Municipal bond

A municipal bond is a debt obligation of a state, city, county, or other sub-federal government entity. The defining feature is tax treatment: interest is generally exempt from federal income tax under IRC Section 103, and from state income tax if the bondholder resides in the state of issuance (a “double-tax-free” bond). General obligation bonds are backed by the issuer’s taxing power; revenue bonds are backed by a specific project’s cash flows. Tax-equivalent yield compares munis to taxable bonds: a 3.5% muni yield for a 35% bracket filer equals a 5.38% taxable yield.

Example: a California resident in the 37% federal and 13.3% state bracket buys $500,000 of California GO bonds yielding 3.8%. Annual interest of $19,000 is fully federal and state tax-free, equivalent pre-tax to a 7.6% taxable yield. Taxable bond yields near 5.0% for equivalent credit quality, so the muni wins.

Common mistake: buying out-of-state munis in a high-tax state. The federal exemption remains, but state tax applies. A Californian buying Illinois munis loses the 13.3% state benefit.

Municipal bonds matter at high brackets, in taxable brokerage accounts, and as a long-duration complement to T-bill ladders for multi-year cash parking.