Glutted market makes tax-free munis a bargain

November 08, 1992|By Knight-Ridder News Service

Tax-free municipal bonds offer some mouth-watering yields these days compared to their taxable cousins, U.S. Treasury and corporate bonds.

Depending on the length of maturity, munis today yield 80 percent to 90 percent of what comparable Treasuries pay. Historically, the spread has been closer to 75 percent. Munis pay less because the interest isn't taxable.

As of Sept. 30, five-year municipals were yielding 4.58 percent. To equal that, a taxable bond would have to yield 6.36 percent for someone in the 28 percent tax bracket, or 6.64 percent for someone in the 31 percent bracket. But a five-year Treasury note was yielding just 5.48 percent.

The reason for munis' high yields is simple: As interest rates fell this year, local governments rushed to refinance their debts. So they issued new bonds and used the money they raised to pay off older bonds issued years ago, when interest rates were much higher.

The frenzy to refinance caused a flood of new issues, and the large supply has held down prices. And when bond prices fall, yields go up.

But don't expect this trend to last forever. Unless overall interest rates continue to fall and local governments continue to issue new bonds, the flooded market sooner or later will run dry. When that happens, muni prices will rise and yields will tumble.

A person can buy individual bonds starting with $5,000, but a bond mutual fund may cost as little as $500.

Most mutual fund companies have free booklets that explain how municipal bonds work: T. Rowe Price ([800] 638-5660) has a pamphlet called "Basics of Tax-Free Investing." Vanguard ([800] 241-6999) has a booklet called "How to Select a Municipal Bond Fund." And Shearson Lehman Bros. ([800] 233-7833, ext. 4848) has a report called "Municipal Bond Bonanza."

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