Municipal Bond
Debt issued by U.S. states and local governments, whose interest is typically exempt from federal (and sometimes state) income tax.
Formula
Taxable-Equivalent Yield = Muni Yield / (1 − Marginal Tax Rate)
A municipal bond (muni) is debt issued by a state, city, county, or other local authority to fund public projects — schools, highways, water systems. Its defining feature is tax treatment: interest on most munis is exempt from federal income tax, and often from state and local tax for in-state residents. That exemption lets issuers borrow at lower nominal yields than taxable bonds.
Two broad types exist. General obligation (GO) bonds are backed by the issuer's taxing power; revenue bonds are repaid from a specific project's cash flow (a toll road, an airport) and carry the project's risk. Munis carry real default risk — Detroit (2013) and Puerto Rico are reminders — though historical default rates are far below corporates.
The practical edge: compare munis to taxable bonds using the taxable-equivalent yield. A 3.5% muni yield is worth far more to a high-bracket investor than the headline number suggests, which is why munis are a staple of high-income portfolios.
Example
A muni yields 3.5% tax-free. For an investor in the 37% federal bracket, the taxable-equivalent yield is 3.5% / (1 − 0.37) = 5.56%. A taxable corporate bond would have to yield above 5.56% to beat it after tax.
Related Terms
Bond
A debt instrument in which the issuer borrows money from the buyer and promises to pay periodic interest plus return the principal at maturity.
BeginnerBond Yield
The return an investor earns by holding a bond — driven by its price, coupon, and time to maturity. Moves inversely with price.
BeginnerCorporate Bond
Debt issued by a company to raise capital, paying a coupon above Treasuries to compensate investors for credit risk.
BeginnerCredit Rating
A graded assessment by agencies like Moody's, S&P, and Fitch of an issuer's ability to repay debt — the standardized scale for default risk.
BeginnerDefault Risk
The probability that a bond issuer will fail to make scheduled interest or principal payments — the core credit risk in fixed income.
Intermediate