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 government promises to pay you interest on that loan and return your principal at a set date in the future.

The government uses the money from bond sales to fund infrastructure like roads, schools, water systems, hospitals, and public transit. Instead of raising all the money through taxes or fees at once, the government spreads the cost across many years by issuing bonds and paying back investors over time.

Municipal bonds are different from corporate bonds because they are issued by government bodies rather than companies. They are also different from U.S. Treasury bonds because they are issued by local governments rather than the federal government.

Key Takeaways

  • Municipal bonds are loans to state and local governments that pay you interest over a set period, typically 5 to 30 years.
  • The interest income from most municipal bonds is not taxed by the federal government, and often not taxed by your state either if you live in the issuing state.
  • Municipal bonds are rated by credit agencies based on the government's ability to repay, with ratings ranging from very safe to high-risk.
  • You can buy municipal bonds directly from the government or through a broker, and you can sell them before maturity on the secondary market.

How municipal bonds are issued and sold

When a local government decides to fund a project, it works with a financial advisor to determine how much money it needs and what interest rate it will offer to attract investors. The government then issues the bonds, usually in denominations of $5,000 or $1,000, depending on the bond.

Most municipal bonds are sold through underwriters — financial firms that buy the bonds from the government and resell them to investors. You can purchase municipal bonds through a brokerage account, a bank, or directly from some government entities through programs like TreasuryDirect (though TreasuryDirect primarily handles federal bonds, some states offer direct purchase programs for their own bonds).

The bond market is less centralized than the stock market. There is no single exchange where all municipal bonds trade. Instead, bonds are bought and sold over-the-counter through brokers and dealers. This means prices and availability can vary depending on where you look.

Tax treatment of municipal bond interest

The main reason many investors buy municipal bonds is the tax treatment of the interest. Interest paid on most municipal bonds is not subject to federal income tax. This is because the federal government does not tax income that funds state and local government operations.

If you buy a bond issued by your own state or a local government within your state, the interest is usually also not subject to state income tax. Some states exempt municipal bond interest from state tax even if the bond was issued in another state, but this varies. A few states tax all municipal bond interest regardless of where it was issued.

This tax advantage makes municipal bonds attractive to investors in high tax brackets, but it also means the interest rates on municipal bonds are typically lower than rates on taxable bonds like corporate bonds or Treasury bonds. The after-tax return — what you actually keep after taxes — can still be competitive depending on your tax situation.

Some municipal bonds are taxable municipal bonds, meaning the interest is subject to federal income tax. These are issued for certain types of projects and pay higher interest rates to compensate for the tax burden.

Credit ratings and bond safety

Before you buy a municipal bond, you should know the financial health of the government issuing it. Credit rating agencies like Moody's, Standard & Poor's, and Fitch rate municipal bonds on a scale that reflects the government's ability to pay back the loan.

Ratings typically range from AAA (highest safety) down to C or D (highest risk of default). A government with a strong tax base, stable revenues, and low debt is more likely to receive a high rating. A government facing budget shortfalls or declining population may receive a lower rating.

The rating affects the interest rate the bond pays. A highly rated bond pays lower interest because investors see it as safer. A lower-rated bond pays higher interest to compensate investors for taking on more risk. You can find the rating of a municipal bond through your broker, the bond issuer's website, or financial databases like EMMA (Electronic Municipal Market Access), which is maintained by the Financial Industry Regulatory Authority.

Types of municipal bonds

General obligation bonds are backed by the full taxing power of the government that issued them. The government promises to raise taxes if necessary to pay back the bond. These bonds are considered safer because they have the government's full backing.

Revenue bonds are backed only by the revenue from a specific project or service, such as tolls from a highway, fees from a water utility, or ticket sales from a sports arena. If the project does not generate enough revenue, the government is not obligated to use tax money to pay back the bond. These bonds carry more risk than general obligation bonds but often pay higher interest.

Other types include bonds for housing, education, private activity, and disaster recovery. Each type has different rules about what the money can be used for and how the bonds are taxed.

Buying and selling municipal bonds

You can buy new municipal bonds when they are first issued or purchase existing bonds on the secondary market from other investors. New issues are often announced in advance, and you can find information through your broker or the Municipal Securities Rulemaking Board.

If you hold a municipal bond until maturity, you will receive your full principal back plus all remaining interest payments. If you sell before maturity, 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 may have to sell at a discount. If interest rates have fallen, you may be able to sell at a premium.

Municipal bonds typically have long maturities — often 10, 20, or 30 years. Some bonds are callable, meaning the government can pay them back early if interest rates fall. This protects the government but can limit your upside if rates drop significantly.

Risks and considerations

The main risk with municipal bonds is default risk — the possibility that the government issuing the bond will not be able to pay back the loan. This is rare but has happened. Checking the credit rating and researching the government's finances can help you assess this risk.

Interest rate risk affects the market value of your bond. If you need to sell before maturity and interest rates have risen, your bond will be worth less. Conversely, if rates fall, your bond becomes more valuable.

Liquidity risk means that some municipal bonds are harder to sell quickly than others. Bonds from large, well-known issuers are easier to sell. Bonds from smaller governments or unusual projects may take longer to find a buyer.

Municipal bonds are also subject to inflation risk. If inflation rises significantly, the fixed interest payments you receive will be worth less in real terms. This is a concern for long-term bonds.

Frequently Asked Questions

Can I lose money on a municipal bond?

Yes, in two ways. If you sell before maturity and interest rates have risen, you will have to sell at a discount, meaning you receive less than you paid. If the government defaults on the bond, you may lose some or all of your principal. However, if you hold the bond until maturity, you will receive your full principal back regardless of interest rate changes.

Are municipal bonds safe?

Most municipal bonds are safe because governments have a strong incentive to pay back their debts — defaulting damages their credit rating and makes future borrowing expensive. However, safety depends on the specific government's finances. Check the credit rating before you buy. Highly rated bonds are safer but pay lower interest.

How much do municipal bonds cost?

Municipal bonds are typically sold in denominations of $1,000 or $5,000, though some brokers allow smaller purchases. The price you pay depends on whether you are buying a new bond at issuance or an existing bond on the secondary market. New bonds are usually priced at par (face value), but secondary market prices fluctuate based on interest rates.

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

Both are government bonds, 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, making them very safe. Municipal bond interest is usually exempt from federal tax, while Treasury interest is taxed federally but not by states.

Can I buy municipal bonds in a retirement account?

Yes, you can hold municipal bonds in an IRA, 401(k), or other retirement account. However, the tax advantage of municipal bonds is reduced in a retirement account because the account itself is already tax-sheltered. You may get better returns by holding taxable bonds in the retirement account and municipal bonds in a regular taxable account.