Municipal bonds are bonds that are issued by state and local governments. By issuing municipal bonds, local governments borrow money to build bridges, roads, hospitals, schools, sewer systems, stadiums, airports, power plants, prisons, and provide for other needs of local governments. Municipal bonds are generally issued to raise money for major capital projects.
Almost all states and local governments such as counties, cities, towns, issue municipal bonds from time to time. There is also a form of government called Special Districts. These are government entities such as school districts that provide one specific type of service to one municipality or to multiple municipalities. Special districts include water districts, fire districts, power districts, sewer districts, airports, etc. Collectively, there are over 50,000 different municipal bond issuers comprising of various states, towns, cities, counties, and special districts that currently have over $2.6 trillion in bonds outstanding.
Just like any borrower, local governments pay interest on municipal bonds to the investors that own them (or bondholders), usually once every 6 months. The major benefit to investors is that the interest earned from municipal bonds is tax-free in terms of federal income taxes. The interest from municipal bonds can also be free of state income taxes, local income taxes, and the alternative minimum tax (AMT).
As a general rule, if you live in the same state as the local government that is issuing the bond, the interest to you on such a bond is tax-free on a state level as well. For instance, a California resident owning a Beverly Hills School District bond would not have to pay federal or California income tax on the interest received from the bond.
Municipal bonds are considered safe investments from a historical perspective. Less than 1% of municipal bonds have defaulted since World War II. One of the reasons for this is that most municipal bonds are backed by the taxation power of the local government that issues the bonds. This means that local governments can generate revenues from taxes (income, property, sales, vehicle, tolls, special levies, etc.) to make sure that they pay back what they owe to bondholders. Certain types of municipal bonds, such as revenue bonds, are not backed by the general taxation powers of a local government.
For bonds that are backed fully by the local government, the taxation power offers a measure of safety to investors. Unlike corporations, local governments very rarely cease to exist altogether and dissolve; this means that as long as the local government exists, the local government should be able to generate tax revenue to pay back the bonds. The combination of tax-free income and safety of principal make municipal bonds attractive to certain types of investors.
