When you consider investing in a bond fund to earn income, you must focus on what you'll have left after paying income taxes on dividends.
If the Internal Revenue Service takes 28 percent or 31 percent of your income, you may be better off investing in a municipal bond fund whose dividends are exempt from federal income tax and may be exempt from state income tax.
The fund's yield may be lower, because the government bonds that it owns carry lower interest rates than taxable bonds of comparable maturities. It could, however, provide more income than you would net from a fund whose dividends were shared with tax collectors.
To find out whether a municipal bond fund will produce more spending money for you, you need to perform a fairly easy calculation. (Keeping comparisons simple, we'll assume that you're only looking at no-load funds and that state taxes aren't a factor.)
Say you're in the 28 percent tax bracket, and you see an attractive municipal bond fund that's yielding 6.25 percent. Divide 6.25 by 0.72 -- the difference between 1.00 and 0.28 -- and you get 8.68. This means that a taxable fund would have to yield 8.68 percent -- called the equivalent taxable yield -- for you to net as much.
If you're in the 31 percent bracket, the equivalent taxable yield would be 9.06 percent. But if you're in the 15 percent bracket, it would be only 7.35 percent.
Because the spreads between yields of taxable and tax-exempt bonds are expanding or contracting much of the time, don't assume you'll always be better off in a tax-exempt fund. Check it out.
Now suppose you determine that your potential income really would be greater if you invest in a municipal bond fund -- a good possibility in today's market. Which type should you consider?
That depends not only on how much income you want, but also on how you feel about credit risk and market risk. Such risks can have a major impact on the volatility of a fund's share price -- a major consideration if you're taking dividends in cash, instead of reinvesting them.
You can cope with credit risk by limiting your search to funds that buy only bonds rated investment grade or unrated bonds of similar credit quality.
You can deal with market risk -- the risk that bond and bond fund prices will fall when interest rates rise -- in your choice of maturities. If you don't plan to be invested long, or just can't tolerate much volatility, look at short-term (one to five years) or intermediate-term (five to 10 years) funds.
Consider a general municipal bond fund, which may buy bonds maturing in 10 to 20 years, if you are willing to stay in it long enough to ride out fluctuations. These funds usually offer higher yields and can maintain their dividend stream when interest rates decline (if their bonds aren't called).
A fund concentrated in Maryland securities may appear desirable. But you may be better off investing in a fund that offers nationwide diversification and whose manager is able to buy the most attractive bonds, regardless of where they're issued.
There are about 120 general municipal bond funds, as classified by Lipper Analytical Services. More than half of them have been in operation over five years. The top 10 had average annual returns of 8.5 percent or more for this period, as the table shows. Among the recent strategies pursued by top performers:
* Emphasizing higher-quality issues among bonds rated investment grade. Says Stephen C. Bauer, portfolio manager of SAFECO Municipal Bond Fund, "Currently you don't get paid to buy lower grades."
* Raising their percentages of discount bonds (whose prices are below their face values) because their prices would rise more than other bonds when interest rates fell. Some bought zero-coupon bonds for added thrust. "It may have meant a little sacrifice in current income," says Donald C. Carleton, portfolio manager of Scudder Managed Municipal Bonds, "but investors should think total return."
* Minimizing holdings of bonds likely to be called by their issuers as interest rates drop. Ian A. MacKinnon, head of Vanguard's fixed-income group, has stressed call protection in his Long-Term Portfolio for several years. "It's beginning to pay off," he notes.
* Reducing exposure in states such as Massachusetts, where budget problems led to indiscriminate slashing of bond prices. Thomas J. Fetter, portfolio manager of Boston-based Eaton Vance Municipal Bond Fund, who usually had 5 percent to 10 percent of his assets in Massachusetts securities, worked it down to 1 percent to 2 percent. He's now at 13 percent.
A note of caution: When you study the funds' prospectuses, don't be surprised if you see that these "tax-exempt" funds have made taxable capital gains distributions. As bond prices rose, managers sold some holdings, realizing gains they had to pass along to shareholders.