What is a Municipal Bond?

A bond is a financial instrument issued by large organization such as a company or a government body which functions very similar to a note. It is a written promise to pay back borrowed funds over time, usually in fixed installments. Municipal bonds are issued by local governments to the public, most often by counties or cities.

Governments issue bonds in order to borrow money from investors. They are usually issued in even denominations and include a payment schedule at a fixed rate of interest over a set number of months or years, meaning any given bond will have a fixed return.

Municipal bonds are somewhat unique in that the Federal government allows interest to be paid on funds borrowed by local governments to be paid free of income tax, and many state and local governments also allow interest to be tax-free. This is why these bonds are often referred to as "tax-free municipal bonds."

There are two items of information investors will want to know about a municipal bond. One is the "par value." Par value is similar to principal, and is the amount of money that will be paid back to the investor when the bond has matured. The second is the "coupon rate," which is also sometimes called the interest rate or yield. It is simply the amount paid each year divided by the par value as a percentage. A bond with a par value of $10000 which pays $500 a year in interest has a coupon rate of 5%.

Many mutual funds include municipal bonds in order to make their tax benefits available to their investors.