Investing in munis could be a timely move, even if you're not in top tax bracket PERSONAL FINANCE

MUTUAL FUNDS

November 22, 1992|By WERNER RENBERG

Of all the investment tips you've heard since the election, probably none has been more common than this: People earning very high taxable income should invest in tax-exempt bonds or bond funds.

The advice has been based on the assumptions that President Bill Clinton would propose -- and Congress would enact -- an increase in the 31 percent federal income tax rate for those making the most money.

Given the spread between taxable and federally tax-exempt yields for comparable maturities, such strategy would seem to make sense.

It would provide such investors more income than they would have left after paying a federal tax of 36 percent (or whatever the new top rate turns out to be) on taxable interest or fund dividends. Funds would seem preferable over individual bonds for the familiar reasons: diversification, professional management, and so on.

Do municipal bond funds, invested in tax-exempt state and local government issues, make sense only if you're targeted by Clinton?

No. If bond funds are right for you -- whether to earn income or to diversify a growth-oriented portfolio -- municipal bond funds could be more profitable than taxable funds even if you're not likely to be in the new top tax bracket.

How do you know which investment is more appropriate for you?

By performing a simple calculation, which you'll want to repeat occasionally because the spreads between yields of taxable and tax-exempt funds with similar maturities change over time.

If you're in the 28 percent bracket and see a tax-free bond fund yielding 6 percent, divide 6 by .72 (or 1 minus .28). You get 8.33.

That's its taxable equivalent yield. It means that a taxable fund has to yield more than 8.33 percent for you to have more income left after the federal tax. (Example: 28 percent of 8.33 is 2.33. Subtract 2.33 from 8.33, and you have 6.) To find one yielding that much, you have to look among those with substantial positions in "junk bonds."

If you're in the 15 percent bracket, your taxable equivalent yield would be 7.03 percent. You might be better off staying in a taxable fund and paying the tax.

With all of today's economic and political uncertainties, you may well ask: "Is this a good time to buy municipal bond funds?"

Except for a seasonal factor, it's as good a time as any.

The seasonal factor: taxable year-end distributions of capital gains that funds realized from sales of securities. You can avoid them when getting started by deferring purchases until after the record date for a fund's distributions, which you can get by phoning.

Leading portfolio managers agree that short-term interest rates could firm a bit as business conditions improve. They add that long-term rates won't change much -- they may even drop slightly -- unless inflation fears are reignited by the incoming administration and Congress.

So what type of municipal fund do you buy?

If you have an investment horizon of at least five years and are willing to accept the volatility of long maturities so that you can benefit from their higher yields and more stable dividends, consider general municipal bond funds. They're invested primarily in investment-grade bonds and have average maturities exceeding 10 years.

In striving to provide superior performance, portfolio managers of the category's top funds pursue a variety of strategies:

* Seeking values among bonds whose prices are depressed for any of several reasons, such as ratings that are lower than warranted or financial problems of states in which they've been issued. "I look for what others have overlooked," says Dreyfus' Richard J. Moynihan.

* Extending maturities. Confident about inflation for at least a couple of years, Financial's William W. Veronda has an average maturity of 22 years. Vanguard's Ian A. MacKinnon is maintaining his "neutral" position of 20 years, but is reluctant to go longer because of the uncertainties represented in Clinton's program.

* Maintaining high average credit quality. They avoid "junk" when the additional yield isn't enough to justify the additional risk.

* Relying heavily on bonds whose issuers are relatively insensitive to recession, such as power, water and sewer districts.

* Choosing hospital bonds only of the highest quality. "I won't chase any yield to get hospitals," says United's John M. Holliday.

* Buying some slightly higher-yielding "private activity" bonds that may subject investors to the alternative minimum tax.

Demand for municipals has been strong this year, and it's expected to remain strong next year. Even before a federal tax increase could be passed, MacKinnon notes, $20 billion in interest payments and proceeds from called bonds will be reinvested in early January.

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