What Are Municipal Bond Funds?

Municipal bond funds are mutual funds that own the bonds of municipalities—states, cities, and their subdivisions.

First: What are municipal bonds?

State and local governments may issue bonds, rather than raise taxes, to fund various projects. Some municipal bonds may be insured by an independent insurer against default of both interest and principal. This means that if the issuer defaults, bondholders will still receive their interest and principal in a timely manner. Some municipal bond funds insure their bonds themselves.

Municipal bonds are issued with a face value (or par) of $1,000 and up. Some even come in $100,000 denominations. These large face values put these out of the reach of many investors. Mutual funds, however, are a convenient way to participate in municipal bond investing because they require less money to invest. Investors who do not have the time or inclination to manage a bond portfolio find mutual funds an attractive alternative. The diversity of bonds included in municipal bond funds is an added feature because it spreads risk over several bond issues.

The tax appeal

The chief appeal of municipal bond funds is that the dividends from interest paid by municipal bonds are usually free from federal taxes and local taxes in the issuing state. There are now some municipal bonds that are subject to federal taxes, but they are rare. Accordingly, many such funds include the words "tax-free" or "tax-free income" in their names. They are also frequently called "tax-free funds." However, they are not free from capital gains taxes, which are levied when bonds within their portfolio are sold at profits or when fund shares are sold by the investor for more than they were purchased.