Cities 101 -- Municipal Bonds
The entire sector of municipal government debt is under $2 trillion according to Census Bureau figures from 2013.
Municipal securities are considered to be second only to Treasuries in risk level as an investment instrument.
Municipal securities are predominantly issued by state and local governments for governmental infrastructure and capital needs purposes. However, state and local governments and other types of government authorities may issue bonds for a variety of other purposes, which include transactions in which the proceeds are borrowed by non-profit institutions (e.g., health care and higher education) and for economic development purposes.
Federal Tax-Exemption of Municipal Securities
Municipal securities existed prior to the formation of the federal income tax. When the federal income tax was exacted, it specifically carved out income from municipal bonds interest as exempt from federal taxation. Additionally, many states also exempt from taxation the interest from municipal securities, for bonds purchased within their state.
Due to the reciprocal immunity principle between the federal government and state and local governments, state and local governments are prohibited from taxing the interest on bonds issued by the federal government.
Municipal debt takes two forms: (1) General Obligation, or GO Debt, that is backed by the full faith and credit (taxing power) of a general purpose government like a state, city or county, and (2) Non-GO debt that is issued by governments and special entities that are usually backed by a specific revenue source (special taxes, fees or loan repayments) associated with the enterprise or borrower.
There are two types of default: (1) the more minor "technical default," where a covenant in the bond agreement is violated, but there is no payment missed and the structure of the bond is the same, and (2) defaults where a bond payment is missed or debt is restructured at a loss to investors.
Debt Service is a Small and Well-Protected Share of State and Municipal Budgets
Debt service is typically only about 5% of the general fund budgets of state and municipal governments.
Most debt is not issued for operating budgets, but rather for capital projects that help governments pay for public projects, such as the construction or improvement of schools, streets, highways, hospitals, bridges, water and sewer systems, ports, airports and other public works.
Most state and municipal governments operate under a standard practice of paying their debt service first before covering all other expenses; in some cases this is required by law or ordinance.
"Facts you Should Know". Joint fact sheet by NLC, NGA, NCSL, CSG, NACo, USCM, ICMA, NASBO, NASACT, GFOA, and NASRA. February 2011.
 2013 State and Local Government Finances, Bureau of the Census, 2013, http://factfinder.census.gov/faces/tableservices/jsf/pages/productview.xhtml?src=bkmk