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What Are Municipal Bonds and How Do They Work?

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What Are Municipal Bonds and How Do They Work?

Municipal bonds are often referred to simply as “municipal bonds.”


What are municipal bonds?

Simply put, municipal bonds (or “municipal bonds” for short) are essentially loans made by individual investors to city, county or state governments to help finance specific infrastructure projects or general day-to-day operations.

In exchange for a temporary use of investors’ funds, the state or municipality provides them with regular interest payments, which are then eventually repaid in full on the loan principal when the bond matures. In many cases, municipal bond interest is exempt from federal and/or state income tax.

In financial terms, municipal bonds are debt securities issued by local or state governments that pay interest to their holders at an annual rate (called a coupon). Municipal bonds (like corporate bonds and treasuries) are tradable, so they can change hands multiple times before maturity, and their market value may change over time, above and below their par or “face value” / or fluctuations below.

What are the two main types of municipal bonds?

Most municipal bonds fall into one of two general debt and income categories, depending on the source of the repayment funds.

1. General obligations

It’s called a general obligation bond because there isn’t a specific source of funding that investors can pay for. Instead, they are backed by the “full trust and credit” of the government entity that issued them, as that government has the power to tax its residents in order to pay interest and principal to bondholders.

2. Income

Unlike GO bonds, revenue bonds are used to fund income-generating projects (such as toll roads or parking meters), which can then be used to provide the funds needed to pay interest and ultimately repay the bondholder’s principal.

What are municipal bonds good for?

In some cases, municipal bonds may only be used to raise funds for the day-to-day operations and expenses of government entities. More commonly, however, the funds generated from the sale of municipal bonds are used to pay for specific projects designed to benefit residents of the issuing state or municipality. Some of the more common specific project destinations for municipal bond funds include schools, roads, bridges, libraries, parks and other infrastructure public works.

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How is municipal bond income taxed?

Interest income from holding municipal bonds is not taxed federally. It also won’t be taxed at the state or local level in many cases, but that depends on the nature of the bond and whether its purchaser lives in the issuing city, county or state. On the other hand, interest income from Treasury and corporate bonds is taxed by the federal government.

For this reason, investors may prefer municipal bonds to Treasuries — even with higher yields — because municipal bonds end up with higher after-tax yields. When comparing municipal bonds to other debt securities, it’s important for investors to keep their tax brackets in mind and consider after-tax yields.

For example, consider a 10-year, $10,000 municipal bond yielding 3.5%, and a 10-year, $10,000 Treasury bond yielding 4%. Investors in the 20% federal income tax bracket prefer municipal bonds because it can earn them $350 a year, while Treasury bonds can only earn them $320 ($400 minus $80 in taxes).

How safe/risky are municipal bonds?

In general, debt securities such as bonds are significantly less risky than equity securities (such as stocks) and most derivative securities (such as options). But how do municipal bonds compare to other types of bonds?

Because municipal bonds are backed by income-generating projects (in the case of income bonds) or income taxes (in the case of general obligation bonds), they have a very low risk of default compared to corporate bonds. That being said, government entities at the local, county and state levels are not entirely immune to default risk. Detroit, Michigan, for example, filed for bankruptcy in 2013. Such events are rare, but they can happen.

Another thing to keep in mind — although it doesn’t directly make municipal bonds “risky” — is that individual municipal bonds are nowhere near as liquid as stocks or exchange-traded funds that include bonds. This means that trading them is usually not as easy as pressing a button in a trading app. There is less and less distance between buyers and sellers, so transactions may take time and bid-ask spreads may be wider than expected.

How to Buy Municipal Bonds

The easiest way to buy many municipal bonds at once while avoiding liquidity risk is to invest in ETFs focused on municipal bonds. ETFs are traded on stock exchanges, so buying shares is easy and there are no fees to worry about other than the expense ratio (the percentage of the investment balance each investor pays the fund’s management each year). Municipal-focused mutual funds also exist, but these can come with additional fees, minimum balances, and other complications.

Those interested in buying municipal bonds individually can do so through their banks, brokerage firms, or even directly from state, county or local governments.

What are the pros and cons of municipal bonds?

Advantages Disadvantages

regular interest payments

Low earnings potential compared to stocks

low default risk

inflation risk

federal tax exemption

relatively low liquidity

Municipal Bonds vs Treasury Bonds: What’s the Difference?

Both municipal bonds and treasuries are government-issued interest-bearing debt securities, but interest income from treasuries is subject to federal tax while income from municipal bonds is not.

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