Muni Bond Mutual Funds Have Led the Way in Rally

Bond mutual fund owners have enjoyed the spoils of the recent bond rally. But the winnings haven’t been distributed evenly:

* The best-performing funds since November have been those that own tax-exempt municipal issues. They’ve benefited not only from the general drop in interest rates, but also from rising demand for munis as a tax shelter--thanks to President Clinton’s proposal to raise income tax rates for the so-called wealthy.

* Next-best funds: those that own corporate bonds--either high-quality issues, lower-quality or lowest-quality “junk” bonds. They pay more than government bonds, and enjoy increased demand whenever investors believe that the economy (and thus companies’ credit-worthiness) is getting better.

* Funds that own U.S. government bonds, meanwhile, trail muni and corporate returns. The implied safety of Treasury securities means you must accept a lower return than on other bonds.

What’s the best fund category to buy now? If you believe in an improving economy, however sluggish, corporate bonds still make sense. Mixed bond funds--those that own corporates, Treasuries and maybe foreign bonds--are also attractive for the diversification they provide. Most major fund companies offer such funds.

Whatever you own--or seek to buy--be sure it matches your risk tolerance. If you can’t bear the thought of losing a lot of your principal should market interest rates rise, stay with shorter-term funds, not those that own long-term bonds. You sacrifice some yield with shorter-term funds, but you gain peace of mind.