Municipal bond investors hunt shelter. Shivers from US tax proposals point to shift in tax-free strategies

It was only a proposal by one member of Congress. But one day last month, it nearly shut down the municipal bond market. For a few hours, almost no bonds were bought or sold. The proposal by Sen. Bob Packwood (R) of Oregon would have made income from currently traded municipal bonds subject to a 20 percent minimum tax. The tax would have applied only to the wealthiest investors, but any tax, the muni-bond business maintains, violates a sacrosanct rule against taxing this source of revenue for states and cities. In this case, once it became clear that the proposal wouldn't pass, trading picked up again.

Another change in municipal bond rules has made more progress. The version of tax reform passed by the House of Representatives last fall would bar the use of tax-exempt bonds for certain projects: sports facilities, hotels, convention halls, and some industrial development.

That proposal, along with concern that bonds issued after the first of this year might be partially taxed, has sent the bond-issuing business into a dive (see chart) that it's only now beginning to reverse.

The upheaval has left people who want tax-free investments wondering where to go. Right now, buying straight municipal bonds seems to be one answer, although few people seem to want bonds issued since New Year's Day because of questions about how they might be taxed.

Three of the most popular alternatives are municipal bond mutual funds, tax-free money market funds, and the newer but increasingly popular unit investment trusts.

Mutual funds. Like most mutual funds, investment companies buying municipal bonds trade them on a daily basis. Investors can get in and out of the funds whenever they want to.

Because municipal bonds have a yield, similar to an interest rate, there are two ways investors can win -- or lose. The fund pays a yield, and the share price, or net asset value (NAV), can change daily. If both the yield and the NAV go up, your total return will be greater than if you were just getting either the higher NAV or higher yield.

Like any mutual fund, there is also the risk that both the NAV and the yield will fall, and you might get back less than you put in.

``If you put $1,000 in a muni-bond fund, there's no guarantee you'll get it back,'' says Charles Kutcher, vice-president for marketing at Fidelity Investment Brokerage Services, a division of the Boston-based mutual fund company.

The current yield on these funds is about 6.5 to 7 percent.

Muni-bond funds do have the advantage of liquidity. If you see the NAV falling and the yield isn't keeping up with your expectations, you can get out at any time.

If it's a true no-load fund, you can get out of it (as well as in) with no charge.

Tax-free money funds. In many respects, these are the same as muni-bond funds. When money market mutual funds and tax-free bond funds became popular in the late 1970s, people wanted a product that had the best of both: fairly high yields and no tax obligation.

The response came from both mutual fund companies and cities and states. Local governments began issuing short-term bonds with lower yields, which saved them money, and the funds learned to adjust their portfolios to keep the NAV at a constant $1 a share.

The yields on these funds are somewhat lower than standard money market funds, but if your tax bracket is high enough, they can work for you. Late last month, the yield on Fidelity's Tax-Exempt Money Market Trust was 4.76 percent, compared with 7.10 on Fidelity Cash Reserve. That's about a 33 percent difference. But if you're in the 33 percent tax bracket or higher, you'll come out ahead with the tax-free money fund.

Unit investment trusts. These sometimes get confused with mutual funds, but they are quite different. ``The unit trust is a fixed portfolio, the mutual fund is constantly managed,'' explains Fred Croft, first vice-president for research with American Portfolio Advisory Services, a subsidiary of Van Kampen Merritt Inc.

The firm issuing a unit trust, Mr. Croft says, puts together a portfolio of municipal bonds (it can also be used for corporate bonds, government securities, and other interest-bearing securities) and the portfolio has a fixed life span. An investor buys one or more ``units'' of the trust, which spins off a specified income.

For example, if you wanted to invest $10,000 in a recently issued trust of municipal bonds from John Nuveen & Co., you would get 95 units with a yield of 7.31 percent. The $9,961.70 invested after the sales charge was deducted would spin off a monthly tax-free payment of $60.42 for 20 years. While Nuveen's units sell for $100, most trusts sell for $1,000 each.

That tax-free status, by the way, applies only to federal taxes; you may still have to pay state taxes, unless the trust was made up of bonds from your state. The same applies to muni-bond and tax-free money funds.

Unit trusts are not as liquid as muni-bond and tax-free money funds. You can get out early, but how much you get back depends on current bond prices and yields, so you won't know what you're getting until you get out. ``You can always get out of the trust, but you're subject to the market rate on the bonds,'' says Kevin Slattery, marketing assistant with Salomon Brothers.

Of the three choices, muni-bond funds would seem best for people who want a fairly high yield and don't want to tie up their money for a long time.

If you have long-range plans for that money, however, or if you want steady income and don't plan to use the principal for several years, the unit trust may be better. Most unit trusts do have a sales charge, while there are several no-load bond funds. At Nuveen, the sales charge is about 4.4 percent, but that's a one-time thing. There's no redemption charge or management fee.

If you have a question that would make a good subject for this column, please send it to Moneywise, The Christian Science Monitor, One Norway Street, Boston, Mass. 02115. References to investments are not an endorsement by this newspaper.

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