Municipal Bonds

Updated 2026-05-17

Municipal bonds are debt securities issued by states, cities, counties, and other governmental entities to finance public projects such as infrastructure, schools, and hospitals.

Key Characteristics

Tax Exemption

A primary attraction for investors is that the interest earned on municipal bonds is typically exempt from federal taxes. In some cases, it may also be exempt from state and local taxes for residents of the issuing state.

Callability and Negative Convexity

Many municipal bonds are Callable Bonds, which means the issuer has the right to redeem them before their stated maturity date. This embedded call option often leads municipal bonds to exhibit Negative Convexity (MBS), a characteristic also seen in Other Loan Participants and Key Third Parties in the Mortgage Ecosystem.

Negative convexity implies that the bond's price appreciation is limited when interest rates fall. This is because the issuer may choose to "call" the bonds and refinance their debt at lower prevailing interest rates, thereby depriving investors of the higher-yielding bond.

References

1. Vanguard. "Negative convexity in municipal bonds: The new rate regime and ..." corporate.vanguard.com.