Municipal bonds, or “munis,” allow investors to earn tax-free income in the form of interest payments from state and municipal governments. Municipal bonds assist fund projects like roads, schools, and other public works.
Even though they do not normally provide high returns, tax-free municipal bonds may be beneficial to some investors. Higher earnings may find them especially useful as a relatively low-risk means to reduce their state and federal tax liabilities, but persons with lower incomes may seek out other assets that grow their overall wealth faster, even without the tax benefits.
Municipalities issue a bond when they need to raise money for a project. An investor buying a muni bond is funding that particular project over a set period of time. The investor expects to receive interest or coupon payments (usually semiannually) and the initial principal back when the bond matures, or when the loan term ends.
The capital market for muni bonds has grown over time. If you think they have a place in your portfolio, there are a few ways to get started. You can buy individual muni bonds or muni funds through an online broker, and many robo-advisors offer munis as part of their portfolio mix.
Here are a few ways to invest in municipal bonds:
Individual bonds: Many investors purchasing muni bonds have a buy-and-hold strategy, intending to hang on to them until maturity. These investors can research and select bonds that work best for their portfolio in terms of risk and return, maturity date and tax benefits.
Municipal bond ladders: When you purchase an individual bond and hold it, you don’t get your principal back until the bond matures. Some muni bonds mature in one to three years, while others mature in 20 or 30 years. Investors needing regular income might consider buying multiple bonds and building a ladder, with bonds maturing annually or in whatever time increment that fits their situation and cash flow needs.
Muni funds: For those who might not feel comfortable picking municipal bonds on their own, investing in munis through mutual funds or exchange-traded funds, also known as ETFs, can make sense. One benefit is accessing a well-diversified portfolio of bonds from municipalities with different credit ratings, a range of projects and bond types, and varied risk and return. This lessens any potential default risk as you spread your dollars across many bonds.
Another benefit is shifting the onus to someone else well-versed in municipal bonds, namely the fund manager, to keep tabs on the municipalities and related risks for you.
Some investment management companies offer state-specific funds so investors can benefit from both federal tax exemption as well as state and local tax exemption. Even if you can’t find a state-specific muni fund that works for you, a national fund can provide federal tax exemption at a minimum.
Benefits of Municipal Bonds
Tax minimization: Many municipal bonds are exempt from federal taxes, and if the investor lives in the same state where the bond is issued, the muni will often be exempt from state and local taxes as well. This especially benefits investors in a higher tax bracket, as the tax exemption enhances the bond’s return.
You might see a calculation for a tax-free municipal bond’s tax-equivalent yield, or TEY, which helps investors compare a muni bond’s return with that of a taxable bond. Here’s how that calculation works:
TEY = tax-free municipal bond yield / (1 – investor’s current marginal tax rate)
For example, if an investor in the 35% tax bracket buys a tax-free muni bond yielding 4%, the calculation would go 4 / (1 – 0.35), and the bond’s TEY would be 6.15%. An investor would need to find a taxable bond yielding 6.15% to be comparable to this muni bond.
Read Also: How Municipal Bonds Work: Exploring the Basics and Structure
Being thoughtful about where they purchase tax-free muni bonds can save investors money. For example, many investors in higher tax brackets strategically buy tax-exempt munis in their brokerage accounts, which are taxable. They put their other less tax-advantaged fixed-income investments in retirement accounts like traditional IRAs and 401(k)s that are designed to defer taxes.
Diversification: When it comes to investing, it makes sense to not put all your eggs in one basket and instead diversify your holdings. This helps minimize investment risk across your portfolio. Investors often use muni bonds alongside Treasurys, corporate bonds and other fixed-income securities since they all have different risk and reward profiles. Usually, a muni bond carries slightly more risk and will have a higher yield than a Treasury, but is less risky and will have a lower yield than a corporate bond.
Many municipal bonds can also be considered socially responsible investments if the project they finance aims to do some social good or community development.
Safety: Municipal bonds are considered a relatively safe fixed-income investment. GO bonds are usually considered safer than revenue bonds, as a municipality can raise taxes to cover outstanding debt obligations, whereas revenue bonds are subject to the earnings made by that particular project. Revenue bonds also can be “nonrecourse,” meaning investors would be left high and dry if project revenues don’t meet expectations.
Some Drawbacks to take note of
Default risk: While these bonds are a relatively safe investment, municipalities can sometimes find themselves in financial hot water. You might recall headlines about defaults in Detroit in 2014 and Puerto Rico in 2018.
Such defaults are rare, and you can combat default risk by researching the municipality and reviewing the credit rating for the bond you’re interested in. Credit rating companies such as Moody’s, S&P and Fitch assign ratings to help investors evaluate the riskiness of each bond. Additionally, the Municipal Securities Rulemaking Board, a regulatory body, maintains a website with disclosure documents, pricing data and other information valuable for muni bond investors.
Interest rate risk: Similar to other fixed-income counterparts, muni bonds generally have an inverse relationship with interest rates. So if interest rates go up, bond prices come down, and vice versa. That’s what we’ve seen in 2022 as bonds have entered a bear market, just like stocks.
If you purchase a bond and later interest rates rise — which is a strong possibility in the current economy — you are locked into receiving a return that is less than what you would receive by buying a new bond at a higher interest rate. Thus, the price or market value of your bond falls as your bond is worth less. On the flip side, if you purchase a bond and later interest rates drop, the price of your bond rises since you’ve locked in a higher return than if you purchased a new bond at a lower interest rate.
Call risk: Some muni bonds are callable, which means the issuer can decide to repay the bond earlier than the maturity date. When interest rates fall, an issuer with the ability to call their bond may choose to do so because the issuer can save money by refinancing or reissuing another bond at a lower interest rate.
When to Consider Municipal Bonds From Outside Your Home State
One significant advantage of municipal bonds, or “munis,” is that the interest they pay is often exempt from federal income tax. They are also generally free from state income taxes if the issuer is based in the investor’s home state. That may seem like a good reason to continue with in-state munis. However, many municipal investors may gain by diversifying beyond their home state, even if it results in a higher state tax burden.
We’ve identified five scenarios in which it would make sense to examine munis from other states. After evaluating all five, we believe that muni investors in all states, with the exception of two high-tax states—California and New York—would profit from investing in a nationwide, rather than a state-specific, portfolio of muni bonds. Even investors in California who are not in a high state tax band can increase their after-tax profits by diversifying nationally.
1. You live in a state with low or no state income tax
If you live in a state with low or no state income tax, you will likely benefit from diversifying your muni portfolio with munis from issuers outside your home state.
The map below shows the maximum marginal income tax rate by state for married taxpayers filing jointly.
Investors in states with low or no state income tax could benefit from out-of-state munis

New Hampshire taxes 4% on interest and dividends only. Washington taxes 7.0% on capital gains income only. Assumes the top tax rate for a married-filing-jointly filer. Does not include phaseouts or other exemptions or deductions, which could result in a different marginal tax rate. Local income taxes are not included.
For investors in states with no state income taxes, like Florida or Texas, there’s no state tax benefit to staying within your home state. For investors in California, on the other hand, the benefit can be large because the state tax rate is the highest in the country—13.3% for the top bracket. Therefore, it may make more sense if you’re in a high-income-tax state to buy bonds issued in your home state, all else being equal.
In some instances, some states tax in-state bonds in the same manner they tax out-of-state bonds. For example, bonds issued by municipalities in Illinois are often subject to state income taxes—even if the tax filer is a resident of Illinois. In other words, Illinois investors don’t necessarily save on their state income tax bill by holding Illinois munis. The rules can get complicated at times, so it makes sense to consult with your tax advisor.
2. You could earn a higher yield, even without state tax breaks
Some out-of-state muni bonds offer higher yields than in-state munis, even after accounting for any state income taxes.
It depends on where you look, though. The table below shows the yields investors in certain states would have to earn on out-of-state munis compared with the yield on an index of 5-year general obligation munis issued by their home state to compensate for the lack of state income tax breaks. This assumes the investors are in their home states’ highest marginal state tax bracket. The difference in yield is expressed in basis points (a basis point is one-hundredth of one percent or 0.01%). Florida, Texas, and Washington don’t have state income taxes, so there’s no spread.
State | Yield on a 5-year state GO | Top marginal tax rate | State GO credit rating | Required out-of-state yield | Difference in basis points |
---|---|---|---|---|---|
CA | 2.46% | 13.30% | Aa2/AA– | 2.84% | 38 |
NY | 2.30% | 10.90% | Aa1/AA+ | 2.58% | 28 |
TX | 2.56% | 0% | Aaa/AAA | 2.56% | 0 |
IL | 3.21% | 4.95% | A3/A- | 3.38% | 17 |
FL | 2.46% | 0% | Aaa/AAA | 2.46% | 0 |
PA | 2.55% | 3.07% | Aa3/A+ | 2.63% | 8 |
MA | 2.42% | 9.00% | Aa1/AA+ | 2.66% | 24 |
NJ | 2.53% | 10.75% | A1/A | 2.83% | 30 |
WA | 2.42% | 0% | Aaa/AA+ | 2.42% | 0 |
OH | 2.40% | 3.99% | Aa1/AA+ | 2.50% | 10 |
Yield for a 5-year national index | 2.81% |
For example, the yield on an index of five-year general obligation bonds issued by the state of California is currently 2.46%. An investor in the highest marginal state tax bracket (which, in California, is 13.3%) would have to earn a yield of at least 2.84%—or 38 basis points more—on a bond from outside of California to achieve the same after-tax yield as on the in-state bond. It may be possible to achieve this higher yield if you invest in a bond issued by the state of Illinois, for example. However, Illinois has a lower credit rating than the state of California, and lower ratings imply higher credit risk.
Using a different example, an investor in the top marginal state tax bracket in Massachusetts would need to earn a yield of at least 2.66% to achieve the same after-tax yield as on the in-state muni. That’s possible by investing in a nationally diversified index of munis with a similar maturity. However, the nationally diversified index may also contain lower-rated issuers, so it may not be a perfect apples-to-apples comparison.
3. You live in a state with few choices
We recommend holding at least 10 different bonds from issuers with dissimilar credit characteristics, to create sufficient diversification in a portfolio of individual bonds. This could be difficult if your home state has a relatively small number of issuers with similar risks, but easier to achieve in a larger states such as California, New York and Texas, which have many issuers.
In fact, bonds from California, New York, and Texas account for approximately 43% of all issuers in the Bloomberg U.S. Municipal Bond Index. But in-state diversification is difficult for smaller states—as the chart below shows, many states have a small number of issuers based on the market value of bonds outstanding.
Bonds from California, New York, and Texas account for the vast majority of munis outstanding

4. You may find more highly rated issuers by searching nationally
We suggest focusing on an average credit rating of AA/Aa for an attractive balance of risk and reward in today’s environment. That means having some lower-rated (A/a or below) munis, but the bulk of the munis in your portfolio should carry higher ratings. It’s easier to find highly rated munis if you live in a state like California, New York or Texas, where there are large numbers of bonds rated in the AAA and AA categories, as illustrated in the chart below.
It’s more difficult if you live in a state like Illinois, Pennsylvania, or New Jersey, where the majority of bonds are lower than AA-rated. Consider diversifying nationally if you live in a state with fewer highly rated options.
California, New York and Texas have high percentages of highly rated bonds

5. You live in a state where issuers face similar risks
There are approximately $3.9 trillion of muni bonds outstanding1 spread among tens of thousands of issuers, and the credit quality of each state and issuer is affected by different factors. Even if you live in a state with many highly rated issuers, it could be beneficial to diversify nationally because those highly rated issuers are subject to similar credit risks, such as economic, political and demographic risks. Credit quality is generally stronger in areas with steadily increasing populations, skilled workforces and diverse economies.
Although historically it has been rare for municipalities to fail to pay interest or make principal payments on time, it does occur occasionally. If the conditions in your home state, or regions of your home state, aren’t favorable, other states’ bonds might be more appealing.
Considering all five factors, we generally suggest investors in all states other than New York and California consider munis outside of their home state. Investors in higher tax brackets in California and New York may benefit from investing in an all-in-state portfolio because of high state income tax rates and access to many different issuers with different credit risks. However, even investors in New York and California who are not in high state income tax brackets could achieve higher after-tax yields combined with greater diversification by diversifying nationally.
As always, your individual situation may vary. So choose a single-state muni or nationally diversified portfolio of munis based on your needs and situation.