Municipal bonds

Municipal bonds are bonds issued by states and local governments.

Types of municipal bonds

 * General Obligation Bonds
 * Revenue Bonds
 * Assessment Bonds

Interest
Interest from municipal bonds is generally exempt from federal income tax and the issuing state's income tax. However, there are a few exceptions.


 * Interest from some municipal bonds is subject to Alternative Minimum Tax (AMT) although whether you actually have to pay AMT depends on your individual circumstances. Such bonds are commonly referred to as AMT bonds.
 * Some states charge income tax on interest from their own municipal bonds.

Capital gains/losses
Capital gains and losses are subject to taxation. One notable point is the treatment of short-term capital losses. If you have short-term capital loss due to tax-exempt interest from a mutual fund held less than 6 months or less, you cannot claim the loss. You can still claim a part of the loss due to market movements, such a rising interest rate. See Publication 564 (2007), Mutual Fund Distributions and Short-Term Capital Losses for more details.

Credit risk
Credit risk is generally much less than that for corporate bonds. Nonetheless, it exists.(Refer to Moody’s US Municipal Bond Rating Scale for data on defaults). Some municipal bonds are insured by private insurance companies. (AFGI Investors' Frequently Asked Questions}

Some investors seek to mitigate the credit risk by diversifying their municipal bonds beyond the state of residence. The caveat is that they may have to pay state income tax on the interest from out-of-state municipal bonds.

Liquidity risk
Municipal bonds are generally illiquid, especially at the retail level. To mitigate the risk, you may consider holding them to maturity or holding them through a low-cost mutual fund, which can trade on the wholesale market.

Role in a portfolio

 * If you have filled up your tax-advantaged accounts with tax-inefficient assets (taxable bonds, REITs,  commodities, etc), and you still need bonds to meet your desired stock/bond asset allocation, you might consider placing municipal bonds (or a mutual fund thereof) in your taxable account.
 * If you are in high tax brackets, and you are saving for short-term cash needs (such as car, home down payment, etc), then you might consider short-term municipal bonds or tax-exempt money market funds. (Note that Vanguard's tax-exempt money market funds contain AMT bonds.  Fidelity offers some AMT-free tax-exempt money market funds as well as those with AMT bonds in them.)

Taxable equivalent yield
Taxable equivalent yield of a municipal bond is one that a taxable bond would have to pay to deliver the same amount of income as the municipal bond. The taxable equivalent yield depends on the investor's tax brackets. The following calculators allow you to calculate the taxable equivalent yield.


 * Vanguard Taxable-Equivalent Yield Calculator
 * Boglehead tfb's Bond Fund Yield Calculator
 * Bond Calculator

It's important to calculate the taxable equivalent yield before purchasing municipal bonds because taxable bonds with comparable credit ratings may have greater yields.

Links

 * EMMA Electronic Municipal Market Access
 * About Municipal Bonds

Academic Papers

 * Downing, Chris T. and Zhang, Frank Xiaoling, "Trading Activity and Price Volatility in the Municipal Bond Market". FEDS Working Paper No. 2002-39. Available at SSRN: http://ssrn.com/abstract=333620
 * Harris, Lawrence and Piwowar, Michael S., "Municipal Bond Liquidity"(February 13, 2004). AFA 2005 Philadelphia Meetings. Available at SSRN: http://ssrn.com/abstract=503062
 * Singh, Rajdeep and Nanda, Vikram K.,Bond Insurance: "What is Special about Munis?". Available at SSRN: http://ssrn.com/abstract=171412 or DOI:  10.2139/ssrn.10.2139/ssrn.171412
 * Wu, Chunchi, Wang, Junbo and Zhang, Frank Xiaoling, "Liquidity, Default, Taxes and Yields on Municipal Bonds"(March 14, 2006). FEDS Working Paper No. 2005-35. Available at SSRN: http://ssrn.com/abstract=687500