Municipal bond

A municipal bond is debt issued by a US state, city, county, or other local government entity to fund public projects such as schools, roads, hospitals, and utilities. The defining feature that sets municipal bonds apart from corporate or Treasury bonds is a tax advantage, interest paid on most municipal bonds is exempt from federal income tax, and often from state and local income tax as well if the investor lives in the state that issued the bond.

Because of that tax exemption, municipal bonds typically pay a lower stated coupon than a taxable bond of similar credit quality, but the after tax return can still come out ahead for an investor in a high enough tax bracket. Comparing a municipal bond to a taxable bond directly requires calculating what is called a tax-equivalent yield, since a five percent tax-free yield can be worth considerably more than a five percent taxable yield once taxes are accounted for.

Municipal bonds are generally split into two broad categories: general obligation bonds, backed by the taxing power of the issuing government, and revenue bonds, backed by the income generated from the specific project being financed, such as toll collections or utility fees. Credit risk varies significantly across municipal issuers, a large, fiscally healthy state carries very different default risk than a smaller municipality facing budget strain, so credit analysis remains relevant even though municipal bonds as a category have historically had low default rates.