Municipal bonds or ‘munis’ are bonds issued by government or other organizations at the state and local level. They are extremely popular because the interest income is exempt from federal income tax and also often from local and state taxes as well. Munis also represent investments in important public projects so there is a satisfaction associated with making a contribution to a community as well.
The moment you buy a muni, you are in essence loaning money to the local or state government, which will use the money to fund local projects and pay you interest usually every six months and then give you the principal back at the date of maturity.
While we did mention that a lot of muni bonds are exempt from federal and state taxes, there are a few that are taxable at the federal level. Interest on muni bonds nearly always are exempt from local and state taxes.
These days a lot of investors who prefer not to research various municipal bonds individually have the option of investing in a muni bond fund. These funds comprise of bonds issued by local and state governments. Most investors only pay attention to the return on bond funds. You should be aware that all else being equal, a higher return will be due to higher risk municipal bonds within the fund.
When looking at bond funds, you should also consider the pre-tax yield of the bonds in it. The tax-equivalent yield calculation will help you compare tax-free bonds to taxable bonds on even ground. You do this by figuring out the pre-tax yield of a taxable bond and then you would know what you should be getting if its yield is to equal the tax-free muni bond yield.