States, cities, municipalities, and county governments can all issue municipal debt, or muni bonds, to raise money. They use the proceeds to improve roads, refurbish schools, or even build sports complexes. The bonds are usually rated by a major rating agency, such as Standard & Poor's or Moody's, based on the quality of the issuer.
Unlike income from bonds issued by corporations or the federal government, income generated by municipal bonds is exempt from federal and sometimes state income taxes. So when examining a municipal bond's yield, you must take the implicit tax advantage into account.
Let's take an example. Say you're an investor in the 25% tax bracket. You want to know which investment offers you a better yield: a corporate-bond fund yielding 7% or a muni-bond fund yielding 6%. After taxes, the muni fund is the higher yielding investment: Take 25% in taxes off the corporate-bond fund's 7% yield, and you're left with an aftertax yield of just more than 5%.
Muni-Fund Considerations >>