Municipal bonds funds invest exclusively in tax-advantaged municipal bond issues. Municipal Bond Funds invest in issues of municipal debt, often with the intention of using its tax advantages.
Bonds held in a ‘muni fund’ might be state or local issues of general obligation or revenue bonds. Gains on muni funds are not taxable at the federal level, and if a person resides in the state in which the bond was issued, they can most likely avoid state or local taxes on gains as well.
This leads investors to compare the tax-free yield of the municipal bond to the taxable yield of other forms of bonds in a favorable way, especially if the individual is in a higher tax bracket, despite the fact that muni funds often have lower interest rates than traditional corporate bond funds.
The lower yield is partially due to the fact that there is less of a risk premium to be paid by the issuing entity; municipal debt is considered safer than most corporate debt, especially since they have taxing power, but these perceptions have changed somewhat in the last decade, since several municipalities struggled to meet their obligations after the 2008 financial crisis.
What Types of Bonds Are There?
What are the Tax Implications of Owning Bonds?