Tax-free municipal bonds are often overlooked, expert says "Munis" recommemded for those in higher tax brackets.

September 19, 1991|By Georgia C. Marudas | Georgia C. Marudas,Evening Sun Staff PHC yBB

Disgusted by the falling interest rates on certificates of deposit and money market accounts?

Tired of paying 28 or 31 percent of those paltry interest payments to Uncle Sam?

Looking for a relatively safe place to put your money?

Has David Murphy got an investment for you!

Municipal bonds, says Murphy, could pay off for many middle- and upper middle-income taxpayers.

Municipal bonds, called munis, are issued by cities and states to raise money for many projects and are one of the few tax-sheltered investments left in place by the 5-year-old Tax Reform Act. Interest paid to investors is exempt from federal income tax and normally from the state and subdivision in which they are issued.

Investors can buy individual bonds through brokers, or shares in mutual funds that invest in a portfolio of municipal bonds. Single-state muni funds are exempt from both federal and state taxes for residents of that state.

It's the munis' tax-exempt status that makes their effective yields for taxpayers in the 28 and 31 percent tax brackets higher than competing investments. For taxpayers in the 28 percent federal tax bracket ($34,000 taxable income for a couple), a yield of 5.70 percent is equivalent to 7.9 percent on a taxable investment. For those in the 31 percent bracket, that 5.70 figure is equivalent to 8.25 percent.

The trouble is, says Murphy, who manages two of Fidelity Investment's no-load (no sales charge) municipal bond funds, a lot of people who could benefit from these investments nevSee INVEST, B9, Col. 4INVEST, From B12er bother.

According to the Public Securities Association, the most recent data available from the IRS show that only 7 percent of the households reporting adjusted gross income of $50,000 to $75,000 in 1989 reported any tax-exempt income while 42 percent posted income from dividends.

For the $75,000 to $100,000 households, only 14 percent reported tax-exempt income and 57 percent had dividend income.

And even for households reporting $100,000 to $200,000 adjusted gross income, only 23 percent reaped income from tax-exempt investments while 68 percent reported dividend income.

Murphy believes that many of the people in the $50,000 to $75,000 bracket are between 30 and 45 years old and are still in the acquisition stage, buying homes, etc., and have yet to begin investing.

"There's also a certain amount of ignorance of how to invest," he says.

Mutual funds, he points out, allow investors to move in and out of the market freely. They also get the benefit of a diversified portfolio and professional management. And no-load funds eliminate brokers' commissions although management fees are paid.

Investors, he finds, are most concerned about the bonds' safety, especially after news stories that focus on bankrupt municipalities. But default rates, he points out, are lower than for corporate bonds.

Murphy says tax-exempt bonds should continue to be a favorable investment over the next decade, and cites a number of reasons:

* Slow economic growth and slow job growth will tend to keep pressure on the Federal Reserve to keep interest rates low. In fact, Murphy foresees rates dropping even further.

* Lower inflation rates also will be reflected in lower interest rates.

* Demand for municipal bonds will outstrip the supply. As interest rates fall, many states and cities will in effect refinance their debt by calling in bonds issued in prior years at higher rates. They will then sell new bonds at lower rates. Usually munis are issued with the provision that they can be called in after a set number of years. By 1995, Murphy says, half of the current outstanding $850 billion in muni debt will have disappeared from the marketplace either because the bonds have been called or have matured.

At the same time, demand for munis will grow, especially as the total tax burden grows as a percentage of income, Murphy says.

Pressures from the U.S. deficit, he says, argue for higher federal tax rates over coming years while states and localities already are raising taxes to make up for falling revenues.

And investors whose bonds have been called or matured will be looking for new places to put their money while more Baby Boomers will begin investment programs.

These factors, Murphy believes, reduce the risk that bonds' market value will fall because of higher interest rates down the line.

Bonds that pay lower rates become less attractive when interest rates rise, and thus lose value in the bond market.

Jane White, spokeswoman for T. Rowe Price, says the Baltimore mutual fund firm also is bullish on the long-term outlook.

"Demand has been very strong and supply has been tight. That tends to support prices," she notes. And, she adds, "Taxes are only likely to go up."

Over the long term, Murphy says, a younger person saving for retirement will likely reap the largest gains by investing in the stock market.

But if equities are the meat and potatoes of an investment portfolio, munis, Murphy quips, "are the green vegetables."

Murphy manages Boston-based Fidelity's Spartan Short-Inter Muni Tax-Freefund, which as of July 31 ranked third of 15 short-term funds. His Limited Term Municipals fund ranked fifth of 29 intermediate muni funds.

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