Municipal bond issued by South Carolina in the 19th century. Source: Wikimedia Commons.

Most investors focus on the stock market because of the huge potential returns stocks can produce in your portfolio. By contrast, bonds tend to be far more conservative, with fewer growth prospects and limited upside. But the bond market is every bit as complex as the stock market, and knowing the ins and outs of various types of bonds can be useful in improving the returns of a diversified portfolio. Among the more interesting kinds of fixed-income securities are municipal bonds, which have some peculiar traits you won't find in any other type of asset. Let's take a closer look at municipal bonds and how they can play a useful role in your investing.

What are municipal bonds?

Municipal bonds are debt obligations that are issued by state and local government entities. As with other bonds, the issuer sells bonds to investors, taking the proceeds and using them toward whatever purpose that particular government body serves. In exchange, investors receive interest payments, usually twice a year, at an interest rate that's fixed at the time of issuance. Each municipal bond also has a maturity date on which the government entity promises to return the invested principal to the bondholder.

Louisiana municipal bonds. Source: Wikimedia Commons.

Municipal bonds have a reputation for being safe investments. Because most government bodies have the power to impose taxes on their constituencies, default rates on municipal bonds tend to be lower than those of corporate bonds. Yet because state and local governments don't have the power to create money, municipal bonds aren't as safe as Treasury bonds, which are backed by the full faith and credit of the U.S. Treasury.

What is the history of municipal bonds?

Municipal bonds have been used by government entities to finance public projects for centuries. In the U.S., the use of municipal bonds has generally paralleled the growth trajectory of the domestic economy, with municipal bonds helping finance the massive infrastructure improvements that took place in the late 19th century and early 20th century.

A big upswing in popularity of municipal bonds occurred with the institution of the federal income tax about 100 years ago. Unlike almost every other type of investment, the interest income on municipal bonds is generally exempt from federal income taxation, meaning that the yield on municipal bonds represents an after-tax return rather than a pre-tax return. In addition, municipal bonds issued by a particular state or city generally pay interest that is also exempt from state and local income taxes imposed by that issuing government entity. As a result, municipal bonds in areas like New York City can end up being triple-tax-free, giving investors a huge tax benefit compared to traditional bonds.

How big is the municipal bond market?

According to statistics from the Municipal Securities Rulemaking Board, the municipal bond market is composed of about $3.7 trillion in bonds. That figure has grown by about 10 times since 1981, and from less than $20 billion back in 1945.

The Securities and Exchange Commission estimates that there are almost 44,000 state and local issuers of municipal bonds. With each issuer typically offering multiple bond issues to investors, those seeking to buy municipal bonds can choose from hundreds of thousands, or even millions, of different securities. That variety gives investors the ability to customize their municipal bond portfolios to give them the exact exposure to credit risk, maturity needs, and interest rates that they want.

Why invest in municipal bonds?

The tax-free nature of municipal bond interest is their biggest appeal and leads many investors to seek out municipal bonds for their portfolios. As you'd expect, municipal bonds typically have lower yields than taxable bonds, as the market takes the tax benefits of municipal bonds into account when setting prices. But over the past several years, the impact of Federal Reserve bond purchases has created unusual conditions in the bond market, and currently, 30-year municipal bonds have an almost identical yield to 30-year Treasury bonds. Given that Treasuries are subject to federal taxes, that situation is extremely unusual and provides a huge after-tax yield advantage for investors -- especially those in top tax brackets.

Possible use of municipal bonds for funding solar power projects. Source: National Renewable Energy Laboratory.

Yet municipal bonds aren't without risk. During the financial crisis, many municipalities suffered huge drops in tax revenue due to plunging property values, which put municipal bond repayment at risk. Several municipalities -- most notably the city of Detroit -- have had to file bankruptcy or seek other forms of protection from creditors, and that has left municipal bondholders with uncertain returns on their investments. Even now that conditions in the credit markets have generally improved, investors aren't entirely satisfied that the municipal bond market is as reliable or safe as the Treasury bond market.

For investors looking to maximize their after-tax returns, municipal bonds can be an especially useful tool in minimizing taxes on investment income while still getting reasonable returns. As is the case across the broader bond market, municipal bond yields aren't all that high right now. But given time, if the Fed starts raising rates as predicted, then municipal bonds could look a lot more attractive in the years to come.