Composition of Municipal Bond Funds

Municipal bond funds include one or both types of municipal bonds (general obligation bonds and revenue bonds) as well as short-term notes of states or cities and their subdivisions.

What are general obligation bonds?

General obligation bonds (GO bonds) are unsecured municipal bonds that finance municipal operations. The creditworthiness of the issuing city or state is the only "collateral" they provide. GO bonds finance projects that do not produce revenue. The municipal issuer repays the bonds with funds raised from municipal fees or property sales.

What are revenue bonds?

Revenue bonds are secured by the revenues generated by the projects they fund. Such revenues include tolls, fees, and rental payments from funded projects. Default of interest may occur if revenues are not high enough to pay bondholders. In that case, payments to bondholders will be deferred.

What you will find in a muni bond fund

Municipal bond funds are more likely to include revenue bonds than GO bonds because revenue bonds are much more common. Of the two types, revenue bonds typically pay a higher interest rate. This compensates investors for the chance that the projects financed may not bring in enough revenue to pay bondholders.

The bonds in municipal funds may all originate in the same state. Investors who live in the same state in which such a fund invests will not have to pay state taxes on its interest-income dividends.

Municipal bond funds may also include short-term notes, which mature in six months to one year. Notes differ from bonds only in their maturities.

The blend of GO bonds, revenue bonds, and short-term notes in a municipal bond mutual fund will largely determine both the risk and return the fund offers.