Interest earned from investments in taxable bonds (Mortgage backed securities, Corporate Bonds, Treasury Bonds, etc) is taxed as ordinary income. Treasury bond interest is exempt from State Tax.
Municipal bond interest is federal tax exempt and depending on the issuer, specifically the state where the issuer is located, the interest may be state tax free.
Keep in mind that if the price of the bond appreciates and you sell it prior to maturity, capital gains taxes apply. Holding period for less than a year results in short term capital gain, longer than a year, long term capital gain. Capital gains also apply when you purchase a bond at a discount to par and it matures at par.
Interest from mutual funds receive the same treatment depending on the type of interest generated from the fund. Capital gain applies to an increase in NAV at time of sale.
Also, keep in mind that certain Municipal Bond interest is subject to AMT.
