State and local governments around the United States issue municipal bonds and use the sale proceeds to finance government backed projects and to cover day-to-day governmental expenses. When the federal government introduced the tax system in 1913, the decision was made to make municipal bonds tax exempt. Nowadays, some high earners have to pay tax on municipal bonds, and some federally backed bonds are not exempt from taxation. However, the majority of municipal bonds are still tax exempt and these bonds appeal to investors for a number of reasons beyond just tax savings.
You can reduce your taxable income by investing in municipal bonds rather than other types of bonds because you have to pay income tax on earnings from other bond offerings. If you fall into the 25 percent tax bracket, then you end up losing a quarter of your potential earnings if you invest in a corporate bond rather than a municipal bond with the same yield. Additionally, aside from avoiding federal taxation, you do not pay state income tax on bond earnings if you own bonds that were issued by government entities based in the state where you live. If your state has no state income tax, you can buy municipal bonds from anywhere and enjoy the tax-free earnings.
Some municipal bonds are used to fund government backed projects, and you stand to lose your money if the project goes bankrupt. However, many municipalities issue general obligation tax exempt bonds backed by tax dollars. In California, the state constitution requires the state government to pay bondholders even ahead of government employees. Therefore, general obligation bonds expose you to less risk than corporate bonds because governments have the ability to increase taxes if funds run short, whereas corporate bonds only provide you with income if the company that issues the bond remains solvent.
You can buy and sell municipal bonds on the secondary market, which means that you do not have to hold your bond until maturity. By comparison, while you can sell corporate bonds and some federal bonds on the open market, you cannot sell federal EE and I savings bonds. Furthemore, you cannot typically sell other income generating securities such as certificates of deposits. While you may have to sell your municipal bond at a discount if interest rates have risen, you can also sell your bond at a premium if interest rates have fallen. When taxes rise, investors often willingly agree to pay a premium to buy tax-exempt bonds on the secondary market, while taxable bonds become much less attractive.
If a municipal bond issuer files bankruptcy, creditors, including bondholders, can contact the liquidators and make a claim on the bond issuer's assets. If the sale of the entity's assets fails to raise enough money to cover all of the entity's liabilities, then bondholders and other claimants stand to lose their investment. However, many tax-exempt bonds are insured. This means that if the government that issues the bond goes bankrupt the insurer covers your losses.