Municipal Bonds in Depth

Why this matters

Treasuries, Corporate Bonds, and Munis introduced municipal bonds with one idea: their interest is usually free of federal income tax. That one feature reshapes everything else about them. It lowers their yields, decides who should own them and who shouldn't, and makes a naive comparison with other bonds wrong. Behind it sits a market unlike the corporate one, with a larger number of issuers,¹ its own kinds of security, and its own way of failing. The tax rules here are US federal rules for 2026, and state rules vary.

Who issues them, and what stands behind them

Municipal bonds are issued by states, cities, counties, towns, and public authorities to fund capital projects like roads and schools, and sometimes operating budgets.² An important factor in a bond's credit quality is its source of repayment, and bonds are classified by it.³

A general obligation bond, or GO bond, commits the issuer to levy taxes sufficient to pay it. A revenue bond has no claim on the government's general funds.³ Its creditworthiness tends to rest on its debt service coverage ratio, the relationship between the revenue coming in and the cost of paying the debt,² which is the interest coverage of Credit Analysis under another name.

A few more features change the picture and are worth checking for.³

• Subject to appropriation. Some bonds are paid only if the issuer's legislature votes the money each year.
• Priority. Other obligations of the issuer may rank ahead of the bonds. A state might, for example, put education spending first.
• Credit enhancement. Some bonds carry insurance, and their rating then reflects the insurer. The rating the bond would have without it, called the underlying rating, shows the issuer's own strength.
• Borrowers behind the issuer. When bond proceeds are lent on to another party such as a hospital or a university, the bonds are generally secured by that party's loan payments, and it's that party's finances that matter.

The tax exemption changes the arithmetic

If a municipal bond is tax-exempt, its interest isn't subject to federal income tax.⁴ Investors accept lower yields in exchange, so a muni's yield can't be set beside a Treasury's or a corporate bond's as it stands. It has to be converted.

Tax-equivalent yield = Tax-exempt yield ÷ (1 − Tax rate)

The tax-equivalent yield is the yield a taxable bond would need to leave the same income after tax. The tax rate that matters is the investor's own marginal rate. For 2026 the federal rates on ordinary income are 10%, 12%, 22%, 24%, 32%, 35%, and 37%.⁵

Marginal federal rate	Sum	Tax-equivalent yield	Against a taxable bond at 5.0%
12%	3.5 ÷ 0.88	3.98%	The taxable bond pays more
22%	3.5 ÷ 0.78	4.49%	The taxable bond pays more
24%	3.5 ÷ 0.76	4.61%	The taxable bond pays more
32%	3.5 ÷ 0.68	5.15%	The muni pays more
35%	3.5 ÷ 0.65	5.38%	The muni pays more
37%	3.5 ÷ 0.63	5.56%	The muni pays more

The same bond is a poor choice for one investor and a good one for another. Nothing about the bond differs. Only the tax rate does.

The dividing line can be found directly.

Break-even tax rate = 1 − Tax-exempt yield ÷ Taxable yield

With the muni at 3.5% and the taxable bond at 5.0%, the break-even rate is 1 − 3.5 ÷ 5.0 = 30%. Above that rate the muni leaves more after tax, and below it the taxable bond does. In general, the higher an individual's tax bracket, the greater the after-tax advantage of a tax-exempt bond.³ The comparison should be made between bonds of similar maturity and credit quality, or it measures those differences as much as the tax.

State taxes

The treatment of a tax-exempt bond can vary with where the investor lives. A bond may be exempt from federal income tax and still be subject to state and local income tax. Some states exempt only their own bonds, and others also exempt bonds of other states.³ Where a state does tax out-of-state bonds, an in-state bond is worth more to a resident. For a resident who pays 24% federal tax and 5% state tax, a 3.5% in-state muni exempt from both has a tax-equivalent yield of roughly 3.5 ÷ (1 − 0.24 − 0.05) = 4.93%. Treasury interest is exempt from state income tax too,⁶ so against a Treasury only the federal rate counts.

The rest of this lesson is for members

Still to come in this lesson: The limits of "tax-exempt", Credit risk: low on average, uneven in detail, Buying and checking a muni, the key takeaways, and 2 quiz questions with explanations.

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