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


Municipal bonds play a crucial role in financing public projects for local, county, and state governments. These debt securities act as loans from investors to fund endeavors like schools, hospitals, and infrastructure. In return, bondholders receive interest and principal repayments by the maturity date. Municipal bonds are a tax-efficient investment option, particularly for individuals in higher tax brackets, as they often come with tax-free interest. Learn about the various types of municipal bonds, their benefits, and potential risks in this comprehensive guide.

Understanding municipal bonds

Municipal bonds, often called “munis,” are important financial tools issued by nonprofit groups, private companies, or government bodies. These bonds help gather funds for major public undertakings, like building schools, hospitals, and roads. While investing in municipal bonds can provide tax-free earnings for individuals, it’s important to note that the interest rates, also known as coupon rates, are generally lower when compared to bonds that are taxable.
Municipal bonds are like a partnership between investors and the community. When someone buys a municipal bond, they’re lending money to the issuing entity, which could be a city, town, or even a state government. In return for lending their money, investors receive regular interest payments over a set period. This is how they earn income from the bond.

One of the key aspects that makes municipal bonds appealing to investors is the potential for tax-free earnings. This means that the interest earned from these bonds is usually not subject to federal income tax. This feature can make municipal bonds especially attractive for individuals in higher tax brackets who are looking to minimize their tax liability while still earning a steady income.

However, because municipal bonds come with the perk of tax-free income, they often come with lower coupon rates. In other words, the interest payments may be smaller compared to bonds that are subject to taxation. This trade-off between tax benefits and lower interest payments is a key consideration for investors when deciding whether to invest in municipal bonds.

In essence, municipal bonds play a significant role in financing projects that contribute to the growth and development of communities. By investing in these bonds, individuals not only support important public initiatives but also have the potential to earn a steady income over time.

Types of Municipal Bonds

Municipal bonds are a complex landscape of instruments designed to finance public projects. They’re categorized based on various criteria, particularly the origin of their interest payments and the source of principal repayments. Notably, the income from a municipal bond might be taxable, contingent on numerous factors. For instance, not all municipal bonds qualify for federal tax exemption. When they don’t, the generated income can be subject to federal taxes. Here’s a deeper dive into the common types:

General obligation bonds (GO)

GO bonds are, in essence, a promise by the issuer, which is typically a government entity. They are:

  • Not reliant on revenue from a specific project for repayment.
  • Often backed by the municipality’s full faith and credit, which means the governmental entity commits to doing everything in its power to repay the bondholders, including raising taxes.
  • Some GO bonds are specifically secured by dedicated property taxes, ensuring a direct revenue source for repayment.
  • Others might be payable from a municipality’s general funds or various other revenue sources.

Revenue bonds

Unlike GO bonds, revenue bonds are reliant on a specific revenue source. They include:

  • Payments ensured through specific taxes such as sales, fuel, or hotel occupancy taxes. This means their security is directly tied to the success and continued operation of the specific revenue-generating project or facility.
  • Conduit revenue bonds, where the municipality acts as a mediator to issue bonds on behalf of a private entity (like a nonprofit hospital). In these cases, the private entity is responsible for interest and principal payments, with the municipality not being liable.

Assessment bonds

These are issued to fund public projects that will directly benefit a specific group or area. The people or entities that benefit from the project will be assessed to repay the bond.

Anticipation notes

Short-term municipal securities that provide funds in anticipation of future revenues, such as tax payments, federal grants, or other receipts. Examples include Tax Anticipation Notes (TANs) and Revenue Anticipation Notes (RANs).

Pre-refunded bonds

Issued to refinance outstanding bonds. The proceeds from the new bonds are typically invested in U.S. Treasuries, which will be used to pay off the older bonds when they become due.

In all cases, it’s paramount for investors to understand the type of bond they’re investing in, its risks, and potential tax implications. Consulting with financial and tax professionals can provide more tailored advice.

Municipal bond risks

While municipal bonds generally carry lower default risk compared to corporate bonds, revenue bonds are more susceptible to changes in consumer preferences and economic downturns than GO bonds. for instance, a utility facility providing essential services enjoys more consistent revenue than a park’s rental space.

As fixed-income securities, municipal bond prices fluctuate in response to changes in interest rates. when interest rates rise, bond prices fall, and vice versa. longer maturity bonds are more sensitive to interest rate shifts than shorter ones, leading to greater income fluctuations for investors. additionally, the majority of municipal bonds lack liquidity, forcing investors in need of immediate cash to liquidate other assets.

A significant number of municipal bonds include call provisions, allowing issuers to redeem bonds before maturity when interest rates drop. this presents a trade-off for investors, as they lose income from interest payments and might have to reinvest at lower rates.

Investing in municipal bonds

  • Minimum investment: Most municipal bonds are issued in $5,000 increments. these bonds can also be part of exchange-traded funds (ETFs) and mutual funds, enabling investors to purchase bond fractions.
  • Term lengths: Municipal bonds are available with terms ranging from two to 30 years.
  • Benefits: Despite potentially lower interest rates compared to riskier assets like corporate bonds or stocks, municipal bonds offer stability and low default rates. additionally, interest from munis is federally tax exempt, enhancing their appeal as an investment option.

Here is a list of the benefits and the drawbacks of investing in municipal bonds.

  • Tax Efficiency: Interest usually exempt from federal income tax
  • Support Public Projects: Fund crucial community initiatives
  • Steady Income Stream: Regular interest payments
  • Lower Default Risk: Less default risk than corporate bonds
  • Diversification: Can reduce overall portfolio risk
  • Lower Interest Rates: Typically lower than taxable bonds
  • Interest Rate Sensitivity: Prices fluctuate with interest rates
  • Liquidity Concerns: Can be harder to sell quickly
  • Call Risk: Issuers might redeem bonds early
  • Revenue Bond Vulnerability: Susceptible to economic changes

Frequently asked questions about municipal bonds

What are municipal bonds?

Municipal bonds, often referred to as “munis,” are financial instruments issued by nonprofit groups, private companies, or government entities. They gather funds for significant public projects like schools, hospitals, and roads. Investors lend money by purchasing these bonds and receive interest payments in return.

Why are municipal bonds considered tax-efficient?

The interest earned from municipal bonds is usually not subject to federal income tax. This makes them particularly attractive for individuals in higher tax brackets aiming to minimize tax liability while maintaining a steady income.

What’s the difference between General obligation bonds (GO) and Revenue bonds?

GO bonds are issued by governmental entities and aren’t backed by a specific project’s revenue. Some are secured by property taxes, while others use general funds. Revenue bonds, on the other hand, ensure payments through specific tax sources or, in some cases, a third party.

Why do municipal bonds often have lower interest rates?

Because municipal bonds offer tax-free income, their interest rates (or coupon rates) are generally lower than bonds that are taxable. This is a trade-off for the tax benefits they provide.

What are the primary risks associated with municipal bonds?

Municipal bonds can be affected by interest rate fluctuations, which influence bond prices. They may also have liquidity concerns, making them harder to sell. Additionally, revenue bonds can be more susceptible to economic downturns, and many municipal bonds come with call provisions, allowing early redemption by the issuer.

How can one start investing in municipal bonds?

Municipal bonds are typically issued in $5,000 increments. They can also be part of exchange-traded funds (ETFs) and mutual funds, enabling a more accessible entry for investors. Terms for these bonds can range from two to 30 years.

Key takeaways

  • Municipal bonds, or munis, are debt securities used to fund public projects by state and local governments.
  • These bonds offer tax-free income for qualified residents and stability for capital.
  • General obligation (GO) bonds and revenue bonds are two common types of municipal bonds.
  • Municipal bond prices fluctuate based on changes in interest rates.
  • Longer maturity bonds are more sensitive to interest rate changes.
  • Investors should consider call provisions and liquidity when investing in municipal bonds.
View article sources
  1. municipal bonds – Cornell Law School
  3. A Beginner’s Guide to Understanding Bonds – SuperMoney
  4. CDs vs. Bonds: Differences And Pros & Cons of Each – SuperMoney