Can "munis" give you more bang for a buck? - tax-exempt municipal bonds

Nation's Business, Feb, 1988 by Ray Brady

Can "Munis" Give You More Bang For A Buck?

If you haven't yet seen your accountant to talk about your 1987 tax return, you probably think you're going to come away from the meeting with a smile on your face.

After all, for months now we've been hearing about the benefits that would flow to all of us from tax reform-- benefits we would start to see as we made out our 1987 returns. And it's true that tax rates are down; for 1987 returns, the top rate is 38.5 percent, and this year the rate on the highest incomes will drop to 28 percent.

But when you come out of your account's office, you may have learned that for many of us--including, lamentably, this writer--rates may be down, but taxes are up.

That is because so many deductions have been done away with. Especially for taxpayers with higher incomes, that's going to mean paying out even more to Uncle Sam.

As one example, if you have been paying large amounts in consumer interest --formerly 100 percent deductible --you must get used to the idea of deducting only 65 percent of your interest costs on your 1987 return. And any interest you pay this year when you buy cars and similar consumer items will be only 40 percent deductible on your 1988 return.

Which brings us to a homey old investment that is now suffering from a bad name: tax-exempt bonds.

These are the bonds issued by states and municipalities to raise money to build schools, roads, sewers, water facilities and other kinds of public works. Under a 19th-century Supreme Court decision, the federal government is barred from taxing such obligations of states and municipalities; and since those entities don't tax their own obligations (though states can, and do, tax bonds issued by other states), the investor who judiciously selects a bond issue can get himself an investment that is absolutely free of federal or state income taxes.

If you are fortunate enough to have an income high enough to put you in the 28 percent tax bracket this year, a 6 percent tax-free return on your money is the same as getting slightly over 8 percent from an investment that is fully taxed. If you live in a high-tax state like New York, California, Minnesota or Iowa, the return from the tax-free bond is even more attractive.

But what about the bad name that municipals have gotten?

There's no denying that these have been bad times for municipal bonds and some of their owners. Last spring, many holders got bloodied when municipal bond prices fell almost 13 points. That meant you lost nearly $650 on every $5,000 face value of debt--a scary drop on an investment that's supposed to be relatively safe.

Since then, municipal bonds' reputation has fallen on even more evil times. Tax reform's lower rates reduced the investor's incentive to buy the bonds, and the Tax Reform Act also diminished the authority of many municipalities to issue them. The tax law did away with some tax breaks that prompted banks and insurance companies to buy, thus keeping the markets stable.

There has been a continuing federal investigation into possibly fraudulent bond sales, and when Wall Street started its current round of layoffs, many firms slashed their municipal-bond departments. All these developments have made the municipal-bond market a far more volatile place than it was in the past.

So why buy at all?

As one unsung genius put it about investing: "Buy 'em when nobody wants 'em." That's certainly true about municipal bonds. As a result of the lack of buyer interest in them, the investor can find general-obligation "munis," with a solid AA rating, returning 6.6 percent tax-free. That's for a 10-year bond, and it's not bad when you consider that a U.S. government bond for the same price now yields an average--and wholly taxable--8.1 percent.

The municipal bond market is, however, a far more sophisticated place than it used to be. You must check an issue carefully, or have a broker who can do so. You must make sure, for example, that a bond issue did not accidentally violate the intricate new restrictions in the tax law. (Offerings that don't meet those standards could become taxable, retroactively.)

Certain purchasers of bonds could be subject for the first time to the alternative minimum tax. So check that out, too.

If all this seems like a lot of work, it may be worthwhile to keep one thing in mind: Many economists feel that, no matter who wins the White House this year, one early act of the new President may be to seek higher tax rates, in an effort to cut the budget deficit.

If that happens, "munis" could look very attractive to many investors.

Photo: When states and cities sell bonds to finance projects such as road and sewer construction, the interest on those bonds cannot be taxed by the federal government. Even so, tax-exempt bonds are not enjoying investors' favor.