What is a Municipal Bond?

A municipal bond, or muni, is a bond issued by a state, city, county or other regional agency. Like other bonds, a municipal bond gives the purchaser a stream of future interest payments and repayment of the principal at some later date. Maturities may range from several months to 40 years. The interest earned by a municipal bond may be exempt from federal and state income tax.

There are several classifications for municipal bonds. A general obligation municipal bond is one guaranteed by the full faith and credit of the issuer. These are generally issued by large, financially stable entities such as states or large cities. A revenue municipal bond is one guaranteed by an identifiable source of future revenue, such as a city's income from utility payments or a county's mineral royalties. Assessment bonds are based on property taxes, and are dependent on property values and the health of the regional economy. Investors consider general obligation munis to be the most secure.

A municipal bond may be issued for a variety of reasons. A state may issue munis to pay for road improvements or school funding. Quasi-governmental agencies such as port authorities may issue bonds to upgrade or expand facilities. Local governments may issue a municipal bond as an alternative to raising taxes on residents to pay for services or capital improvements.

Like federal treasury and corporate bonds, a municipal bond will be rated by an agency such as Standard & Poors, Moodys or Fitch. Unlike Treasury bonds, a municipal bond does not carry a guarantee from the federal government. Because of the tax-free status of municipal bonds, investors are often willing to accept below-market interest rates; this makes issuing munis attractive to governments as a relatively cheap source of financing.

An investor may purchase a municipal bond directly from the issuing authority, or purchase it in the secondary market after the initial offering. It is also possible to invest in municipal bonds indirectly by investing in a mutual fund that specializes in munis.