Municipal bond funds: a tax-free route to revenue
With stock prices often under water these days, some investors are looking for an escape hatch.
One could be municipal-bond mutual funds. More important for those currently suffering post-tax-day shock, these funds offer a tax-free investment.
"There might be some opportunity right now," says Robert MacIntosh, portfolio manager of 53 muni-bond funds for Eaton Vance Corp., a large Boston-based mutual fund group.
Municipal bonds are issued by states, municipalities, and other government bodies. Altogether, some 50,000 entities have issued bonds valued at about $1.3 trillion. The interest is free of federal taxes, and states generally exempt from state taxation those bonds issued by their own government, cities, or other authorities (say, a highway, port, or airport authority).
For two weeks or so, bonds - taxable corporate bonds as well as muni bonds - were hit hard by an assumption of some investors that the slump in the economy is about to end. Investors have been switching money back into stocks.
As a result, when stock prices rose recently, bond prices fell. In the case of Eaton Vance's muni-bond funds, their share prices backed up suddenly. Shareholders were still in the black for this year, but barely - perhaps up 3/10ths of a percentage point.
Then the Federal Reserve, in a surprise move between its regular policy meetings, cut short-term interest rates half a percentage point last Wednesday. Bond prices bounced back up some.
Nonetheless, Mr. MacIntosh, who is also Eaton Vance's chief economist, figures "the recession" isn't over. If so, that will be good for bonds. Interest rates will still come down and the value of outstanding bonds will rise.
"Municipal bonds will have a decent year," he predicts. They may provide an interest rate (or coupon yield) of 4.75 to 5 percent, plus a percentage point or two in rising share prices.
That won't match last year's return. Eaton Vance funds invested in longer-term muni bonds saw share prices rise in the "13 percent range" and funds invested in shorter-term bonds in the "9 percent range."
In 2000, the Lehman Muni Bond Index was up 13.3 percent, while the Standard & Poor's 500 Index was down 9.1 percent.
"Anytime you get a big shakeout in the investment world it's a good time to step back and look at your investment portfolio," advises Eric Jacobson, a senior analyst at Morningstar Inc., a Chicago firm that tracks mutual fund performance. Many investors will find they are underinvested in bonds, versus corporate stocks.
If so, tax-savvy investors should consider putting some money in municipal bonds. Currently, muni bonds offer a higher after-tax yield than Treasury bonds. That holds true for anyone paying federal income tax at a 15 percent rate or higher, says MacIntosh.
Many investors enjoyed as high as 30-percent, 40-percent returns on their stocks for a few years prior to 2000. "As a result, a lot of people have been ignoring municipals," he adds.
But for those making investments through a tax-sheltered vehicle, such as an Investment Retirement Account or a 401(k) plan, investment in a muni-bond fund makes no sense. They are better off invested in higher-yield corporate or Treasury bonds.
Those considering investing in munis have a lot of choice. Most major fund groups, such as Fidelity or Vanguard, offer a range of choices, including funds for investors in various specific states. Altogether there are more than 800 separate muni-bond funds.
Of course, investors can through a broker buy municipal bonds directly from the over-the-counter market. This avoids the sales charges or management fees levied by fund managers. But investors lose the diversified portfolio and the analysis of returns and risks of various muni-bond issues that MacIntosh and other fund managers carry out in selecting bonds.
Investors must also decide whether to purchase shares of muni-bond funds that have no sales fee (no load) and sold without a middleman, such as those offered by Fidelity or Vanguard, or through brokers, bank investment officers, or other financial advisers. The latter include Eaton Vance funds. They charge a sales fee, which goes toward rewarding the financial adviser who made the sale.
"You have to make a decision whether you are comfortable doing it yourself [buying a bond fund] or if you need help," says Mr. Jacobson. If the choice is a no-load fund, investors should educate themselves about municipal bonds and bond funds.
"For a lot of people, that's too much to handle," he adds. In that case, he advises sticking with big-name fund groups and making sure the load is modest. A typical up-front load might be 4 to 4.5 percent off the top of the money invested.
MacIntosh argues that it is wise for an investor to make use of a financial consultant to work out what is a proper allocation of an individual investor's portfolio to muni-bond funds. For some, a short-term fund might be right; for others, a long-term fund. Or it could be a high-risk fund that buys muni bonds that are less secure but offer higher yields.
(c) Copyright 2001. The Christian Science Monitor