Municipal bonds: GO vs revenue bonds and tax-free yield math

A municipal bond, or muni, is a loan to a state, city, county, school district or other public body. Governments sell munis to pay for roads, schools, water systems, hospitals and airports, and repay them from taxes or from the money those projects earn. Their selling point is tax treatment: the interest on most munis is excluded from federal income tax, and often from state income tax for residents of the issuing state.

That exemption is why muni yields look low next to Treasuries and corporate bonds, and why comparing them takes a calculation rather than a glance. A 3.0% tax-free yield is worth 4.41% to an investor in the 32% federal bracket and exactly 3.0% to someone who pays no income tax. This guide explains the two main kinds of muni, how the tax exemptions work, how to compute a taxable-equivalent yield including state tax, and how a national muni fund's price has behaved since 2008.

Who issues munis and why

Munis are how American local government borrows for long-lived projects. Rather than raise taxes for the full cost of a bridge in the year it is built, a state can borrow and repay over the 30 years people use it. Issuers include states, cities and counties, school and utility districts, public universities, hospital systems, airports and housing agencies.

Two broad credit structures cover most of the market, as described by the Municipal Securities Rulemaking Board (MSRB), the market's rulemaker:

• General obligation bonds are backed by the issuer's "full faith and credit," meaning its power to tax residents to pay bondholders. Because repayment can come from taxes, GO bonds typically require voter approval.
• Revenue bonds are repaid from the income of a specific project or system, such as a toll road, airport, electric or water utility, college or hospital. They generally don't need voter approval, and the bondholders' safety depends on that one revenue stream.

Munis are rated on the same AAA-to-D scales as corporate bonds (see Credit ratings and credit spreads: how bond risk is priced), and many issues are not rated at all. Many munis are also callable, so the issuer can repay early when rates fall.

How the tax exemption works

The MSRB describes three federal tax statuses a muni can have:

1. Tax-exempt. The interest is generally excluded from gross income for federal tax. This is most of the market.
2. Taxable. Some munis fund purposes that don't qualify for the exemption. They pay yields closer to corporate bonds.
3. Subject to the alternative minimum tax (AMT). The interest is exempt from regular federal tax but counts for the AMT, which matters only to investors who owe it.

State tax is a separate layer. Many states exempt interest on their own munis for residents but tax interest on other states' bonds; that is why single-state muni funds exist. The details, including how muni interest is reported on Form 1099-INT and why it still counts toward taxing Social Security benefits, are in How dividends and interest are taxed: qualified, ordinary, muni.

The exemption covers interest, not gains: a capital gain from selling a muni or muni fund at a profit is taxable like any other gain. And tax-exempt status depends on the issuer following the rules attached to the bond. Official statements warn that an issuer's failure to meet them can make the interest taxable, in some cases back to the date the bond was issued.

Treasuries have the opposite pattern: their interest is federally taxable but exempt from state and local income tax, per TreasuryDirect. That matters when comparing the two.

Taxable-equivalent yield

The chart applies the first formula to a 3.0% muni yield at each federal rate: 3.41% at 12%, 3.85% at 22%, 3.95% at 24%, 4.41% at 32%, 4.62% at 35% and 4.76% at 37%. Reading it backwards: a taxable bond has to pay more than the bar for your bracket before it beats the muni after tax.

The second formula answers the reverse question. A 3.0% muni against a 4.0% taxable bond: 1 − 3.0 ÷ 4.0 = 25%. Investors whose marginal rate is above 25% keep more from the muni; those below keep more from the taxable bond.

The formula compares only promised yields. It ignores differences in credit risk, call features, maturity and liquidity between the bonds, which can be larger than the tax difference.

Real data: how a national muni fund behaved

The MUB exchange-traded fund holds investment-grade munis from many states. On monthly closing prices, price only:

Three lessons sit in those rows. First, munis have their own stress episodes: in late 2008 and again in late 2010, MUB fell more than AGG, a broad taxable bond fund with a large share of Treasuries, which tend to rally in a flight to safety. Second, munis still carry interest-rate risk: in the 2022 rate shock MUB fell 12.7%, less than AGG but far from safe. MUB's largest decline on monthly closes was 14.1%, from January 2021 to October 2023. Third, the flat long-run price line says nothing about total return. Like all bond funds, MUB pays out its interest as distributions, so its price barely moved over 18 years while it paid tax-exempt income every month.

Pitfalls and limitations

• Wrong account. In an IRA or 401(k), interest isn't taxed each year anyway, so the muni's lower yield is simply lower. Munis belong, if anywhere, in taxable accounts.
• Low brackets. Below the break-even rate, a taxable bond pays more after tax.
• Revenue risk is project risk. A revenue bond is only as strong as the toll road or hospital behind it. Read the official statement.
• Thin trading. Most individual munis trade rarely, so dealer markups can be large, especially for small lots. Recent trade prices are published on the MSRB's free EMMA site.
• Calls. A callable muni bought above face value can be repaid at face years early, cutting the return you expected.
• Tax rules change. The exemption, brackets and AMT are set by Congress and can change. Check the IRS and a tax professional for your own situation.

Munis compared with other high-grade bonds

More on the others: Treasury bills, notes and bonds: the US government’s debt menu, Corporate and high-yield bonds: how company debt behaves and TIPS and breakeven inflation: how inflation-protected bonds work.

How Finabase does it

Finabase does not list individual municipal bonds, their ratings or their yields, and it has no tax-equivalent-yield calculator. You can follow the muni market through funds: the MUB symbol page charts the national muni ETF's price, and its Dividends & splits tab, MUB's, lists the monthly distributions. For the taxable side of the comparison, the Treasury yields table shows yields from 1 month to 30 years. The tax chart and the fund table on this page are ours, from the formula above and Finabase chart data. For individual issues, EMMA is the official public source.

Frequently asked questions

Are municipal bonds tax-free?

Most are free of federal income tax, and many are free of state tax for residents of the issuing state. Some munis are taxable or subject to the alternative minimum tax, and gains from selling a muni are taxable.

What is the difference between a GO bond and a revenue bond?

A general obligation bond is backed by the issuer's power to tax and usually needs voter approval. A revenue bond is repaid only from a specific project's income, such as tolls or utility fees, so its safety depends on that project.

How do I compare a muni yield with a taxable yield?

Divide the muni yield by one minus your marginal tax rate. At a 24% federal rate a 3.0% muni equals 3.0 ÷ 0.76 = 3.95% taxable. Add your state rate if the muni is also state-exempt for you.

Should I hold munis in an IRA?

The tax exemption is wasted there, because interest in an IRA isn't taxed each year. A taxable bond with a higher yield usually leaves more in a tax-deferred account.

Summary

Municipal bonds are loans to state and local governments, backed either by taxing power (general obligation bonds) or by one project's revenue (revenue bonds). Most pay interest free of federal income tax and often of in-state income tax, which is why their yields look low. Convert them with the taxable-equivalent yield: a 3.0% muni is worth 3.41% to a 12% taxpayer and 4.76% to a 37% taxpayer, and comparisons with Treasuries must account for the Treasury's own state exemption. Munis carry credit, call and rate risk like other bonds: MUB's price fell 12.7% in the 2022 rate shock. They make the most sense for high-bracket investors in taxable accounts.