property taxes, sales taxes, income taxes — to pay bondholders. Because the issuer has broad revenue sources, these bonds are considered lower risk. If the specific project funded by the bond does not generate enough money, the government still must pay you from its general budget.

Revenue bonds are repaid only from the income generated by the specific project the bond finances. For example, a bond issued to build a toll road is repaid from toll revenue. A bond issued to build a hospital is repaid from patient fees and hospital revenue. If the project fails to generate expected income, bondholders may not be repaid in full. Revenue bonds typically carry higher risk than general obligation bonds and therefore offer higher interest rates to compensate.

Tax treatment of municipal bond interest

The primary reason many investors buy municipal bonds is the tax treatment of the interest income. Interest paid on most municipal bonds is exempt from federal income tax. This means you do not report that interest on your federal tax return, and the IRS does not tax it.

Some municipal bonds are also exempt from state and local income taxes. This is most common when you buy a bond issued by your own state or locality. For example, if you live in New York and buy a bond issued by New York City, the interest is typically exempt from New York state income tax and New York City income tax in addition to federal tax. If you buy a New York bond but live in California, the interest is exempt from federal tax but subject to California state income tax.

The tax exemption applies only to interest income, not to capital gains. If you buy a bond for $1,000 and sell it for $1,100 before maturity, the $100 gain is subject to capital gains tax. If you hold the bond to maturity and receive your $1,000 principal back, there is no gain and no tax.

A small number of municipal bonds are taxable municipal bonds. These are issued for certain purposes that do not may have access to for tax exemption, such as financing private business activities. Interest on taxable municipal bonds is subject to federal income tax and usually state and local taxes as well. These bonds typically offer higher interest rates than tax-exempt bonds to offset the tax burden.

Credit ratings and default risk

When you lend money through a municipal bond, you face the risk that the issuer will not repay you on time or in full. This is called credit risk or default risk. To help investors assess this risk, rating agencies evaluate the financial health of the issuer and assign a credit rating.

The three major rating agencies are Moody's Investors Service, Standard & Poor's (S&P), and Fitch Ratings. Each uses a letter-based scale. Moody's uses Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C, with modifiers. S&P and Fitch use AAA, AA, A, BBB, BB, B, CCC, CC, and C. Bonds rated in the upper categories (Aaa/AAA through Baa/BBB) are considered investment-grade, meaning the issuer is expected to meet its obligations. Bonds rated below that are considered speculative or high-yield.

A higher credit rating does not mean the bond is risk-free. It means the rating agency believes the issuer has a strong ability to repay based on its current financial condition, tax base, and management. Ratings can change if the issuer's finances deteriorate. You can find credit ratings for municipal bonds through the rating agencies' websites, your broker, or financial data services like Bloomberg or Morningstar.

How to buy and sell municipal bonds

You can buy municipal bonds through a broker, either online or through a financial advisor. When you place an order, the broker finds a seller in the secondary market — the market where existing bonds trade between investors. The broker charges a markup on the price, which is how they make money on the transaction.

Municipal bonds trade in the secondary market throughout the day, though trading volume is lower than for stocks or Treasury bonds. This means you can sell a bond before maturity if you need the money, but the price you receive depends on current interest rates and the bond's credit quality. If interest rates have risen since you bought the bond, you will receive less than you paid. If interest rates have fallen, you may receive more.

You can also buy new municipal bonds directly from the issuer during the initial offering, often called the primary market. New issues are announced in the Municipal Securities Rulemaking Board (MSRB) Electronic Municipal Market Access (EMMA) system, which is free and open to the public. EMMA also provides pricing data, credit ratings, and official statements for municipal bonds.

Maturity dates and callable bonds

Municipal bonds have stated maturity dates, typically ranging from 1 to 40 years. At maturity, the issuer returns your principal. Some bonds mature all at once; others are structured as serial bonds, meaning different portions mature on different dates. For example, a 20-year serial bond might mature $50,000 per year for 20 years.

Many municipal bonds are callable, meaning the issuer has the right to repay the bond early, before the stated maturity date. Issuers typically call bonds when interest rates fall, because they can refinance at a lower cost. If your bond is called, you receive your principal back but lose the opportunity to collect interest at the higher rate you originally locked in. The bond's official statement discloses whether it is callable and on what dates.

Frequently Asked Questions

Can I lose money on a municipal bond?

Yes, in two ways. First, the issuer may default and fail to pay interest or principal. Second, if you sell the bond before maturity and interest rates have risen, the market price will be lower than what you paid. You can avoid the second risk by holding the bond to maturity, but you cannot eliminate default risk entirely.

Are municipal bonds safe?

Municipal bonds issued by financially stable governments with investment-grade credit ratings are generally considered low-risk. However, "safe" is relative. Default rates on municipal bonds are historically low, but they are not zero. Bonds issued by governments with weak finances or speculative credit ratings carry higher risk.

What is the difference between a municipal bond and a Treasury bond?

Both are issued by government entities, but Treasury bonds are issued by the federal government and municipal bonds are issued by state and local governments. Treasury bonds are backed by the full faith and credit of the U.S. government and are considered the safest bonds available. Municipal bond interest is exempt from federal tax; Treasury interest is not.

How much do I need to invest in a municipal bond?

Municipal bonds are typically issued in $5,000 denominations, though some brokers allow you to buy smaller amounts. The total amount you invest depends on how many bonds you purchase and the price per bond in the secondary market.

What happens if I need to sell my municipal bond before it matures?

You can sell the bond in the secondary market through a broker. The price you receive depends on current interest rates and the bond's credit quality. If rates have risen, you will receive less than you paid. If rates have fallen, you may receive more. The sale is subject to capital gains tax if you sell at a profit.