It has always been easy to explain how investing in municipal bonds and bond funds makes sense for people in the 40 to 50 percent tax brackets. But 10 to 15 percent brackets? That's possible, too, when yields on municipal bonds are running at 85 to 90 percent of taxable Treasury issues, as they are nowadays. If a person is in the 50 percent tax bracket, he needs to find a tax-free investment with a yield of no better than 5 percent to match 10 percent taxable yields. Someone in the 40 percent bracket can make do with a 6 percent yield for the same result.
But lately, yields on long-term municipal bonds have been hovering around 10 percent, while returns on 30-year Treasury bonds are in the 11 to 12 percent range.
Figures like these have brought smiles to the faces of people who manage mutual funds that specialize in tax-free investments, despite the uncertainties raised by the Treasury Department's tax simplification plan, which includes a modified flat-tax proposal.
``Even if the top rate drops, not much is likely to happen,'' says Robert A. Dennis, president of the Managed Municipal Bond Trust, a tax-free fund offered by Massachusetts Financial Services, a Boston-based mutual fund. ``Not when muni bond yields are as much as 90 percent of comparable taxable yields.''
Even if the gap between tax-free and taxable rates widens again, says Steven Norwitz, a vice-president at T. Rowe Price funds in Baltimore, it should narrow again if the Treasury's tax proposal passes. ``I would expect interest rates would go up to make [municipal bonds] more attractive,'' he says. ``Yields on new issues would have to reflect the new tax brackets.''
Yields on new issues also have to reflect the fact that each one of them is coming out in a much more competitive marketplace, judging by the tremendous increase in the use of bonds as a financing mechanism among states, cities, and towns. Property-tax revolts have quickly increased public officials' interest in bonds as a means to pay for public projects.
In 1970, state and local governments issued $18.1 billion in munis, according to the US Advisory Committee for Intergovernmental Relations. Almost all of those bonds -- $17.2 billion worth, to be exact -- were in the so-called ``traditional public purpose'' category, which includes streets, bridges, sewers, and water supply systems. That left a very small share for such ``nontraditional'' uses as housing, industrial development, pollution control, and hospitals.
By 1979, however, the balance had shifted so that $26.9 billion was raised for traditional purposes, and an almost equal amount -- $25.6 billion -- was for nontraditional purposes. In 1982, the last year for which the committee has complete records, the figures were $39.8 billion for traditonal purposes and $43.4 billion for nontraditonal uses, which by now included $1.6 billion for loans to college students. ``That's the latest fad,'' says Suzanne Calkins, a senior analyst at the committee.
It is possible that, at least for this year, the debate on taxes could result in even more bonds being issued, particularly the controversial industrial development bonds (IDB). If a new tax bill did outlaw IDBs, any bonds issued before a certain date (such as when a bill was reported out of committee) would be exempt from the new restrictions.
Even though yields on some A-rated 20-year bonds are at 10 percent or more, they could go higher if Congress passed one of the main features of the Treasury's tax simplification proposal: a reduction in the top tax rate to 35 percent. A lower rate, tax experts say, would force municipalities to even higher yields to attract new investors.
Balancing that possibility, however, are the new limits on tax shelters -- including stricter reporting requirements contained in the 1984 tax act and new restrictions proposed by the Treasury. These developments could move some investors from shelters to municipal bonds.
If yields on new issues do go up, this would lower the value of existing bonds. This is where the mutual fund managers feel they have an advantage: If prices do take a serious nose dive, the funds can move part of their assets into short-term issues, including tax-free money market securities, to minimize erosion of capital. They can also take cautious positions in lower-rated or unrated munis to maintain yields, something most of them do to varying degrees anyway.
Bond funds are also available to more investors, since most funds have a $1,000 minimum initial investment. If you want to invest in single issues, you'll run up against brokers' minimums for accounts, typically $5,000 or more. Moreover, that $5,000 does not provide as much diversification as the $1,000 put in a fund.
Another lure offered by bond funds is the ability to save on state as well as federal taxes. Companies that offer double tax-free funds for investors in states with heavy tax burdens include Fidelity, Dreyfus, Scudder, Prudential-Bache Securities, Massachusetts Financial Services, and J. W. Seligman & Co. Among these funds, you can find tax relief if you are a resident of Arizona, Georgia, Maryland, Massachusetts, Michigan, Minnesota, New York, North Carolina, Ohio, Oregon, South Carolina, Virginia, or West Virginia.
Finally, one of the latest wrinkles in muni bond funds is the insured fund. By buying only bonds insured by one of the major bond insurance companies, these funds can to offer additional security to investors concerned about a repetition of such problems as the default of Washington Public Power Supply System bonds in 1983. The Vanguard Insured Long-Term Portfolio, introduced early last year, accounted for about one-quarter of Vanguard's tax-free fund sales in the third quarter of last year, says William Hostler, Vanguard's marketing director.