What are municipal bonds?

Municipal bonds are essentially debt securities issued by state and local governments to finance various public projects, such as building schools, highways, or hospitals. What makes these bonds particularly appealing to investors is their tax-exempt status; the interest earned on municipal bonds is often exempt from federal income taxes and, in some cases, from state and local taxes as well. This tax treatment provides an attractive yield for investors, especially for those in higher tax brackets, as they can effectively earn a higher after-tax return compared to taxable bonds.

In contrast, bonds issued by private companies don't have the same tax advantages as municipal bonds and are considered corporate debt. Stocks represent ownership in a company or government agency, which differs fundamentally from the concept of bonds representing borrowed funds. Federal institutions may issue bonds as well, but these typically pertain to federal debt rather than the specific financing needs of state and local governments that municipal bonds serve. Thus, the distinction of tax-exempt status and the purpose of funding public projects makes the definition of municipal bonds clear and distinct.