Municipal Bond Yields Look Attractive Now

Let's face it, yields on safe fixed-income investments don't look very sexy right now. Certificates of deposit, Treasury securities and money market mutual funds have seen better days. What's an investor to do?

Consider tax-free municipal bonds.

Yields on munis today--relative to those of Treasuries, CDs and other taxable, fixed-income investments--are the highest in three years. Thanks in part to unloading of munis by big institutions, yields on tax-frees in recent months simply haven't fallen as far as have yields on their taxable cousins.

Consequently, if you are in the 28% or 33% federal income tax bracket, you can earn more after-tax income from a muni than from a taxable-yield investment. Some longer-term munis are yielding as much as 3 or 4 percentage points more than Treasuries of similar maturities, after tax.

You might do better with some muni issues even if you are in the 15% income tax bracket. In the past, investors in the lowest brackets almost never made out better with tax-frees.

"This is an exceptional opportunity to buy muni bonds," says Richard A. Ciccarone, director of fixed-income research at Blunt Ellis & Loewi, a Chicago brokerage. "We're looking at yield levels, particularly in long-term muni bonds, that are attractive for all taxpayers."

The reason yields from munis have become so attractive has a lot to do with banks and insurance companies--traditionally the biggest buyers of tax-frees. These behemoth institutions have been unloading their munis in big chunks, thanks to changes in tax laws that reduce the benefits in holding such bonds. The tax-rules changes affecting these big institutions are complicated and of no particular interest to little folks, but the result has been that banks and insurers--which held about 65% of all munis a decade ago--now only own about 39% of them.

Individual investors have picked up some of the slack, but not all of it. Consequently, supply has exceeded demand, and anybody who's taken Economics 101 knows what that means: lower prices, higher yields.

Municipal yields now are 90% or more of yields from Treasuries with comparable maturities. Usually, the ratio is between 80% and 90%; at times it has fallen into the 70% range.

"That's a buying indicator when the ratio gets to be that high," says Zane B. Mann, publisher of California Municipal Bond Advisor, a Palm Springs newsletter.

The after-tax impact of that closed-up differential can be dramatic with some muni issues.

Take public power bonds, issued by utilities such as the Los Angeles Department of Water and Power. High-quality public power bonds with maturities of about 10 years currently are yielding about 7%, analyst Ciccarone says.

If you're in the 15% income tax bracket, that's equivalent to a taxable investment paying 8.25%. If you're in the 28% bracket, that's equal to 9.72% taxable. And if you're a 33% taxpayer, it's the same as 10.45% taxable.

Not bad, when you consider that 10-year Treasury bonds are yielding about 7.9%, before tax. And if you buy the bonds of California entities such as the DWP, the interest will be exempt from state taxes as well--an added advantage over taxables.

There are, of course, potential drawbacks to muni investing. If yields rise the value of the bonds will fall, giving you a potential capital loss. That is particularly true of long-term munis. (Of course, if yields fall, the value of your bonds will rise.) So if you think interest rates may shoot back up, stick to shorter-term issues.

Munis also can be "called"--that is, the issuer may seek early redemption, in effect forcing you to sell back your bond and perhaps robbing you of a high yield.

Nonetheless, munis still look like a good bet for the conservative part of your portfolio. They certainly are a lot less risky than many corporate bonds. As holders of many of those issues sadly testify, corporate bonds are prone to so-called event risk--of a takeover or leveraged buyout, for example, that saddles the issuer with heavy debt, increases the risk of default and thus lowers the value of its bonds.

And you'll be heartened to know that California munis survived the Bay Area Quake--there was virtually no panic dumping of bonds in the state as investors generally remained, well, unshaken. That, in part, reflected a flight to quality from the stock market and investor confidence in the state's ability to finance repairs and reconstruction, newsletter publisher Mann said.

How should you go about boosting holdings of munis?

Mann likes public power and educational facility bonds. Educational facility bonds issued in California, such as those of the California Educational Facilities Authority, are yielding at least 7% on maturities of 15 to 20 years. Because they are "double tax free"--exempt from both state and federal taxes--a 7% yield is equivalent to a taxable yield of 10.70% for those in the 33% income tax bracket and 9.95% for those in the 28% bracket.

But if you have less than, say, $50,000 to invest, the best way to go would be municipal bond mutual funds or unit investment trusts. That's because, with less than $50,000, you can't buy enough individual bonds to give you adequate diversification. And if you buy a no-load fund that doesn't charge sales commissions, your costs will be lower than if you buy individual issues through a broker.

What are some of the attractive buys in muni funds these days?

One of the best fund families for municipals is Vanguard Group (800-662-7447), according to Catherine Gillis, securities analyst at Mutual Fund Values, a Chicago-based investment advisory service. Vanguard's funds have generally performed well, are no-load and have among the lowest expenses of any fund groups, she said.

They also offer a range of maturities, so if you want the biggest yields and think rates will be coming down, you can choose from two long-term portfolios they offer. But if you want to play it safe, you can take their short- or intermediate-term portfolios.

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