Municipal bond

Also called Muni bond

A bond issued by a state, city or other local government entity whose interest is generally exempt from federal income tax.

What it means

States, cities, school districts and public authorities issue municipal bonds to pay for projects such as roads, schools and water systems. General obligation bonds are backed by the issuer’s taxing power, while revenue bonds are repaid from a specific source, such as tolls. Investors earn interest and can gain or lose on price changes if they sell before maturity.

Muni interest is generally exempt from federal income tax and is often exempt from state tax for residents of the issuing state. Some bonds can be subject to the alternative minimum tax, and capital gains on sales are taxable. Defaults have historically been uncommon but do happen. Because of the tax break, munis usually yield less than taxable bonds, so comparing them requires the tax-equivalent yield.

Formula

Tax-equivalent yield = Muni yield ÷ (1 − Marginal tax rate)

Muni yield = the bond’s tax-free yield
Marginal tax rate = the investor’s tax rate on the next dollar of income, as a decimal

Example

Suppose a muni yields 3% and an investor is in the 24% federal bracket. The tax-equivalent yield is 3% ÷ (1 − 0.24), or about 3.95%, so a taxable bond would need to yield more than that to come out ahead.

How it’s used

Earning tax-free income in a taxable brokerage account
Investors in higher tax brackets seeking after-tax income
Supporting local public projects

Strengths and weaknesses

Strengths

Interest generally free of federal income tax
Often free of state tax for in-state residents
Historically low default rates for many issuers

Weaknesses

Lower yields can make them a poor fit in low tax brackets or retirement accounts
Prices fall when interest rates rise
Credit quality varies widely between issuers

Educational information only, not financial, tax or legal advice. Rules, limits and rates change; check the IRS, your lender or plan, or a qualified professional before acting.