Are muni bonds still a safe tax haven? - economic factors for planning investments in municipal bonds

Black Enterprise, June, 1994

No tax-free investment has been more alluring during the 1990s than municipal bonds (munis). Last year, with higher Federal taxes (top rate 39.6%), investors by the droves were drawn to municipal bonds.

And why not? Consider this: Anyone in the 36% bracket can earn the same after-tax income from an AA-rated, tax-free bond yielding 5.5% as from a taxable security yielding 8.57%.

You reap even greater tax benefits if you live in the state issuing the bond. For example, for a New Jersey resident (7% maximum state tax rate) who is a 39.6% taxpayer, the taxable yield of a 5.5% muni bond would equal 9.79%.

Last year, muni bonds were called or refunded by the scores. What happened? Investors tried to take advantage of low interest rates. But bond prices rise when rates fall and vice versa.

How has all of this affected mutual funds with muni bond holdings? "This was a record year for muni bond funds because of pre-refunding, with billions flowing into new issues," says Robert W. Tracinski, analyst with Chicago-based Morningstar Inc. But as the surge in muni demand continues, supply will trail off.

That could trigger a higher number of munis being called by year-end. In fact, analysts project more than $175 billion in muni bonds will be called or retired through 1996, unless rates rise dramatically.

But what muni investors really ought to focus on is maturities. "The shorter the maturity, the less volatile the bond," says Pierre Dunagan, account executive, Dean Witter Reynolds, Matteson, Ill.

Look for intermediate term funds (seven to 10-year maturity dates), he says. While these funds may not offer high-powered returns, they do boast competitive yields and less interest-rate sensitivity. Funds with long-term maturities could suffer if rates go up.

Skittish investors have every right to question the credit quality of munis--less than 50% are rated at least single A or better. Check such sources as Standard & Poor's and Moody's Bond Survey. Also, survey the issuing municipality. The local paper or comptroller's office can provide a diagnosis of the city's financial health.