What are Tax-Exempt Municipal Bonds?

Dale Marshall

Tax-exempt municipal bonds are debt instruments issued by American municipalities. The interest on these bonds is exempt from taxation as income by the municipal, state, and national governments. They are commonly issued by municipalities nationwide for the purpose of raising funds for projects for the public good, and their tax-exempt status gives them the ability to compete favorably with the bonds issued by large corporations that can afford to pay better interest rates.

Man climbing a rope
Man climbing a rope

When a municipal government identifies a public need, it's frequently unable to save up the funds to address the need in a timely manner. If a small city needs to build a new school due to a population increase, for example, it may not have enough capital funds put aside for the purpose, and cannot wait until it does. To raise the funds, then, it will sell bonds, the proceeds of which will be dedicated to the construction of the new school.

The potential purchasers of tax-exempt municipal bonds are concerned with two things: the rate at which interest will be paid on the bonds, and the municipality's ability to pay the debt on time. Municipalities have an advantage in borrowing money because government debt is tax-exempt — that is, the interest income it produces cannot be counted as income for the purposes of income tax. That means that a person paying an effective income tax rate of 35% (federal, state, and municipal combined) would actually receive only 6.5% interest on a 10% corporate bond. That person would be better off purchasing tax-exempt municipal bonds paying 7% than the fully-taxed 10% corporate bond.

There are limitations on the tax exemption, though. Out-of-state purchasers of tax-exempt municipal bonds can count only on exemption from federal income tax, as the exemption from municipal and state income tax usually applies only within the state in which the bonds are issued.

Purchasers of tax-exempt municipal bonds are also concerned with the municipality's ability to pay the bond. Tax-exempt municipal bonds are usually categorized by the source of the repayment, such as general obligation bonds, revenue bonds and assessment bonds. General obligation bonds are repaid from the municipality's general fund. Considered the safest of the different municipal bonds, they carry the lowest interest rate. Revenue bonds are paid from a specific revenue stream, often from the project the bond is underwriting, such as a parking deck or a toll road. Riskier than general obligation bonds, they carry a somewhat higher interest rate. Assessment bonds are among the riskiest municipal bonds, because they're paid from assessments levied on property owners within the city's borders. For example, a bond may be sold to fund repairs to sidewalks in a neighborhood and be paid from assessments levied on the neighborhood's property owners.

Tax-exempt municipal bonds are usually issued in multiples of $5,000 US Dollars (USD). Interest on short-term bonds is usually paid semi-annually, with the principal being repaid on the maturity date. Long-term bonds may be paid according to the same schedule, or may be amortized so that each semi-annual payment includes both principal and interest.

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