If it makes sense for you to invest in a general municipal bond fund whose income dividends are exempt from federal income tax, consider investing in a high-yield muni fund. And if President Clinton and Congress put you into a higher income tax bracket this year, such funds carry added benefits.
As a taxpayer in the 28 percent bracket, you might earn more income from a municipal bond fund than you'd have left after tax on a taxable bond fund of similar maturity and quality.
To exceed the income that a 5 percent dividend from a high-grade tax-exempt fund would provide, for example, you would have to earn more than 6.94 percent before tax from a taxable fund. This figure, called the tax equivalent yield, would rise to 7.81 percent for someone in the new 36 percent bracket, and to 8.28 for the new 39.6 percent bracket.
If it's hard to find a suitable high-grade taxable fund offering such yields today, you can see that a high-yield municipal bond fund paying, say, 0.5 percent more could be even more rewarding.
As classified by Lipper Analytical Services, general municipal bond funds must invest at least 65 percent of their assets in issues rated as investment grade (Aaa, Aa, A, or Baa, according to Moody's).
High-yield municipal funds, however, may invest 50 percent or more in securities that are rated lower. Sub-investment grade issues, often referred to as speculative or "junk" bonds, pay more because of doubt about the issuers' ability to pay interest or repay principal.
Both general and high-yield municipal bond funds tend to own long-term bonds, exposing you to higher levels of interest rate risk -- the risk that bond prices fall when interest rates rise.
High-yield funds also may expose you to credit risk. Note the "may." A number of high-yield municipal funds are primarily invested in issues of investment grade -- albeit, perhaps more Baa's than Aaa's -- and own few state and local government bonds of lower quality. Although their prospectuses indicate that portfolio managers are authorized to invest in Ba or lower-rated paper, they might hold few of those securities now -- possibly because they offer too little additional income to justify the additional risk.
Before you invest in a high-yield municipal bond funds, determine whether you can accept the inherent risks. Then study prospectuses and shareholder reports to understand what the funds can buy and what their credit quality mixes are.
Yields alone won't tell you enough. A fund can have a relatively high yield because its portfolio is riskier or because its annual operating expenses are lower. The opposite is also true. Vanguard Municipal Bond Fund's 14-year-old High-Yield Portfolio, one of the oldest, has an average credit quality of A (vs. Aa for its Long-Term sibling). With operating expenses of 0.23 percent, 0.30 to 1 percent less than those of others, Senior Vice President Ian A. MacKinnon has less incentive to reach lower for higher yields.
The $1.9 billion fund has 11 percent of its assets in the revenue bonds of each of three sectors: hospitals, electric utility, and water and sewer districts.
Like its competitors, Vanguard has given particular attention to the scrutiny of hospital offerings because of their higher yields, reflecting that sector's financial problems. It has accumulated $210 million of A-rated hospital bonds whose coupons average 6.78 percent.
Hospital issues make up about 27 percent of T. Rowe Price's Tax-Free High Yield Fund. It has always been high in hospitals -- as high as 37 percent of assets -- William T. Reynolds, director of Price's municipal bond division, points out.
& 1993 By WERNER RENBERG