The prospect of getting high tax-free income from a long-term municipal bond fund might seem increasingly attractive these days, as you receive IRS forms that remind you of how much taxable income your investments brought in 1991.
But you may be hesitant to get into such funds. Maybe you're concerned about the ability of state and local governments, which issued tax-exempt bonds that funds own, to pay interest and repay principal when scheduled.
If so, why not take a look at insured municipal bond funds?
The 26 national funds making up this group are invested 65 percent or more in tax-exempt bonds whose timely interest and principal payments are guaranteed by insurance companies. (In addition to the 26, other insured funds are invested only in securities issued within single states.)
Because bond insurance is sometimes misunderstood -- it doesn't guarantee prices of the covered bonds or the funds' shares -- it's important to remember what it involves before considering such funds.
The coverage is often bought by governments when they issue new bonds. Why? They hope that by raising their credit ratings, they will make the bonds more salable and enhance their resale values. Last year, insured bonds accounted for $51.7 billion, or 27 percent, of the new municipal issues volume of $190.6 billion, according to Securities Data Co.
Policies also may be taken out by bond owners, such as mutual funds, to cover uninsured bonds they have bought.
Premiums paid by issuers -- which can run from 0.2 percent to 0.4 percent of the bonds' principal value -- are reflected in the bonds' prices. Premiums paid by funds are included in the annual operating expenses, slightly reducing yields.
If a city or other issuer defaults on an interest payment, the company insuring the bond is expected to make the payment instead. It is not obligated, as some people have thought, to repay the principal of an entire bond issue whose maturity is years away.
The insurance costs have not kept the funds, as a group, from performing about as well as general municipal bond funds. Their average return of 7.3 percent for the five years ended in 1991 is only slightly less than the 7.6 percent average of the general funds, according to Lipper Analytical Services. Their 1991 average returns and dividend distribution rates also lagged slightly, 11.4 percent vs. 11.9 percent and 6.0 percent vs. 6.2 percent.
Managers of some ordinary long-term bond funds who may hold some insured bonds say they don't buy more because they'd rather perform their own research into the credit-worthiness of uninsured bonds' issuers. That way, they can pass along any premium savings to shareholders.
To advocates of insurance, such as David Hamlin, manager of Vanguard's Insured Long-Term Portfolio, it's not a substitute for credit research but "an extra layer of protection."
Like his competitors, Hamlin also looks at the strength of the companies writing the insurance. Vanguard will obtain policies only from those whose claims-paying abilities have been rated triple-A by Moody's Investors Service and Standard & Poor's, the same agencies that provide credit ratings for the bonds themselves.
Of these, three stand out: Municipal Bond Investors Assurance Corp., whose parent, MBIA Inc., will become 83.5 percent publicly owned following the imminent, additional sale of shares by major financial institutions that have been its principal owners; Financial Guaranty Insurance Company, indirectly a wholly-owned subsidiary of GE Capital; and AMBAC Indemnity Corp., totally owned by the public.
Given that long-term yields remain significantly higher than NTC short- or intermediate-term yields, insured municipal bond funds are generally continuing to stay with maturities of 20 or more years.
Because declining interest rates have led issuers of higher-coupon bonds increasingly to call them for redemption ahead of schedule, managers such as Hamlin have been trying to get as many years of call protection as possible. The aim: to sustain higher dividend streams.
Funds going after higher coupons to generate higher current income are more likely to have them called, requiring them to reinvest sales proceeds at lower interest rates.
Having an expense ratio of 0.25 percent, Hamlin doesn't have to reach for yield to be competitive. The fund has led the group in total return for the last five years.