A municipal bond is a debt security that’s issued by government entities, such as cities, states and counties, to fund day-to-day expenses and to finance projects, such as schools. Investors buy the bonds, and the government entity that issues the bonds pays the interest payments, also known as the coupon rate, at periodic intervals as specified by bond parameters. Typical repayment intervals are semi-annually. A bond’s maturity date – when the bond issuer repays the principal to the investor – can vary. Municipal bonds, also called munis, have varying maturity dates, which can range from one to 20-plus years.
What is a Municipal Bond Yield?
There are two types of municipal bond yields: current yield and yield to maturity. The current yield of a municipal bond is the annual return on the dollar amount of your investment (the interest you earn on the amount you paid for the bond). The yield to maturity is the rate of return you receive at the bond’s maturity date.
Municipal Bonds Advantages and Disadvantages
- The income you make on your investment in municipal bonds is typically tax-free, both at the federal and state level. Although the interest rate may look slight, the tax savings offsets this low-interest rate. Forbes offers this example: If your income places you in the 28 percent tax bracket, a municipal bond that pays 5 percent interest is comparable to dividend stocks or corporate bonds that pay a 6.94 interest rate.
- Purchasing municipal bonds and earning interest on your investment doesn't bump you up to the next tax bracket.
- Although it’s a minimal risk, government entities can default on paying municipal bonds. For example, if you hold a municipal bond in a city that files for bankruptcy, you may lose your money unless the city has bond insurance. Matt Fabian of Municipal Market Analytics noted in 2017 that municipal bond defaults are currently “experiencing modest volatility.”
- Investors face call risks. A “call” happens when a municipal bond issuer pays the bond in full before its maturity date. The U.S. Securities and Exchange Commission notes that many bonds are “callable” and recommends that potential investors understand a bond’s call requirements before investing.
Municipal Bonds Tax Free
Although the interest income you make on a municipal bond investment is usually exempt from federal and/or state taxes, there are some notable exceptions, including:
- Social Security benefits tax. The IRS includes the interest income you make from municipal bonds in your modified adjusted gross income to determine your taxable Social Security income. You may face a steep tax assessment of 85 percent if half of your Social Security benefits plus other income, which includes interest income from municipal bonds, is greater than $34,000 (if you file an individual tax return). This amount increases to $44,000 if you file jointly.
- State income tax. Although you’re typically exempt from paying state income taxes on municipal bonds that you purchase in your home state, out-of-state bonds don’t carry the same benefit. If you purchase a municipal bond outside your home state, you’ll typically pay that state’s income tax on the interest you earn.
- Municipal bonds tax. Some municipal bonds are subject to federal taxes. One example is the Build American Bonds (BAB) program. Municipal bonds issued under the BAB program are federally taxable. This is not necessarily a drawback, however, because taxable bonds often pay a higher rate of interest to compensate investors for the tax penalty.
Types of Municipal Bonds
According to the U.S. Securities and Exchange Commission, the types of municipal bonds fall under two categories:
- General obligation bonds, which are unsecured, and backed only by the “full faith and credit” of their issuers.
- Revenue bonds, which are backed by revenues from a specific source or project, such as a highway toll.
Municipal Bonds Examples
Municipal bonds raise money to improve infrastructures, such as roads, bridges and airports. These bonds also provide construction funds for building schools, hospitals and water/wastewater facilities. Although the
- Forbes: Municipal Bonds - Wall Street's Hidden 6.5% Income Secret
- U.S. Securities and Exchange Commission: What are Municipal Bonds?
- Barron's: Uptick in Muni Defaults Could Hurt More Investors in 2017
- Charles Schwab Corporation: Not Always Tax Free - 7 Municipal Bond Tax Traps
- Brookings: Building Better Infrastructure with Better Bonds
- The GMS Group: Municipal Bond Market Yields