Introduction to municipal bonds: Key concepts and considerations

Bonds play a major role in a well-diversified investment strategy, providing a generally reliable income stream, preserving capital, and enhancing portfolio diversification, among other advantages.

Municipal bonds can offer investors unique benefits, particularly the chance to support local infrastructure projects that can have a tangible impact on their community. One of the most attractive features of municipal bonds, or “munis,” are their tax advantages, as their interest income is typically exempt from federal income tax, and in some cases, state and local taxes as well. However, it's important to note that not all municipal bonds are tax-exempt, making it essential for investors to have a clear understanding of potential benefits and risks.

Municipal bonds are financial instruments issued by state and local government entities to finance the development, maintenance, and management of public infrastructure projects, such as construction of schools, hospitals, essential transit systems, and utilities. Issuers include states, counties, cities, school districts, universities, hospitals, utilities, airports and many other non-federal governmental entities. 

When an investor buys a municipal bond, they are essentially providing a loan to a public issuer in exchange for receiving a series of scheduled interest payments over a defined period. At the bond’s maturity (or when it is called), the investor typically receives back their original investment amount.

The two main types of municipal bonds are general obligation bonds (GO) and revenue bonds. The source of these interest and principal payments is what distinguishes the two main categories of municipal bonds:

General obligation and revenue bonds can also be insured or pre-refunded.

• Insured bonds come with a guarantee, backed by pledged collateral or the assurance of an insurer, to cover interest and principal payments if the issuer fails to meet its obligations.
• Pre-refunded bonds are often redeemed before their scheduled maturity date. In these situations, the funds for interest and principal payments have already been secured and are held in escrow until the issuers can legally call the bonds. The bonds usually trade at premium prices and offer lower yields compared to other securities, as they are generally regarded as some of the highest quality investments in the municipal market.

Municipal bonds offer a unique advantage in the form of income tax exemptions that are not available with other types of fixed income securities. This feature can be particularly beneficial for investors in higher tax brackets, as it helps to significantly reduce their overall tax liabilities. Depending on the specific municipal bond, the interest income earned may be exempt from federal, state, or local taxes, and in some instances, all three levels of taxation. This tax-exempt status can enhance the after-tax return on investment, making municipal bonds an attractive option for those seeking tax-efficient income. Investors should carefully evaluate the tax implications of municipal bonds in the context of their individual financial situations and consult with their tax advisors to maximize the benefits. For the most current and detailed information, investors are encouraged to refer to our internal resources or access external sources such as the Municipal Securities Rulemaking Board (MSRB).

Depending on an individual’s tax bracket, a tax-exempt municipal bond with a lower yield may offer a higher after-tax return than a higher yielding taxable municipal bond.

Online tools like E*TRADE from Morgan Stanley’s Taxable Equivalent Yield Calculator can help investors determine comparable yields on specific taxable and tax-exempt bonds by using their personal tax requirements.

Investors should be aware that some municipal bonds may be subject to an additional “alternative minimum tax,” or AMT. This might be the case for a bond issued to support a project that provides both public and private benefits.

Investors should also be aware that purchasing a municipal bond at a discount might trigger the de minimis tax rule. The de minimis tax rule establishes the level by which gains resulting from a municipal bond purchased at a market discount will be taxed at the capital gains tax rate, versus the ordinary income tax rate. Please consult your tax professional for information regarding any municipal bond tax implications. You may also visit the MSRB Tax and Liquidity Considerations for Buying Discount Bonds for more information.

While municipal bonds are typically viewed as low risk due to their strong track record of creditworthiness, it is important to acknowledge that, like any investment, they still involve potential risks.

• Type of account: When considering municipal bonds, investors should evaluate the type of account they are using to optimize the potential benefits. For instance, while retirement accounts like IRAs offer tax efficiencies for all types of securities, a brokerage account might be more advantageous for leveraging the tax benefits specific to municipal bonds. Holding municipal bonds in tax-sheltered accounts like traditional IRAs, SEPs, or Qualified Plans can negate their tax advantages. This is because withdrawals from these accounts are taxed at distribution, and early withdrawals before age 59½ may incur a 10% federal tax penalty, regardless of the tax-exempt status of the original funds. Additionally, all qualified distributions from Roth IRAs are tax-free, irrespective of the source of the funds. For further guidance, please consult your Tax or Legal Advisor.
• Minimum investment: Keep in mind that the minimum investment for municipal bonds is generally higher than that for other fixed-income assets, such as corporate bonds. Municipal bonds are typically issued in denominations of $5,000, whereas corporate bonds may be offered for $1,000.
• Taxable municipal bonds: Some municipal bonds may be taxable if they are issued under federal programs to fund a deficit of state or local pension funds, industrial development projects the federal government won't subsidize or to refinance debt. Taxable municipal bonds are not exempt from federal income taxation, often because the proceeds do not provide a direct or significant benefit to the public.

The source of this article, Building the Nation - A Simplified Guide to Municipal Bond Investing, was originally published on March 2, 2022.

CRC# 4854675 10/2025