What are municipal bonds?

Municipal bonds are one of the safest and most tax-advantaged investments available today. Issued by state and local governments, these bonds provide a way to raise funds for public infrastructure projects like roads, bridges, schools, and hospitals. But how do they actually work? In this article, we’ll break down everything you need to know about municipal bonds—from their basic structure to their unique tax advantages and investment benefits.

1. What Are Municipal Bonds?

Municipal bonds, commonly known as “munis,” are debt securities issued by state or local governments, or their agencies, to finance public projects. These projects can range from building infrastructure like schools, hospitals, and highways, to funding various public services like water supply systems and urban development.

When you buy a municipal bond, you are essentially lending money to the issuer in exchange for periodic interest payments and the return of your principal investment when the bond matures. The issuer, whether a city, county, or state, promises to repay you with interest, and the bond will mature after a specified period, which can range from a few years to decades.

2. How Do Municipal Bonds Work?

Municipal bonds function similarly to other types of bonds. When an investor purchases a bond, they are lending money to the issuer (the state or local government). The bondholder receives regular interest payments, known as “coupon payments,” typically every six months, until the bond matures.

At maturity, the issuer repays the original amount (the principal) to the bondholder. The interest income from these bonds is often exempt from federal income tax, and may also be exempt from state and local taxes if you purchase bonds issued by your state or municipality. This tax exemption is a significant benefit for many investors, especially those in higher tax brackets.

• Coupon Payments: The municipality agrees to pay bondholders a fixed interest rate (coupon rate) for the life of the bond. These payments are usually made semi-annually.
• Principal Repayment: At the bond’s maturity, the municipality returns the original amount of the bond (also called face value or par value) to the bondholder.
• Tax Benefits: Interest on most municipal bonds is exempt from federal income tax, and may be exempt from state or local taxes if you live in the state where the bond was issued.

3. Types of Municipal Bonds

There are two main types of municipal bonds: General Obligation Bonds (GO Bonds) and Revenue Bonds. Each comes with its own set of risks and rewards.

General Obligation Bonds (GO Bonds)

General obligation bonds are backed by the full faith and credit of the issuing government. These bonds are typically considered low-risk since they are backed by the municipality’s ability to raise taxes (like property taxes) to pay bondholders. They are often used to fund public projects such as schools, parks, and infrastructure improvements.

Revenue Bonds

Revenue bonds are backed by the revenue generated from a specific project or service, such as tolls from a highway or fees from a public utility. Unlike GO bonds, revenue bonds are riskier since the ability to repay bondholders depends on the success of the specific project that the bond was issued to fund. If the project doesn’t generate enough revenue, the issuer might struggle to meet its obligations.

4. Benefits of Investing in Municipal Bonds

Municipal bonds offer several benefits that make them an attractive option for conservative investors. Here are the top reasons to consider them:

• Tax Exemption: As mentioned, the interest income from municipal bonds is generally exempt from federal income taxes. If you buy bonds issued by your state or locality, you might even avoid state and local taxes.
• Stable Income: Municipal bonds provide predictable, fixed interest payments, making them a good option for those seeking a steady income stream, such as retirees.
• Lower Risk: Especially with General Obligation Bonds, municipal bonds are considered relatively low-risk compared to stocks and corporate bonds, making them a good choice for risk-averse investors.
• Support Public Infrastructure: By investing in municipal bonds, you’re helping to fund important public projects, contributing to the improvement of schools, hospitals, roads, and more.

5. Risks of Municipal Bonds

Like all investments, municipal bonds come with certain risks. It's important to be aware of these before you invest:

• Credit Risk: This is the risk that the issuing municipality may not be able to make interest payments or repay the principal when due. This risk is higher for revenue bonds.
• Interest Rate Risk: The value of your municipal bonds can decline if interest rates rise. If you sell your bonds before maturity, you might not receive the full value.
• Liquidity Risk: Municipal bonds can be less liquid than other securities, meaning you might not be able to easily sell your bonds in the market without affecting the price.