Just like any borrower, local governments pay interest on municipal bonds to the investors that own them (or bondholders), usually once every 6 months. The major benefit to investors is that the interest earned from municipal bonds is usually tax-free in terms of federal income taxes. The interest from municipal bonds can also be free of state income taxes, local income taxes, and the alternative minimum tax (AMT).
Municipal bonds are considered among the safest of investments. Research reveals that less than 1% of municipal bonds have defaulted since World War II. One of the reasons for this is that most municipal bonds–general obligation bonds– are backed by the taxation power of the local government that issues the bonds. This means that local governments pledge their unlimited taxing powers (also termed full faith and credit) to make sure that they pay back what they owe to bondholders. Certain types of municipal bonds, such as revenue bonds (bonds repaid from fees and charges rather than taxes), are not backed by the full faith and credit of a local government and, as a result, usually carry higher interest rates to the issuing government.
