Secure Tax-Free Income: Your Guide to Municipal Bonds

Municipal bonds, or "munis" for short, are a cornerstone of tax-advantaged investing. They are essentially loans you make to state and local governments—a simple way to earn income while funding projects in your community, such as schools, hospitals, or highways. They are exempt from U.S. Federal income tax and serve as a key building block in the bond portfolios for taxable investors.

This piece will explore:

• What are municipal bonds, and what makes them attractive to investors?
• Some key characteristics of municipal bonds.
• Why are municipal bonds difficult for investors to buy and sell on their own?
• How we recommend investing in municipal bonds.

What Are Municipal Bonds?

Municipal bonds are debt securities issued by state and local governments or other government entities to fund capital projects such as schools, highways, hospitals, or water projects. When you invest in a muni bond, your money is put to work funding essential public projects. 

The muni bond market is vast and offers a wide array of options for investors, with over 55,000 issuers and more than 1.1 million bonds, according to SIFMA data. By comparison, there are fewer than 5,000 publicly traded U.S. companies. More general information on bonds can be found in our article on bonds and bond funds.

Why Are Municipals Attractive to Investors?

Municipal bonds provide the following benefits to investors: 

• Federal Tax-Free Income: Interest earned on municipal bonds is exempt from U.S. federal income tax. 
• Double Tax-Free Potential: If you live in the state where the bond was issued, the interest is often also exempt from state and local income taxes.

Example: A California resident who owns California municipal bonds pays zero federal or state income tax on the interest.   By contrast, a New York resident who owns those same California bonds would be subject to state income tax on their interest.  This makes them especially attractive to investors in high-tax states, while investors in low-tax states often own portfolios of securities from around the nation.

Understanding the Basics: How Municipal Bonds Work‍

Like any investment, munis have key characteristics that influence their value and risk. Municipal bonds generally carry a fixed coupon, which is the set, regular interest payment you receive until the bond reaches the end of its term, known as the maturity date.

• Interest Rate Sensitivity (Duration). A bond’s duration measures its sensitivity to changes in interest rates. Longer-maturity bonds usually have higher durations than shorter-maturity bonds.  In general, when interest rates rise, bond prices fall. Conversely, bond prices rise when interest rates fall.  The longer a bond's duration, the more sensitive its price is to interest rate changes.
• Credit Risk (Risk of Default). Credit risk measures the likelihood that a bond will default on its interest or final principal payments.  Generally, the lower a bond’s credit rating, the more the issuer has to pay to borrow money.
• Call Provisions. Munis sometimes include a “call provision,” which allows the issuer to pay off the bond early (typically after 10 years for a 30-year bond). This may happen when interest rates drop, allowing the issuer to refinance at a lower cost. Investors need to pay attention to bond call features, as they can significantly impact bond pricing.

Is Now the Time to Buy? Measuring Value with the Muni/Treasury Ratio

A simple way to determine if muni bonds are currently a good option is the Muni/Treasury ratio. The ratio compares the yield of a muni bond to the yield of a US Treasury bond with the same maturity. 

A higher ratio means munis offer better value relative to Treasuries, making them more attractive at that time. For example, if the ratio is 75%, municipal bonds would be appealing to anyone with a tax rate higher than 25%. 

Why You Need Professional Help to Buy Munis

We strongly recommend professionally managed accounts for muni bonds. This provides tax advantages and overcomes the difficulties of the individual bond market, where numerous issuers, the large number of bonds, and illiquidity make fair-priced trading challenging for non-institutional investors. Additionally, there are no centralized exchanges for bond trading.  As a result, they can trade infrequently, and achieving fair pricing on trades can be difficult.  Pricing can be opaque for all but the most traded securities, such as U.S. Treasuries.

The Smart Way to Invest: Professional Management

Using professionally managed accounts allows you to benefit from the tax advantages while overcoming the challenges of the individual bond market.

• Mutual Funds and ETFs: We recommend using institutionally managed mutual funds, exchange-traded funds (ETFs) or separately managed accounts (SMAs) to invest in municipal bonds. These pooled investments give you instant diversification across thousands of bonds and are managed by professionals, and are managed by institutional managers who have a fiduciary obligation to their clients to seek the best execution prices.
• Separately Managed Accounts (SMAs): For larger allocations to municipal bonds, an SMA may be a good solution, as it can be customized to your specific needs, such as: 
  
  • State Preference. Focusing on bonds from your home state for maximum tax savings. 
  • Risk Profile. Adjusting the portfolio’s duration and credit quality to match your goals.

It is important to note that municipal bonds can become illiquid and sell off during financial panics, such as in March 2020 during the COVID-19 selloff and, to a lesser degree, after the April 2025 post-Liberation Day selloff.  

If you need liquidity in your fixed-income portfolio, maintaining an allocation to U.S. Treasury bonds as a complement can serve two purposes for investors. First, Treasuries can be sold if the investor needs to fund cash flow. Second, they could also be sold to take advantage of the crisis itself, whether by increasing the municipal allocation or adding to other riskier areas of their portfolio.

To discuss how municipal bonds fit into your overall financial strategy and tax planning, please reach out to your Farther advisor.  If you aren’t currently working with a Farther advisor, contact us, and we can introduce you to one. With professional guidance, municipal bonds offer a clear path to generating secure, tax-free income for a financially confident future.