Municipal bonds are issued by state and local governments to finance public-works projects such as roads, sewers, schools, and stadiums. The interest paid by municipal bonds issued by your state or local government is typically free of federal income tax. If a bond was issued by a municipality outside the state in which you reside, the interest could be subject to state and local income taxes. Some municipal bond interest could be subject to federal and state alternative minimum taxes. Municipal bond investing is typically best suited for investors in higher income tax brackets, because a muni bond’s lower tax-free yield may be worth more to them than the after-tax yield from a taxable bond. For example, a 3% tax-free yield is equivalent to a 4.62% taxable yield for an investor in the 35% federal income tax bracket. U.S. Treasury bonds are generally considered to be among the safest investments because they are guaranteed by the federal government as to the timely payment of principal and interest. Corporate bonds typically offer higher interest rates than government bonds with comparable maturities, because companies could conceivably default on their obligations. Of course, investments seeking to achieve higher yields also involve a higher degree of risk. Most corporate bonds are evaluated for credit quality by the three prominent ratings agencies, which assign ratings based on their assessment of the issuer’s ability to pay interest and principal as scheduled.
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