Municipal bond funds are worth checking out


June 20, 1993|By WERNER RENBERG

Although we still don't know the changes in the Internal Revenue Code that Congress may pass, you can be sure of one thing if your tax bracket's rate is, or will be, 28 percent or higher:

If you want to own fixed-income securities outside of a tax-sheltered savings plan, take some time to study municipal bond mutual funds, whose income is exempt from federal income tax.

Ads for these funds and individual municipal bonds may have slighted their risks in the period since President Clinton called for higher taxes on "the wealthy." But don't minimize their probable reward: more income than you'd have after paying federal income tax on taxable securities.

Whatever your current or expected tax bracket, you can easily figure out whether -- and by how much -- tax-exempts would be better for you.

Say that you're in the 28 percent bracket and a tax-exempt investment offers a 5.35 percent yield. A taxable investment of comparable maturity and quality would have to offer more than 7.43 percent to beat it.

The calculation: Subtract 0.28 from 1.00 to get 0.72. Divide 5.35 by 0.72. The result: 7.43, known as the taxable equivalent yield.

For many, if not most, individual investors, municipal bond funds are more attractive than individual bonds. Funds allow you to invest small sums, reinvest small income distributions, achieve diversification, and use the skills of professional managers.

The 285 national municipal bond funds tracked by Lipper Analytical Services -- which excludes funds concentrated in issues of single states -- are classified into five categories: insured, high yield, and short, intermediate and long maturity.

If you want the stream of relatively high income available from longer maturities and will be invested long enough to tolerate the risk that prices would fall when interest rates rise, consider the general municipal bond fund category.

Invested primarily in long bonds rated in the top four investment grades -- AAA, AA, A, and BBB -- these funds earned an average annual total return of 10 percent over the last five and 10 years. Thanks to falling interest rates, they exceeded that in the last year.

But because rates can't fall indefinitely and would be expected to turn up when the inflation gets more serious, you might question whether a long-term fund is appropriate.

Top-rated managers say their funds could still be right for people with long investment horizons. If interest rates remain relatively stable, these funds will generate more income.

Even if rates rise, long-term investors shouldn't panic. As Jerome J. Jacobs, portfolio manager of Vanguard Municipal Bond Fund's Long-Term Portfolio, points out, investors with truly long horizons should ultimately be better off because their money would be compounding at higher interest rates.

This isn't to say, of course, that managers are staying with the longest maturities. Several whose funds' average maturities had exceeded 20 years have come down -- even below 20.

One who hasn't, William W. Veronda, manager of Financial Tax-Free Income Shares, still averages over 25 years. "I continue to feel very comfortable in view of the economy's low-growth mode," he explains.

Those who have been better able to hold up income distributions from longer bonds in the face of lower rates -- without reaching for low quality issues -- are managers who have emphasized call protection. That is, they have tried to avoid high-interest bonds that state and local government units could call for redemption and replace with new issues bearing lower coupons.

David J. Eurkus, portfolio manager of Putnam Tax Exempt Income Fund, is one of those who anticipated the decline in rates a few years ago and began to stress call protection. The result: Only $56 million of bonds in his $2.2 billion portfolio are subject to call by the end of 1995.

Given the degree of interest rate risk that characterizes long-term bond funds, managers of the leading funds are not eager to expose their shareholders to high credit risk, too.

Joseph Deane, manager of Shearson Managed Municipals Fund, whose 8.5 percent return makes it the group's leader for the first five months of 1993, is "staying high grade." About 50 percent to 55 percent of his portfolio is in AAA or AA bonds.

Pamela Hunter, whose Vista Tax Free Income Fund led the pack over the last five years with an average return of 11.7 percent, is about 45 percent invested in the top two grades.

With new issues ahead of the pace set in 1992, when Securities Data Co. calculated $232 billion worth were sold, funds have plenty of places to put the money that investors are sending them.

What are the leading fund managers buying? Securities of states where business conditions are improving and/or where governments are showing fiscal responsibility. Among issues most mentioned: those of Florida, Texas, Maryland and Virginia.


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