Municipal bonds are what help the local and state governments pay for construction projects for schools, highways, hospitals, bridges, streets, water and sewage systems, airports, and low income housing. There are many different types of municipal bonds available. These include general obligation bonds, industrial revenue bonds, housing bonds, limited and special tax bonds, tax anticipation notes, revenue anticipation notes, and bond anticipation notes.

The differences among the various categories of municipal bonds are based on how the issuer expects to repay the bonds and make the interest payments. Other bonds are issued with specific provisions to raise the taxes or create new taxes. These bonds are known as limited or special purpose bonds.

Municipal bonds are high quality issues since the government is the one that is standing behind them and typically in little danger of going bankrupt. Some of the municipal bond issuers purchase insurance that will guarantee that their bonds will be repaid. The bondholders pay for the insurance in the form of a lower return.

A principal benefit of municipal bonds is that they are free from federal income taxes. Also, if you buy municipal bonds issued in your state, then you don't have to pay state income taxes on the interest you are paid on the bond. These bonds are then referred to as "double tax free." And, if you buy municipal issued bonds by the city or local area where you reside, you won't have to worry about paying any local income taxes on the interest on the bonds. If you live someplace where the local taxes are high, like New York City, these bonds can be quite beneficial from an overall return standpoint.

The trade off you make when you buy a municipal bond is that you receive a lower coupon rate or current yield than you would receive get with a comparably rated, similar maturity corporate bond. The tax savings are designed to make up the difference so that in the end you could come out in front by buying the tax-free bond with a lower yield.

Generally, municipal bonds make more sense for investors in high tax brackets. Remember, however, that the payoff of saving on your tax bill may not be worth giving up the additional returns you might be able to get from another asset class or type of bond.

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