How Do State Municipal Bonds Work?

Features

State municipal bonds are usually issued in multiples of $5,000. The rate of interest to be paid is set when the bonds are sold and the amount of interest will stay the same until the bonds mature. Interest is usually paid semi-annually. The face amount of the bond is returned on the maturity date. Municipal bond maturities can be up to 30 years.

Once issued, municipal bonds can be bought and sold on the secondary municipal bond market. The price of a bond and yield is determined by current interest rates, the credit quality of the issuing state and the time until the bond matures. The coupon rate is the amount of interest a bond pays annually and the yield to maturity is the total return to the bond-holder, taking into account the market price and time until maturity.

The interest paid by state municipal bonds is exempt from federal income tax for the bond-holder. The tax-free income is a primary reason investors buy state municipal bonds. If the bond-holder is a resident of the state that issued the bond, the interest is also exempt from state income taxes. The taxable equivalent yield of a municipal bond can be calculated by dividing the muni bond yield by one minus the taxpayers federal plus state tax rate if applicable. For example, the bond-holder has a marginal federal tax rate of 33 percent, state tax rate of 8 percent and the municipal bond yields 3 percent. Divide the 3 percent yield by 1 minus 0.33 plus 0.08 equals 3 divided by 0.58 resulting in a taxable equivalent yield of 5.08%.

There are several ways to invest in state municipal bonds. Most full service investment brokers and dealers have departments dedicated to finding bonds for the dealer's customers. An investment advisor can discuss the municipal bonds that are available. Municipal bond mutual funds usually hold bonds from across the country. State-specific municipal bond mutual funds are available for investors from large, high-tax states such as New York and California. Municipal bond unit investment trusts (UITs) will buy a portfolio of state-specific bonds and hold them until a termination date, when the trust assets are sold and distributed to investors. UITs are sold through investment advisors and offer a diversified portfolio of municipal bonds with a fixed termination date.

The interest paid by a municipal bond is fixed once the bond is issued. A rising interest rate environment will cause the market value of bonds to decrease. Bond investors then must hold the bond until maturity or sell on the secondary market for a lower price. A bond portfolio with diversified maturity dates can adjust to changes in interest rates without taking significant losses.