Under present federal income tax law, the interest income you receive from investing in municipal bonds is free from federal income taxes. In moste states, interest income received from securities issued by governmental units within the state is also exempt from state and local taxes. Also, interest income from securities issued by U.S. territories and possessions is exempt from federal, state and local income taxes in all 50 states.
There are basically two types of bond yields: current yield and yield to maturity. Current yield is the annual return on the dollar amount paid for a bond. Yield to maturity is the total return received by holding a bond until it matures. It equals the interest you receive from the time you purchase the bond until maturity, plus any gain (if you purchased the bond below its par, or face, value) or loss (if you purchased it above its par value).
Tax-exempt yields are usually stated in terms of yield to maturity, with yield expressed at an annual rate. If you purchase a bond with a 6% couplon at par, its yield to maturity is 6%. If you pay more than par, the yield to maturity will be lower than the coupon rate. If you purchased below par, the bond will have a yield to maturity higher than the coupon rate. When the price of a tax-exempt security - or any bond for that matter - increases above its par value, it is said to be selling at a premium. When the security sells below par value, it is said to be selling at a discount.
Gains & Losses
You may generate capital gains on a tax-exempt security if you sell it at a profit in the secondary market before it matures. Long-term capital gains (which require a 12-month holding period) resulting from the sale of tax-exempt municipal bonds are taxed at a maximum rate of 15% for all sales on and after May 6, 2003. If you sell your security for less than your original purchase price, you may incur a capital loss. Under current law, up to $3,000 of net capital losses can be used annually to reduce ordinary income. Capital losses can be used without limit to reduce capital gains. Special rules apply to a tax-exempt bond purchased at a premium or a discount and called before maturity. (Since tax laws frequently change, consult your tax lawyer or accountant for up-to-date tax advice).
While the interest payment, also known as the coupon rate, cannot be changed during the life of the bond (unless it's a variable-rate security), the market price of a security changes as market conditions change. If municipal bonds are sold prior to maturity, they will receive the current market price, which may be more or less than the original price. Therefore, it is important to understand how the direction of interest rates might affect the value of your holdings. As with other fixed-income securities, municipal bond prices fluctuate in response to changing interest rates. Prices increase when interest rates decline, and prices declint when interest rates rise. Reasons for this are...
excerpts from fmsbonds.com
a site specializing in municipal bonds