MUTUAL FUNDS/ RUSS WILES : Tax Hike May Raise Appeal of State Muni Issues

Tax rates in California appear to be heading higher, and that could make municipal bond funds more attractive.

Democrats in the state Legislature want to increase California’s top personal income tax rate to 11% from the current 9.3% as a way to shore up Sacramento’s worsening finances. Many Republican legislators oppose the proposed hike, so it’s not yet certain whether it will become law. But any time tax rates rise, muni bonds and bond funds become more valuable because of the tax-exempt interest they spin off.

Zane Mann, publisher of the California Municipal Bond Advisor newsletter in Palm Springs, believes that in-state bond prices have already started to inch upward in anticipation of higher taxes. Bond prices have also received a boost from the general decline in interest rates that started last fall.

Most municipal securities pay interest that’s free of federal taxes. Mutual funds that hold in-state bonds get an added break because their income also avoids state tax levies. Hundreds of California cities, counties and other governmental entities have issued thousands of bonds whose interest qualifies for this double exemption.

Currently, the combined tax rate for top-bracket Californians is 37.4%, reflecting a maximum 31% federal rate and 9.3% state levy, less deductions for state taxes paid. If the Democrats’ 11% proposal goes through, the maximum combined rate would increase to 38.6%, Mann says.

That’s not a big difference, but when it comes to bond returns, every little bit counts. For example, the taxable-equivalent yield of a 7% California muni issue is 11.18%, meaning that you’d need to find a corporate bond paying that much to earn the same real amount. Under an 11% marginal state tax rate, the taxable-equivalent yield of that 7% muni bumps up to 11.4%.

You can make a taxable-equivalent calculation by taking a California bond’s yield and dividing it by: 1 minus 0.374 (or whatever your combined marginal tax rate is).

Actually, the Democrats’ plan would apply an 11% rate only to a person earning more than $100,000 a year, or couples making in excess of $200,000. Of course, high-income individuals tend to be the heaviest buyers of municipal securities, one of the few types of tax shelters left.

The double exemption available on California muni bond funds explains why they’re so popular. But are they riskier than national muni bond portfolios, which obviously have better geographic diversification? “That argument has some validity with other states, but the California economy is so enormous that the funds can get ample diversity here,” Mann says.

Besides, California municipalities haven’t been hit as hard by the recession as issuers in Massachusetts, New York, Pennsylvania and other trouble spots, says Larry Troutman, portfolio manager of the Dreyfus California Tax-Exempt Bond Fund. Mann points out that only 26 California municipalities had their credit ratings downgraded in 1990, while 31 enjoyed upgradings. Nationally, the number of downgrades exceeded upgrades by better than 3 to 1 last year.

Still, this doesn’t guarantee that a California bond fund won’t slip in price. Downgradings--which reflect a deteriorating financial situation for a bond’s issuer--lead to lower bond prices, as do rising interest rates and other factors.

That’s why it’s important to realize that muni bond funds can be volatile at times. In 1987, a spike in interest rates peeled more than 15% off the values of some muni bond funds within a matter of months, although they recovered somewhat later in the year. Prices were even more volatile in the early 1980s.

One factor that favors muni bond portfolios generally--not just California funds--is the demand/supply equation. Demand has intensified, Troutman says, ever since the Tax Reform Act of 1986 limited other types of shelters. That same legislation has curtailed the supply of new bonds coming to market by imposing a narrower definition of just what qualifies as a tax-exempt issue.

Nationally, about $125 billion to $130 billion in new municipal bonds came to market in ’89 and ‘90, Mann says, and he expects about the same level this year. By contrast, roughly $205 billion in munis were issued in ’85.

Troutman believes that California munis are generally attractive at current prices. But he cautions that since interest rates have already been trending lower since the mid-’80s, they might be closer to a major bottom than a top. “We’ve probably seen 75% of the long-term decline,” he says.

Consequently, Troutman suggests that conservative investors stick with California bond funds whose holdings mature in 10 years or less, on average, since interest rate fluctuations affect long-term issues more severely. You can find out about a fund’s average maturity by checking the most recent shareholder report or calling the fund company directly.

One additional factor to focus on is portfolio composition. Municipal issuers receive credit ratings just like corporate borrowers do, with grades ranging from triple-A down to D (for issues in default). Some muni issues are nothing more than tax-exempt junk bonds. “Obviously, lower-rated bonds are more sensitive to poor economic conditions,” says Eileen Comerford, an assistant vice president at J. & W. Seligman & Co., a New York firm that runs 20 muni bond funds, including three California ones.

Junk muni bonds are characterized by their high nominal yields. But they also carry more price risk. For this reason, Comerford suggests sticking with funds that have historically delivered a good total return, rather than those sporting the highest yields.

Although municipal defaults are much less common than corporate failures, the frequency could pick up a bit in the current weak economic climate--even in a strong state like California.

DOUBLE YOUR PLEASURE California municipal bond funds pay interest that’s exempt from both federal and state income taxes. This is an attractive feature at a time of vanishing tax shelters. In general, muni bond portfolios are fairly homogenous in that their returns tend to cluster together. Even so, Morningstar Inc. of Chicago rates the funds listed below as slightly better bets. Keep in mind that capital gains, unlike interest payments, are taxable even on muni bond investments. So, part of the total return figures shown might be taxable, especially in years when the funds did particularly well, such as 1986.

Total Return Sales Fund/phone ’86 ’87 ’88 ’89 ’90 Charge Benham Calif. Tax-Free Intermediate-Term (800-472-3389) 12.6% 0.8% 5.9% 7.9% 7.0% None Dreyfus Calif. Tax-Exempt Bond (800-645-6561) 17.7% -1.7% 9.7% 8.6% 6.7% None Fidelity Calif. Tax-Free High-Yield (800-544-8888) 17.5% -3.7% 1.8% 9.7% 7.0% None Franklin Calif. Tax-Free Income (800-342-5236) 16.4% -0.5% 12.0% 8.6% 6.3% 4% Kemper Calif. Tax-Free Income (800-621-1048) 18.4% 3.5% 7.5% 11.6% 6.7% 4.5% Paine Webber Calif. Tax-Exempt Income (800-544-9300) 19.2% 0.7% 10.2% 9.0% 6.7% 4.25% Putnam Calif. Tax-Exempt Income (800-225-1581) 18.1% 0.4% 12.4% 10.0% 6.7% 4.75% Calif. Muni Bond Fund Average 17.3% -1.8% 10.5% 9.6% 6.4%