Unit Trusts Ideal for Those Willing to Wait

Unit investment trusts, a convenient way for small investors to buy diversified portfolios of municipal bonds or other fixed-income securities, are enjoying a sales boomlet.

Thanks to higher yields on these mutual fund cousins--and an investor flight to quality following the October stock market debacle--sales of unit trusts rose to $4.3 billion in the first four months of this year, up 13% from the same period a year ago.

Many trusts with top-quality tax-free bonds are offering yields of between 7.5% and 8%, better than many comparable mutual funds.

“People are looking for predictable streams of income,” says Thomas Littauer, a senior vice president of Van Kampen Merritt in Chicago, one of the nation’s largest sponsors of unit trusts. “People are buying these as safe, conservative investments.”

“Brokers are sitting around waiting for the phone to ring. They’ve got to get on the phone and sell something, and this is what’s selling,” says Zane B. Mann, publisher of California Municipal Bond Advisor, a Palm Springs newsletter.

But a decision to invest in unit trusts should be considered carefully, experts say. The trusts--because they lock in yields for years and carry high front-end sales fees--are generally suitable only for conservative, long-term investors willing to hold them for many years. Also, not all trusts are the same; some offer higher yields but carry less-creditworthy bonds with higher risk of default.

Unit trusts, which now have more than $120 billion in assets outstanding, are in many ways similar to mutual funds. They allow small investors to obtain shares, usually called units, in a diversified portfolio of securities, often for a minimum outlay of as little as $1,000.

The vast majority of unit trusts invest exclusively in tax-free municipal bonds, although some also invest in corporate and government bonds, utility stocks, mortgage-backed securities or bank certificates of deposit. Investors who buy into a trust are entitled to interest and dividend payments on a regular basis, usually monthly.

However, trusts differ from mutual funds in one major respect: Their portfolios generally remain fixed (one exception: if bonds are “called”--redeemed before maturity--by issuers). Accordingly, unit trusts last until most or all of the bonds mature, usually between 20 and 30 years, and their yields generally remain fixed. Mutual funds, on the other hand, buy and sell securities constantly as market conditions change, so their yields may change over time.

So with a unit trust, “You know exactly what you are getting,” newsletter editor Mann says.

Currently, yields on unit trusts investing in municipal bonds are as much as one-half to a full percentage point higher than comparable mutual funds. Van Kampen Merritt, for example, is offering an insured tax-free trust with a yield of 7.54% (equivalent to a before-tax yield of 11.25% for an investor in the current top 33% tax bracket). A year ago, yields on equivalent trusts were under 7%, Van Kampen Merritt’s Littauer says.

Another attraction: Annual management and custodial fees on trusts are virtually nil, since it doesn’t take a genius to manage a fixed portfolio. So investors’ yields aren’t eroded as much by annual charges. Total annual fees on unit trusts typically run as low as 0.1%, compared to 1% or more at many mutual funds. Over 20 years or more, those lower annual fees can make a big difference in your return.

Accordingly, unit trusts appeal to conservative investors willing to hold their units for a long time.

And many tax-exempt trusts now offer private insurance on bonds in their portfolios, protecting investors against defaults.

But what if you aren’t sure you will hold your trust units for long? You may be better with other alternatives, such as no-load mutual funds.

Here’s why: Unit trusts, which are primarily sold through stockbrokers, usually charge up-front sales fees of between 4.5% and 5.5%. No-load mutual funds charge no such fees.

So, if you hold trust units for only a little while, those up-front fees could erode your return significantly.

“Unit trusts should only be viewed as long-term investments,” says newsletter publisher Mann. “You should actually plan to hold them until maturity.”

Also, if you need to sell your units before the trust matures, you may not get all of your initial investment back. While you can sell the units back to your broker, prices of units--just like prices of bonds--fluctuate with interest rates. As interest rates rise, unit prices fall, since no one will pay full price for your units if they can buy units in a new trust paying higher yields for the same price.

Conversely, however, if interest rates fall, you could make a profit on your trust units.

If you are interested in unit investment trusts, here are some tips on how to select them:

- Always read trust prospectuses carefully before investing. Look at the credit ratings of the bonds to judge the quality of the portfolio.

- Don’t be fooled by trusts offering above-market yields. If yields are higher than those prevailing in the marketplace, chances are the bonds have greater risks of default. Or the bonds might be more likely to be called, eventually depriving you of the high returns.

Such a lesson was learned by hundreds of investors in several unit trusts sponsored by Miller & Schroeder Financial in Minneapolis. One trust, introduced in March, 1986, offered an initial tax-free yield of 9.84%, far more than market rates at the time. But a year later, one in five of the bonds in the trust had defaulted, pushing down yields and trust unit prices.

- Be wary of trusts investing in high-yield “junk” municipal bonds. Because unit trusts don’t have active management, problem securities may not get weeded out of the portfolio until it’s too late.

“If you have an urge to get a high yield, go to a mutual fund” where there is active management, Mann argues.

- Be careful about trusts sponsored by newly established firms without long track records, Mann suggests. Large trust sponsors with the longest track records include John Nuveen & Co. and Van Kampen Merritt.

- If safety is your prime concern, go with insured trusts. They generally yield about 0.3 percentage points less than uninsured trusts, but that may be a small sacrifice for sleeping better at night.

- If you live in a high-tax state like California, consider investing in unit trusts investing in bonds from your state so you can be exempt from state and federal tax. That double tax advantage may overcome the lower yield for single-state trusts.

For example, Van Kampen Merritt is currently offering a California tax-free bond unit trust with a yield of 7.25%. For an investor in the top federal and state tax brackets (with an effective combined tax rate of 39.23%), that is equivalent to a before-tax yield of 11.93%. Van Kampen Merritt’s national bond trust yielding 7.54%, exempt only from federal tax, is only equivalent to a before-tax yield of 11.25%.