Tax-Exempt Munis May Help Satisfy Hunger for Bonds

If you have a case of bond fever--a strong desire to lock in today’s yields because you think interest rates are going lower--be sure you look first at tax-exempt municipal bonds.

Even before President Clinton’s tax increases passed Congress, muni yields were attractive; they’re more so now. And not just for the rich.

A California couple with taxable income of $70,000 won’t face a tax increase, but they’re still in a combined federal and state tax bracket of 34.7%. For them, a 5.5% California tax-exempt muni yield is the same as earning 8.42% on a taxable bond. If you’ve looked around, you know you can’t find 8%-plus yields on many securities worth owning.

So, if you need income, or to offset the risk of your stock investments with something a little more certain, look at munis. Two ways to buy:

* Individual bonds. If you have at least $50,000 to invest, you can create your own portfolio of California bonds through a full-service or discount broker. There is $130 billion in California munis outstanding from the state and the many city, county, school district and other local issuers, so in theory there are plenty of bonds to choose from.

Right now, though, many bond dealers say it’s tough to find the kind of California bonds that most buyers want: shorter-term (maturing in two to 10 years) and insured (i.e., a private insurance company guarantees the interest payments in case the issuer defaults). “There’s a real dearth of that paper,” says Peter Auzers, who manages muni bond trading in the West for Fidelity Investments.

Why? Many investors are worried about the fiscal strength of the state and its municipalities as the recession deepens. Because few people can independently research the health of bond issuers, the easy way out is to buy only insured bonds.

The cost of being safe is about 0.20 point: If a 10-year uninsured muni yields 5.05% annually, a similar insured bond would yield about 4.85%.

If you’re willing to assume the risk of uninsured bonds for a higher return, ask your broker about bonds from the biggest issuers--the state itself, for example, or Los Angeles County. It’s inconceivable that such major entities would default on their debt; and if you’re like most buyers of individual bonds, you plan to hold them to maturity, which means you won’t care if short-term bad publicity temporarily sinks the market price of the bonds.

(Buy-and-holders, note: Issuers can “call” bonds well before maturity; ask before you buy.)

Auzers says a popular strategy among individuals is laddering: splitting your muni investment evenly among bonds maturing, say, every two years for the next 10 years. That way, you’ve always got a piece of your portfolio turning over relatively soon. But for this you need at least $50,000, and more realistically $100,000.

Another idea: unit trusts, sold by brokers in $5,000 lots. These are shares in small pools of bonds that mature around the same time, so you get a fixed annual yield, similar to owning single bonds.

* Bond mutual funds. The funds are the easiest way to buy munis, because you don’t need a broker’s help. For as little as $1,000, you get a piece of a well-diversified portfolio of bonds.

An advantage of owning a fund over individual bonds: If interest rates rise, the yield your fund pays will eventually rise, as it buys newer bonds. The disadvantage: Your share price can drop if rates rise as older, lower-yielding bonds lose value, and that means your principal can decline permanently if rates go on an extended climb.

There are about 100 California muni funds now, including shorter-term funds. Most, however, own longer-term bonds. At the end of July, the average annualized yield on uninsured California funds was 5.7%, according to Lipper Analytical Services.

Not surprisingly, lower-yielding funds that own insured California bonds have performed best this year in total return (appreciation plus interest earnings), because those bonds have been in hot demand. But independent fund rater Morningstar Inc. in Chicago now gives its highest ratings to two uninsured funds: Alliance Municipal Income Fund of California (800-227-4618) and Benham California High Yield (800-472-3389).

Morningstar analyst Robert Tracinski admits that the Alliance and Benham funds may take more risk than some people may want, but he says their long-term performance has paid off.

Muni Returns, by State

Here are the Top 10 categories of single-state muni bond mutual funds year-to-date, ranked by total return (interest earnings plus capital appreciation). In California, funds that own safer bonds (insured issues) have performed best.

Avg. muni fund total return Avg. 12-mo. State Jan. 1-July 31 fund yield Washington +9.07% 5.8% Connecticut +7.90% 5.5% New York +7.85% 5.5% Missouri +7.79% 5.3% Kansas +7.71% 5.5% California (insured) +7.70% 5.4% Texas +7.70% 5.7% New Jersey +7.67% 5.3% Florida +7.64% 5.7% California (uninsured) +7.57% 5.7%

Source: Lipper Analytical Services