A state, city, or local government issues municipal bonds.  Municipalities issue bonds to raise capital for their day-to-day activities and for specific projects such as schools, roads, sewers, hospitals and highways.  Interest income on municipal bonds is generally exempt from federal tax.  If an investor who is a resident of the state of issuance holds the bonds, interest income may also be exempt from state and local income taxes.  Tax-free municipal securities are usually inappropriate for accounts with tax advantages such as IRA’s and other retirement accounts.

Learn more about bonds at
http://apps.finra.org/Investor_Information/Smart/Bonds/000100.asp