Glossary · Bonds and rates
Municipal bond
A municipal bond is a loan to a US state, city or other local government, usually to build things like schools or roads; its interest is often tax-free.
Also called: muni, munis, muni bond, tax-free bond
In plain words
Your town needs a new school but doesn’t have $50 million lying around. It borrows the money from investors by selling municipal bonds, “munis” for short, and pays them back over 20 or 30 years out of taxes or the project’s income.
Their special feature: the interest is usually free of federal income tax, and often of state tax too if you live in the state that issued them. So a muni can pay a lower rate than a corporate bond and still leave its owner with as much money after tax.
There are two main kinds. General obligation bonds are backed by the issuer’s power to tax. Revenue bonds are repaid from one project’s income, such as a toll road, an airport or a water system, and are riskier.
Example
Tax-equivalent yield
- A muni pays 3% a year, free of federal tax.
- You pay a 35% federal tax rate on extra interest income.
- A taxable bond would have to pay 3% ÷ (1 − 0.35) = 4.62% to leave you the same 3% after tax.
- At a 12% tax rate, the same muni is worth only 3% ÷ 0.88 = 3.41% of taxable interest.
The higher your tax rate, the more a muni’s tax break is worth.
One level deeper
The US municipal market has tens of thousands of issuers, from states and big cities to school districts and hospitals. Individuals own a large share, directly or through funds, because the tax break is worth most to people in high tax brackets.
Defaults are rare among rated munis, but they happen. Detroit’s bankruptcy in 2013 was the largest by a US city, and Puerto Rico, a US territory, restructured its debts after 2017. Like other bonds, munis also lose value when interest rates rise.
Not every muni is tax-free: some pay taxable interest, and the interest on some counts toward the alternative minimum tax. A gain from selling a muni for more than you paid is taxed as usual.
Why it matters
Munis pay for much of America’s public building: schools, roads, bridges, water and power.
For people in high tax brackets, their after-tax yield can beat taxable bonds of similar risk.
Their tax break costs the federal government revenue, which is why it comes up whenever tax rules are reviewed.
A common mistake
Myth: Municipal bonds are always the better deal because they are tax-free.
In fact: Only if your tax rate is high enough. Munis pay lower rates to start with: for someone in a low tax bracket, or holding them in a tax-free retirement account, a taxable bond often leaves more money.
Questions people ask
Are municipal bonds tax-free?
Their interest is usually free of federal income tax, and of state tax if you live in the issuing state. Some munis are taxable, and gains from selling one at a profit are taxed.
Are municipal bonds safe?
Most are high-quality and rarely default, especially general obligation bonds of states and large cities. Revenue bonds for single projects are riskier, and all bonds lose value when interest rates rise.
What is a tax-equivalent yield?
The yield a taxable bond would need to match a tax-free one: the muni’s yield ÷ (1 − your tax rate). At a 24% tax rate, a 3% muni equals a 3.95% taxable bond.
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About the numbers
- This page explains a term. It is not investment advice.