For Tax-Wary, a Good Time to Examine Munis

The municipal-bond market may be poised for a comeback this year.

These local-government bonds haven't exactly shined of late. Bonds have sagged this year on inflation concerns; some investors remain nervous after California's high-profile Orange County muni-bond default at the end of 1994; and politicians have talked up a "flat" tax that would remove the federal tax exemption muni bonds enjoy. The upshot: More money has been flowing out of muni funds than into them this year.

But investing patterns "come in cycles," says Lacy Herrmann, president of the Aquila family of mutual funds in New York. Given rising concerns about a possible correction in the stock market and attractive yields from bonds, the muni market is "getting close" to a rebound of interest from investors, he says.

Bonds provide needed diversification, agrees Paul Toft, portfolio manager of the Victory National Municipal Bond Fund.

Munis can also provide solid returns, particularly if you are in a tax bracket of 28 percent or higher, Mr. Toft says. He points to an AAA-graded 26-year municipal issue from Illinois that yields 6.20 percent. A person in the 36 percent tax bracket, "would have to earn a taxable equivalent of 9.69 percent" to equal that yield.

Victory's National-muni fund was ranked by Lipper Analytical Services the No. 1 muni fund for the 12-month period ending May 31. Two single-state muni funds managed by Toft, those investing in Ohio and New York, were also No. 1 in their categories for that period.

Single-state or national?

National muni funds buy bonds from many places; interest income is generally free of federal taxes. Single-state funds buy only issues from a particular state, so income can be free of both federal and state taxes, if you live in the state of issue.

In addition to good after-tax yield, municipals offer high safety in terms of preservation of capital, says Mr. Herrmann of Aquila, which also offers single-state muni funds. Despite the Orange County case and some other bond defaults during the early 1990s, munis are still the "second safest" financial market, after US Treasury bonds, he says.

State and local governments, eager to protect their ratings - and ensure their ability to place future bond offerings - almost always stand behind payment guarantees on their issues.

Flat-tax uncertainty

A question that has dogged the municipal market this past year is tax reform - including discussion of a flat tax that would remove muni-bonds' tax exemption.

Any major change in the tax code could have a major impact on muni bonds, says Kenneth Willmann, who manages the USAA National Municipal Bond Fund, in San Antonio, Texas. But far-reaching reform - including a flat tax - faces major hurdles, he says. President Clinton, if reelected, would probably be inclined to veto a flat tax, he says. If Republican challenger Bob Dole were elected and then allowed a flat tax to go forward, it would probably be late 1997 at the earliest before such a change would became law.

Meantime, with bond prices down and yields up, there is room for some buying of municipal issues, Mr. Willmann says.

If buying does heat up, it would be welcome news for the muni-bond industry. The last positive month for municipal funds, with inflows exceeding outflows, was November 1995, according to the Investment Company Institute, a mutual-fund trade group in Washington.

At the end of April - the most recent statistics available - muni funds had assets of $244 billion, compared with $253 billion at the end of 1995. The number of municipal funds is also down slightly.

Not surprisingly, studies show that most holders of municipal bonds, whether individual bonds or muni funds, are either close to or actually in retirement.

"But we're urging younger investors to buy muni funds as well as older investors," says Richard Olson, marketing director of the Integrity family of single-state mutual funds based in Minot, N.D. (There are Integrity funds for North Dakota, South Dakota, Montana, Nebraska, and Kansas.)

Younger investors "who earn high salaries can clearly benefit over time by investing in muni funds," Mr. Olson says, especially if they buy single-state finds that give them a double exemption, on both federal and state taxes.