Municipal bonds ("munis") are what help local or state governments to pay for public projects, such as the construction or improvement of schools, schools, streets, highways, hospitals, bridges, low-income housing, water and sewer systems, ports, airports and other public works.
There are many different types of municipal bonds, including general obligation bonds, limited and special tax bonds, industrial revenue bonds, revenue bonds, housing bonds, moral obligation bonds, double barreled bonds, tax anticipation notes, bond anticipation notes, and revenue anticipation notes.
The differences between all these kinds of munis comes down to how the issuer expects to eventually repay the bonds and make the interest payments. For instance, in the case of general obligation notes, the bond is simply backed by the "the full faith and credit" of the issuer. That means the local or state government that has issued the bond can use just about any means available to guarantee payments, including raising taxes.
Other bonds are issued with specific provisions to raise taxes or create a new tax. These are known as limited or special tax bonds. Will the project being undertaken generate revenue from tolls, sewage fees, water bills, or other services? These are revenue or industrial revenue bonds.
The key point is how the issuer of a municipal bond expects to be able to repay the bond.
Municipal bonds are usually high quality issues, since the governments that stand behind the bonds are generally not in danger of going bankrupt. At least, that's the conventional wisdom -- but there are plenty of examples that show otherwise. Just look at New York City's fiscal problems of the 1970s or, more recently, Orange County, California's brush with bankruptcy.
Some municipal bond issuers purchase insurance to guarantee that their bonds will be repaid. But who do you think actually pays for that insurance? The bondholders, in the form of a lower return. Better stick with highly-rated bonds if you're looking for protection, rather than this type of insurance.
In order to encourage taxpayers to invest in these bonds, thereby allowing cities and states to make necessary improvements, the federal government has made interest payments from muni bonds exempt from federal income taxes. Muni bonds are known as tax-free for this reason.
If reducing taxes is your goal, it gets even better. If you buy a municipal bond issued in your state, then you don't have to pay state income taxes on the interest you are paid on the bond. These bonds are double tax-free munis.
And if you buy a muni issued by the city or locality where you live, you won't have to pay local income taxes. The term to describe these is -- you guessed it -- triple tax-free. If you live someplace where the local taxes are high, like New York City, these bonds can be attractive.
The trade-off you make when you buy a municipal bond is that you receive a lower coupon rate or current yield than you'd get with a comparably-rated, similar maturity corporate bond. The tax savings are supposed to make up the difference so that in the end you could come out ahead by buying the bond with the lower yield.
Generally, muni bonds make more sense for investors in high tax brackets. Remember, however, that the payoff of saving on your tax bill might not be worth giving up the additional returns you might be able to receive from another asset class or type of bond.