Municipal Bond: Definition, Types, Risks, and Tax Benefits

What Is a Municipal Bond?

Municipal bonds are debt instruments that local, county, and state governments issue to secure financing for civic improvements, including the construction of highways, bridges, or schools.

Municipal bonds act like loans, with bondholders becoming creditors. In exchange for borrowed capital, bondholders/investors are promised interest on their principal balance, the latter being repaid by the maturity date. Municipal bonds are often exempt from most taxes, which makes them attractive to people in higher income tax brackets.

Types of municipal bonds include general obligation and revenue bonds.

Understanding Municipal Bonds

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

A municipal bond is categorized based on the source of its 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.

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.

The Bottom Line

Municipal bonds are debt instruments issued by local governments to finance the needs of a community, such as the building of a community center or park. They offer investors a low-risk investment of fixed income and can be a good option to diversify a bond portfolio.