Municipal bonds, or munis, are bonds issued by states, cities and counties to fund new or ongoing projects or improvements.
Munis are categorized as either general obligation (GO) or revenue bonds. GO bonds usually require voter approval because they are paid for with tax revenue and typically subsidize capital improvements like the creation of roads, parks and schools.
Like Treasuries, GO bonds are backed by the issuing government's ability to collect taxes to pay its debts. But unlike federal government issues, municipal bonds are subject to credit risk. Cities and counties, in particular, have been known to default on their obligations.
Revenue bonds, on the other hand, are not backed by the government's right to collect taxes, but by the issuer, which can be any state or local government, government agency, or authority, like the Port Authority of New York. Investors are repaid with fees, tolls or lease payments that are collected when the project is completed. Revenue bonds typically support the creation of airports, transportation systems, colleges, hospitals and turnpikes. Double-barreled bonds are a combination of the two and are repaid with a combination of tax revenue and fees.
Like Treasuries, munis offer favorable tax treatment. In addition to being exempt from federal tax, municipal bonds are also exempt from state, city and county taxes if you live in the same municipality where the bond is issued.
However, not all munis are tax-exempt. Taxable municipal bonds are subject to federal income tax because they do not fund projects that qualify as public services, like shopping malls or sports stadiums. At the same time, some munis are exempt from regular federal income tax, but may be subject to the alternative minimum tax (AMT). These private purpose revenue bonds are used to fund non-governmental projects like airports, housing and student loans. Approximately 9% of all munis fall into this category.
Scottrade does not provide tax advice. This material is for informational purposes only. Please consult your tax or legal advisor(s) for questions concerning your personal tax or financial situation.