Is there beauty in tax-exempt bond funds?

March 02, 1994|By Andrew Leckey | Andrew Leckey,Tribune Media Services

Beauty is in the eye of the beholder. Tax-exempt municipal bond funds always look good to investors at tax time. But they're especially attractive in a year in which the tax bite on the well-off has been boosted and few alternatives remain.

To equal a 5 percent tax-exempt yield, an individual in the 28 percent tax bracket would need a taxable yield of 6.94 percent. For someone in the 36 percent bracket, a 7.81 percent taxable yield would be required. A taxpayer in the highest 39.6 percent bracket would have to snare a taxable yield of 8.28 percent.

Just one problem. Last year, municipal bond fund total returns (yield plus price appreciation of the underlying bonds) were better than 15 percent, making the deal even more attractive. But this year the Federal Reserve has already increased rates once, and the likelihood of higher rates means the total return bonanza is unlikely to repeat.

"Municipal bond funds performed well in 1993 because of the rate drop and higher demand because Americans knew they were facing higher income tax rates," said Pamela Hunter, manager of Vista Tax Free Income Fund, which turned in a 12-month total return of 14.92 percent. "But I don't know that we're going to see the double-digit total returns this year of the past couple of years."

When rates increase, the yield of the new bonds put into a portfolio will be higher. But the value of existing bonds will decline.

"Though it will be difficult, I think it will still be possible to achieve double-digit returns of 10 or 11 percent," said James Colby, portfolio manager of Evergreen Insured National Tax Free Fund, up 15.34 percent in total return the past 12 months.

Keep maturities in mind. "If the maturity of a municipal bond fund is greater than 10 to 15 years, you're looking at fairly large volatility on the downside when interest rates rise," warned John Markese, president of the American Association of Individual Investors.

Ms. Hunter, Mr. Colby and Mr. Markese all expect short-term rates to hit 4 percent this year but are uncertain about long-term rates. Ms. Hunter predicts they won't be much higher, probably trading in a range of 6.20 percent to 6.60 percent, while Mr. Colby thinks they could actually slide to 6 percent or increase as high as 6.75 percent. Mr. Markese forecasts they'll hit 7.25 percent. With such divergence of opinion, we'll have to wait to see what happens next.

"The interesting thing about municipal bonds is that they don't react quite as strongly to interest rates as other bonds, since supply and demand are often factors in their prices," said Robert Tracinsky, analyst with the Morningstar Mutual Funds investment advisory. Supply this year is expected to be much less, with demand remaining high.

Best performing investment-grade national municipal bond funds, according to Morningstar, have been:

* UST Master Tax Exempt Long Term, Boston, $86 million in assets; 4.5 percent "load" (initial sales charge); $1,000 minimum initial investment; average bond maturity of 24 years; 12-month bond yield of 4.01 percent; 12-month total return of 15.43 percent.

* Evergreen Insured National Tax Free, Purchase, N.Y.; $42 million in assets; no load; $2,000 minimum; average bond maturity of 22 years; 12-month bond yield of 5.19 percent; 12-month total return of 15.34 percent.

* Vista Tax Free Income, New York; $102 million in assets; 4.5 percent load; $2,500 minimum; average bond maturity of 18 years; 12-month bond yield of 4.94 percent; 12-month total return of 14.92 percent.

* Flagship All American Tax Exempt "A," Dayton, Ohio; $197 million in assets; 4.2 percent load; $3,000 minimum; average bond maturity of 22 years; 12-month bond yield of 5.69 percent; 12-month total return of 14.70 percent.

* Sierra National Municipal, Northridge, Calif.; $409 million in assets; 4.5 percent load; $250 minimum; average bond maturity of 21 years; 12-month bond yield of 5.42 percent; 12-month total return of 14.59 percent.

* Seligman Tax Exempt National "A," New York; $131 million in assets; 4.75 percent load; $1,000 minimum; average bond maturity of 26 years; 12-month bond yield of 5.03 percent; 12-month total return of 14.39 percent.

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