Investors who don't believe Bush's lips are snapping up muni bonds

George Bush has his audiences happily echoing one of the best-known lines from his stump speech. ``Read my lips. No new taxes.''

Now, if the vice-president would say ``no new revenues,'' he would have an instant effect on the municipal bond market. But the fact that most investors still believe that even Mr. Bush, if he becomes president, would have to find some way to increase revenues - whether or not he calls them taxes - has helped keep up the demand for tax-free investments, even in a year when there are fewer bonds to choose from.

But when any investment starts getting a lot of attention, some people forget the fundamentals. This year, the fundamentals for muni bonds are after-tax return and quality.

``One reason demand is so high this year when there is less supply is that people are discounting future tax increases,'' which means they expect higher tax, says Catherine Carter Lynch, executive vice-president of Lynch Municipal Bond Advisory in New York. ``We've got Congress talking about taxes, and to a thoughtful person it's pretty much a foregone conclusion. Something will happen.''

Tax-frees have also been in demand simply because there aren't as many of them available this year, a situation that will change before the year is over, says Terry Trim, a vice-president with Van Kampen Merritt Inc., a brokerage in Chicago.

``The fourth quarter tends to produce a higher level of new issues, which tends to drive prices down'' and yields up, he notes. Many government agencies hold off on new borrowing until near the end of the year; then they want to get their municipal projects started in a hurry, Mr. Trim explains.

A third reason municipal bond demand has been strong is the stock market. It is now one year since the plunge of Oct. 19, 1987, and many individual investors still don't want much to do with stocks, so they're staying with the relatively greater safety of high-quality municipal bonds. The yields may not be spectacular, but at about 7 percent and tax-free, they're not bad, and good enough for many skittish investors.

All this helps explain why municipal bond mutual funds have had the highest net sales of any fund category in 1988. Through the first eight months of the year, sales of equity funds added up to $20.1 billion, according to the Investment Company Institute, the mutual-fund trade group. But redemptions out of these funds came to $23 billion, for a net loss of nearly $3 billion, the ICI reports.

Municipal bond funds, meanwhile, reported sales of $8.1 billion with redemptions of just $5.6 billion. And single-state funds, where investors can get income free of both federal and state taxes, showed similar net gains with sales of $5.4 billion and redemptions of $2.9 billion.

The reason for this phenomenon can be summed up in two words: demand and supply. This year, while the prospect of future tax (or revenue) increases has helped increase the demand, a two-year-old tax law has helped decrease the supply.

The 1986 Tax Reform Act put new limits on the types of bonds cities and states could issue, so many of them rushed to get out as many bonds as they could before the law took effect on Jan. 1, 1987. In 1987, new municipal debt added up to $114 billion, down nearly $50 billion from the year before.

At the same time, the 1986 tax law took away many deductions and other means of cutting taxes, and put most potential muni bond buyers in the 28 percent tax bracket. That makes it a harder decision for investors looking for the best after-tax return. Depending on the yield from the bond - or the bond mutual fund - some investors in the 28 percent bracket will be better off in taxable securities.

To compare the after-tax return of tax-free and taxable investments, just divide the tax-free yield by .72 (1 minus 28 percent), if you are in the 28 percent bracket. So if the yield on a municipal bond or bond fund is 7 percent, divide 7 by .72 to find out that you would need a yield of 9.72 percent from a taxable investment to get an equivalent after-tax return.

But ``there are times when you have to be careful about comparing taxable and tax-free yields,'' Ms. Lynch says. ``Such as the time right now, when the income tax rate is likely to rise over the next few years.''

If you think you will be paying more federal or state taxes in coming years, you may be willing to accept a somewhat lower yield relative to taxable investments, because taxables may be hit harder as time goes on.

In any case, investment advisers say, this is no time to be making compromises on quality. Most advisers and fund managers are recommending bonds with at least an A or AA rating from Moody's and Standard & Poor's. With a higher rating, you may be getting less yield but not receiving that much more security in return.

These advisers are recommending nonnuclear electric utilities, turnpikes, and better-quality state housing finance agencies as three preferred sources of tax-free bonds.

``If you can get straight, general-obligation, high-quality debt or bonds that have US government bonds placed in escrow for security, those are very good, straightforward securities,'' Lynch says.

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