Municipal bonds (munis) are debt securities issued by state and local governments, and their interest income is typically exempt from federal income tax. The key comparison metric is the tax-equivalent yield: TEY = Municipal Yield / (1 - Tax Rate). For example, a 3.5% muni yield in the 32% tax bracket has a TEY of 5.15%, meaning a taxable bond must yield at least 5.15% to match the muni's after-tax income.

The tax advantage of municipal bonds grows with your tax bracket. Investors in the 37% federal bracket benefit the most because each dollar of tax-exempt income avoids 37 cents in federal taxes. If the muni bond is also exempt from state taxes (often the case for in-state bonds), the combined tax savings can be substantial, making the effective TEY even higher.

While tax-free income is attractive, investors should also consider credit quality, liquidity, and call risk when evaluating municipal bonds. General obligation bonds are backed by the full taxing power of the issuer, while revenue bonds depend on specific income streams like toll roads or utilities. Always compare the TEY to available taxable yields with similar credit quality and maturity before making an investment decision.