As an example of the above, very simply consider one bond paying 2% for one year and neglect interest during the year. Lets say the market is now at 5%. The seller would have to discount the bond $30 to give a 5% return to the buyer.
So the US government is still paying you $20 while the seller is paying you $30. The $30 was not interest paid by the US government and therefore is not tax free in a state.
