Municipal Bond
A municipal bond, or muni, is debt issued by a state, city, county or other local government entity, with interest that is often exempt from federal income tax.
States and local governments issue municipal bonds to fund schools, roads, water systems, hospitals and other public projects. General obligation bonds are backed by the issuer's taxing power, while revenue bonds are repaid from a specific income source such as tolls or utility fees.
The main attraction is the tax treatment. Interest on most munis is free from federal income tax, and often from state tax if you live in the issuing state. Because of this, munis usually pay lower stated yields than taxable bonds of similar quality.
To compare, investors calculate the taxable-equivalent yield: the muni yield divided by (1 minus the tax rate). Example: a 3% muni for an investor in a 32% federal bracket equals about 4.4% on a taxable bond.
Municipal defaults have historically been rare, but credit quality varies between issuers. Munis are generally most useful in taxable accounts for investors in higher brackets, and they make little sense inside an IRA or 401(k).