Unlock the hidden power of municipal bonds and discover how your investments can earn tax-free income while funding your community’s future.
Municipal bonds, commonly known as "munis," are debt securities issued by state and local governments to finance public projects such as infrastructure, education, and healthcare. These bonds offer a unique combination of tax advantages, income stability, and relatively low risk, making them a popular choice for investors seeking regular income, especially those in higher tax brackets.
What Is a Municipal Bond?
A municipal bond is a debt obligation issued by a nonprofit organization, a private-sector corporation, or another public entity using the loan for public projects, such as constructing schools, hospitals, and highways. Municipal bonds, which are also known as muni bonds or munis, can generate tax-free income for qualified residents but pay lower coupon (interest) rates as a result compared with taxable bonds.
Types of Municipal Bonds
Municipal bonds are categorized based on the source of their interest payments and principal repayments. A bond can be structured in different ways, offering various benefits, risks, and tax treatments. Income generated by a municipal bond may be taxable. For example, a municipality may issue a bond not qualified for federal tax exemption, resulting in the generated income being subject to federal taxes.
A general obligation bond (GO) is issued by governmental entities and not backed by revenue from a specific project, such as a toll road. Some GO bonds are backed by dedicated property taxes; others are payable from general funds.
A revenue bond secures principal and interest payments through the issuer or via sales, fuel, hotel occupancy, or other taxes. When a municipality is a conduit issuer of bonds, a third party covers interest and principal payments.
Risks of Municipal Bonds
Default risk is low for municipal bonds compared with corporate bonds. However, revenue bonds are more vulnerable to changes in consumer tastes or general economic downturns than GO bonds. For example, a facility delivering water, treating sewage, or providing other fundamental services has more dependable revenue than a park’s rentable shelter area.
As a fixed-income security, the market price of a municipal bond fluctuates with changes in interest rates: When interest rates rise, bond prices decline; when interest rates decline, bond prices rise according to Investopedia.
In addition, a bond with a longer maturity is more susceptible to interest rate changes than a bond with a shorter maturity, causing even greater changes in the municipal bond investor’s income. Furthermore, the majority of municipal bonds are illiquid; an investor needing immediate cash has to sell other securities instead.
Many municipal bonds carry call provisions, allowing the issuer to redeem the bond prior to the maturity date. An issuer typically calls a bond when interest rates drop and reissues municipal bonds at a lower interest rate. When a bond is called, investors lose income from interest payments and face reinvesting in a bond with a lower return.
Reviewing municipal bond documents is a crucial step for investors seeking reliable, tax-advantaged opportunities.
Tax Benefits of Municipal Bonds
Municipal bonds offer significant tax advantages that can enhance an investor's after-tax returns. The interest income from these bonds is often exempt from federal income taxes and, in some cases, state and local taxes if the investor resides in the state where the bond was issued. This tax-exempt status makes municipal bonds particularly attractive to individuals in higher tax brackets.
For instance, an investor in the 35% federal tax bracket would need to earn a taxable yield of approximately 5.5% to achieve an equivalent after-tax yield of 3.5% from a tax-exempt municipal bond. This makes munis particularly attractive for high-income investors looking to reduce their tax liabilities according to Barrons.
It's important to note that not all municipal bonds are tax-exempt. For interest on a municipal bond to be exempt from federal income taxes, the issuer must meet several requirements in the federal income tax code. For interest on a municipal bond to be free from state and local taxes, the buyer generally must be a resident of the state where the bond was issued, although there are exceptions.
Municipal Bonds in 2025: Market Outlook
As of mid-2025, the municipal bond market has experienced a surge in issuance, with municipalities issuing nearly $120 billion in bonds in the first quarter alone. Nearly 90% of these bonds were tax-exempt, highlighting the continued attractiveness of munis to investors seeking tax-efficient income.
The yield-to-worst (YTW) for the Bloomberg Municipal Bond Index, which is a broad basket of munis, is 4% as of June 25th. It's important to note that this is an index of bonds and includes both short, intermediate, and longer-term bonds as well as some higher- and lower-rated issuers. While 4% may not seem attractive compared to other fixed-income investments, it's because interest from municipal bonds is usually exempt from federal and potentially state income taxes. After adjusting for the impact of taxes, munis will likely yield more than corporates for investors in the 22% and above federal tax brackets.
Despite concerns over potential changes to the tax-exempt status of municipal bonds, recent legislation has maintained the current tax brackets and does not restrict or remove the muni tax exemption. This stability has helped sustain investor confidence in the municipal bond market.
People Also Ask
What are municipal bonds?
Municipal bonds are debt securities issued by state and local governments to finance public projects. They offer investors tax-exempt interest income and are considered low-risk investments.
How do municipal bonds differ from corporate bonds?
Municipal bonds are issued by government entities, whereas corporate bonds are issued by companies. Munis typically offer tax-exempt interest and have lower default rates compared to corporate bonds.
Can municipal bonds be purchased through mutual funds or ETFs?
Yes, investors can purchase municipal bonds through mutual funds or exchange-traded funds (ETFs), which provide diversified exposure to a range of municipal securities.
Are municipal bonds suitable for all investors?
Municipal bonds are particularly beneficial for high-income investors seeking tax-efficient income. However, they may be less advantageous for those in lower tax brackets or for investors seeking higher yields.
What are the risks associated with municipal bonds?
Risks include interest rate fluctuations, credit risk of the issuing municipality, and potential exposure to the federal Alternative Minimum Tax (AMT). It's important to assess these risks before investing.
Conclusion
Municipal bonds offer a compelling investment option for those seeking tax-efficient income, stability, and diversification within their portfolios. With their low default rates and potential for tax-exempt returns, they can play a valuable role in a well-rounded investment strategy, particularly for high-income investors. However, as with any investment, it's essential to conduct thorough research and consider individual financial circumstances before investing in municipal bonds.
