Municipal Bonds Win Attention as Short-Term Rates Fall

NORMAN LIND - who manages the Spartan Municipal Income Portfolio in Boston - got some unexpected help late last week when the Federal Reserve Board slashed its key discount rate from 3.5 percent to 3 percent. Fixed-income investors eager to maximize returns are now likely to focus on long-term bonds more than ever, given the decline in short-term rates.

Bond prices shot up immediately after the Fed's announcement Thursday. For instance, 30-year Treasury bonds rose $14.06 on $1,000 of value.

Mr. Lind says that with low inflation and relatively low rates of return on competing investments such as money market accounts, bank certificates of deposit, and stocks, "long bonds look like a very reasonable buy."

But that's not the only reason for the widespread perception here that municipal bonds should do well in the months ahead: Throughout the United States, many states and municipalities are struggling to reduce budget deficits. Many states are either turning to higher taxes or are expected to do so. That trend should make tax-exempt municipal bonds more attractive, experts say.

Moreover, some $6 billion to $10 billion worth of municipal bonds either came to maturity or were called for redemption on July 1; another $5 billion to $7 billion worth of bonds may be called for redemption by the end of September. And many of the proceeds from these redemptions are expected to be reinvested in new municipal bond issues.

Municipal bonds are issued by states, cities, counties, and other local government agencies. These investments are among the few tax shelters left for small investors, following Washington's closing of tax loopholes since the mid-1980s.

Roughly 75 percent of the $1.08 trillion in outstanding municipal bonds are now held by individual investors and mutual funds. Many bonds purchased in the early 1980s - when inflation was scooting along at a higher clip than now - had yields of 12 to 16 percent. Today, yields are running around 6 percent. The Spartan Municipal Income fund, for example, has a yield of 6.30 percent, Lind notes.

The problem for bondholders is that many government agencies are now exercising preset "call provisions" in their older issues - provisions that allow the bonds to be redeemed after 10 years at a specified price prior to their maturity date. But holders of the older issues purchased in 1982 or earlier must then figure out what to do with the proceeds from their redeemed bonds.

Lind says that most municipal bond investors will reinvest their cash into newer bonds. He suggests that investors who have held individual bonds in the past might consider the benefits of a bond fund. The Spartan fund he manages was started two years ago; it currently has assets of $840 million. Spartan is a member of the Fidelity family of mutual funds.

The Spartan Municipal Income Portfolio is a "national" fund, comprising bonds from municipal entities around the US. The average maturity on the bonds in the fund is 20 years. But Lind says that he is constantly buying and selling issues, which keeps the "effective" maturity at around 11 years.

Despite "sticker shock" - the realization by investors that yields on munibonds are about half where they were back in the early 1980s - municipal bond funds have been on somewhat of a roll. For the first five months of 1992, gross sales of munibond mutual funds, including reinvested dividends, reached $21 billion, compared with gross sales of $15 billion in the same period in 1991.

Total assets in municipal bond funds reached $168 billion at the end of May, compared with $133 billion for the same period in 1991, says John Collins, a spokesman for the Investment Company Institute, the main trade organization for the mutual fund industry, in Washington.

Most municipal bonds are not taxed by the federal government. Most states levy no taxes on municipal issues sold to residents of their own states, although interest on bonds purchased from other states may be subject to taxes.