Muni Bond Fund May No Longer Be Tax-Free
Individual investors are pouring record amounts of money into a widening array of municipal ond funds this year to reduce expected pain from President Clinton’s proposed tax hikes.
But if you’re among the millions of investors suddenly thinking seriously about municipal bond funds, you should know that this is no longer a homogeneous industry that largely invests in plain-vanilla bonds that earn tax-exempt interest.
Indeed, partly as a result of record early payoffs and rapidly declining interest rates, your municipal bond fund may not even be tax-free any more. Moreover, the fund manager may be taking risks that could make both dividend yields and fund prices highly volatile.
What’s happened to municipal bond funds and how does it affect you? Here’s a look:
Q: What do you mean, my municipal bond fund might not be tax-free any more?
A: Interest earned on municipal bonds is free of federal tax. However, mutual funds also pass through their capital gains and losses when trading individual bonds. And a number of fund managers say they’ve had substantial taxable capital gains in the past year because they sold old bonds when prices soared.
“The vast majority of the securities in my portfolio have embedded capital gains or realized capital gains,” says William T. Reynolds, head of T. Rowe Price’s municipal bond division. “That’s just a fact of the market right now.”
The end result: If your fund manager hasn’t been actively trying to reduce taxable gains, up to about 30% of your muni-fund earnings may actually be subject to federal tax.
Q: Should I avoid funds that are paying taxable capital gains?
A: Not necessarily. But it should figure into your calculation of the fund’s after-tax return. Consider two funds, similar in every way except that one is paying an 8% tax-free dividend and the other is paying 8%, but 30% of that is taxable. The second fund’s after-tax yield is actually around 7%.
When comparing funds, just make sure you check to see what portion of the total return was taxable versus tax free.
Q: Why did the bond prices soar?
A: Mainly for two reasons. Interest rates have declined sharply, which makes all previously issued, higher-coupon bonds more valuable. Those old bonds then trade at a premium above their face value.
Also as a result of declining rates, many municipalities decided to “advance refund” their bonds--a type of refinancing. How this works is complicated, but the end result is the advance refunded muni becomes a shorter-term bond with a pristine credit rating. That frequently boosts the price. Indeed, some advance refunded issues sell for upward of $1.30 for every $1 of face value.
Q: Why would the manager sell out at that point?
A: The premium is fleeting. Usually the premium is highest about five years from maturity and it gradually declines as the maturity gets closer, says Tom Kenny, manager of municipal research at Franklin Advisors in San Mateo. If managers sell when they think the premium is at its peak and buy new bonds, they lock in the premium and stabilize the fund’s value, Kenny adds.
Q: How have bond “calls” affected mutual funds?
A: Most fund managers anticipate calls--when issuers redeem bonds before they mature, usually so they can use the proceeds to issue new bonds at lower rates--several years before they actually happen. Managers then do one of two things: Line up additional securities to buy with the proceeds or sell the bonds well in advance of the payoff. Either way, they can end up with taxable capital gains.
Q: You said funds are also taking risks that could make prices and dividends more volatile. What are you talking about?
A: In an effort to boost yields, a number of funds are investing in low-quality securities--so-called “junk munis”--and hybrids, such as “inverse floaters.”
While junk munis pay higher coupon rates of interest, they also have greater default risk. And they’re subject to bigger price swings because they make investors nervous.
Meanwhile, inverse floaters boost investment returns in a declining rate environment, but could depress returns when interest rates start to rise. These bonds also are about twice as volatile as an ordinary bond, so they, too, could cause your fund’s value to jump around a bit.
Q: Does this mean that municipal bond funds aren’t a great investment anymore?
A: Not at all. In many cases, municipal fund yields are exceptionally rich compared to after-tax yields on similar investments. If President Clinton is successful in his bid to raise taxes on upper-income taxpayers, as seems likely, the after-tax yields will look even better.
Additionally, there are lots of traditional funds and funds that skillfully manage the new risks in the market. Investors simply need to investigate and make sure they feel comfortable with their fund manager’s strategies before they invest.
Choosing a Municipal Bond Fund
Here are key pieces of information you’ll need in evaluating a municipal bond fund:
* Quality. Get investment ratings on the fund’s bonds. Any bond that’s rated below a “B” would be considered a junk bond, which pays higher interest but is more volatile than higher-rated securities. Most funds can tell you the average investment rating on their bonds and the minimum rating their fund is allowed to buy.
* Volatility. Low-rated securities, derivatives and bonds that are likely to be called in the next few years can increase the chance that your bond fund will gain or lose value quickly. Find out how much of the fund’s assets are in derivative products.
* Performance. Check how the fund has done in both up and down markets. Anyone can do well when the market’s hot. You want someone who can warm up a frigid market.
