What is a Municipal Bond?
A Municipal Bond is a bond that is issued by a state, city or other government entity. These government entities sell bonds to investors when they need money to pay for projects or expenses, such as fixing roads, building a new school or paying city employees.
Municipal bonds are a form of debt for these government entities because when it sells you a bond, it is borrowing money from you, and it has to pay you back at a later date.
A municipal bond is also called a Muni Bond. Muni bonds are usually tax-exempt at both the federal and state levels, which means when you receive a coupon payment, you don’t have to pay federal tax on it or state tax if you live in the state where it was issued.
Because of this tax benefit, the coupon on muni bonds is usually lower than similar taxable bonds. But that doesn’t mean you make less money when you buy a muni bond.
Let’s go through an example of how a muni bond works.
Assume you live in the state of New York, and you buy a 10 year New York City muni bond with a 5% coupon and a 10 year corporate bond with a 6% coupon. In 10 years, you will have received a total of $500 in coupon payments from the NYC muni bond, and a total of $600 in coupon payments from the corporate bond. But you have to pay taxes on the coupons you received from the corporate bond. Assuming you have to pay a total of 35% for federal and state taxes, after taxes you only get $390 from the corporate bond. So you made more money from the NYC muni bond, even though it had a lower coupon.
Remember, a muni bond is usually tax-exempt at both the state and federal levels, so make sure you take this tax benefit into account when buying a muni bond.