Tax-exempt securities and municipal bonds are not opposing terms. Municipal bonds are a type of tax-exempt security, and the terms are sometimes used interchangeably. Municipal bonds are far and away the most common form of tax-exempt securities. When United States Savings Bonds are used to pay for education, they are also free of federal, state or local taxes.
Municipal Bonds and Tax Exemption
Municipal bonds are securities that states, municipalities and counties issue and that investors purchase. The bonds are issued for a period of time during which investors receive interest payments. At maturity, the end of the bond's duration, investors receive their initial investment back. Investments in municipal bonds are not subject to federal taxes. The bonds sometimes also are free from local and state taxes. The best chance for avoiding local and state taxes on a municipal bond is to purchase one in the state where the bond originated.
Types of Bonds
General obligation bonds, one of the more frequently issued municipal bonds, are issued to pay for government operations. The government's ability to raise taxes to make bond payments serves as backing for the bonds. Revenue bonds, meanwhile, are issued to pay for particular capital projects, such as building roads, bridges, schools, athletic facilities, community facilities and government facilities. Municipal bonds also sometimes finance private development that a government hopes to aid, though those private activity bonds are sometimes taxed under the alternative minimum tax and are therefore not tax exempt.
Tax-exempt securities are attractive to investors most often because of their low tax obligations. This is particularly true of investors who are in the higher income tax brackets because tax-exempt securities give them relief from taxes on their income. Municipal bonds can be a particularly appropriate investment choice when it appears that tax rates are going to increase. Tax-exempt securities also provide regular income to investors.
One of the drawbacks to investors with tax-exempt securities concerns their lower yield. Also, municipal bonds are fixed-income securities and are vulnerable to interest rate risk and credit risk. Interest rate risk refers to the fact that interest rates will rise and fall during the life of a bond, affecting bond prices. If rates rise, the value of a bond will decrease. Credit risk refers to the possibility that the issuer of a security might not be able to make principal and interest payments and will be forced to default, leaving investors without a return.