Municipal Bonds

Municipal bonds are debt instruments of state and local governments or government-related entities (e.g., bridge or highway authorities). General obligation (GO) bonds are backed by the full taxing ability of the issuer and are considered the safest of municipal bonds. A second type of municipal bond, the revenue bond, is backed by some type of revenue-generating source (e.g., fares, tolls, fees) and generally pays a slightly higher rate of return.

Municipal bonds are generally attractive to persons in the 25% marginal tax bracket and higher. Even though municipal bonds pay a lower return than other bonds, investors keep more of what they earn because the interest is generally federally tax-exempt. Interest is also state tax-exempt if bonds are issued by an investor’s state of residence. An exception is the so-called private purpose municipal bond sold to finance sports stadiums, airports, hospitals, and the like. Municipal bonds are generally sold by brokerage firms in $5,000 increments with less expensive "minibonds" requiring a lower amount (e.g., $500). Interest is paid semi-annually. Investors can also obtain the tax advantages of a municipal bond by purchasing a municipal bond mutual fund, often for an initial investment of $1,000 or less. To determine your marginal tax bracket, refer to Figure 1 in Unit 7, Tax-Deferred Investments Investing Unit 7: Advantages of Retirement Accounts.

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