Municipal bonds are debt obligations issued by states, cities, counties and other governmental entities, which use the money to build schools, highways, hospitals, sewer systems and many other projects for the public good.
When you purchase a municipal bond, you are lending money to a state or local government entity, which in turn promises to pay you a specified amount of interest (usually paid semiannually) and return the principal to you on a specific maturity date.
Not all municipal bonds offer income exempt from both federal and state taxes. There is an entirely separate market of municipal issues that are taxable at the federal level, but still offer a state — and often local — tax exemption on interest paid to residents of the state of issuance.
Most of this booklet refers to municipal bonds that are exempt from federal taxes. See page 8 for more about taxable municipal bonds.