Recent action in the credit markets has created situations that are unusual in the relatively placid world of bonds. Whether you're hoping for a buying opportunity or are concerned about existing holdings, it can pay to understand some basics of municipal bonds.

All munis are not alike

Exemption from federal income tax isn't a muni bond's only tax advantage. If you live in the state where the muni is issued, the interest also may be free from state and local income taxes. Municipal bonds have special tax status because they are issued by state and local governments to pay for a variety of projects. Revenue bonds finance specific public works projects; their interest payments are secured by revenue from those projects. General obligation (GO) bonds are secured by the full faith and credit of the issuing body. Because of that taxing authority, GO bonds are generally perceived as less risky than revenue bonds, and usually pay a lower interest rate.

Still other muni bonds may be taxable, depending on what they're used to finance. For example, so-called private activity bonds fund projects that provide a significant benefit to private interests, such as a sports stadium. Because they lack the tax advantages of tax-exempt munis, their rates typically are more comparable to corporate bonds. They also are included when calculating any alternative minimum tax (AMT) liability, so you may want to consult a tax professional about them.

Interest paid by a muni bond fund may or may not be tax free, depending on how the fund is invested; obtain and read a fund's prospectus before investing, and weigh your objectives, risk tolerance, and time horizon.

Are munis appropriate for you?

Although the stated interest rate on a muni bond is generally lower than the rate offered by a taxable bond of similar credit and duration, a tax-free muni bond actually may provide a greater after-tax yield. The higher your tax bracket, the more attractive a tax-exempt investment becomes. For example, if your marginal tax rate is 35%, a taxable investment would need to yield 9.23% to equal a tax-exempt yield of 6%. You'll need to compare a bond investment's tax-equivalent yield to know if it's a tax-efficient choice for you.

Other factors to consider

Munis involve a variety of risks. Like other bonds, muni prices typically tend to rise when interest rates fall, and drop when rates go up. Liquidity risk--the possibility that you might not be able to sell a bond--has been a factor recently. So has credit risk--the risk (real or perceived) that a bond's issuer may not make interest or principal payments. Inflation risk also can decrease demand for bonds and in turn lower their prices, because rising consumer costs cut the purchasing power of a bond's fixed interest payments.