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What, municipal bond funds with no state or federal taxes?

In 1985 and '86, the ``hot'' mutual fund money was traveling overseas. As foreign stock markets boomed, international funds made record gains and attracted record numbers of new shareholders. In 1987, the ``hot'' money may come back to the United States, but not all of it to the stock market. Instead, much of the cash may be diverted to municipal bond funds.

``If it's not the hottest, it's one of the hottest areas in new funds,'' says Burt Berry, publisher of No Load Fund*X, a San Francisco newsletter. ``A lot of it has to be due to changes in the tax laws.''

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Before tax reform, municipal bond funds appealed to people who wanted to cut their federal tax bills. If these people lived in a state with a high income tax, they could cut the state bill as well, by investing in ``single state'' funds that bought bonds from their home state.

Now that tax reform promises to cut federal taxes for many people, more investors are looking for ways to cut their state taxes, and the mutual fund industry is scrambling to accommodate them.

Single-state funds are available in more than 20 states. California alone has nearly 30 such funds, followed by New York, Massachusetts, Ohio, and Michigan. There are even some triple tax-free funds for residents of New York City.

Double tax-free funds are also available to residents of Arizona, Colorado, Georgia, Hawaii, Indiana, Kentucky, Louisiana, Maryland, Minnesota, North Carolina, Ohio, Oregon, Pennsylvania, South Carolina, Texas, Virginia, and West Virginia.

These investments are available from companies offering load and no-load products, including the Delaware Group, Dreyfus, Fidelity Investments, Vanguard, Benham Capital Management, IDS Financial Services, Colonial Investment Management, and Putnam Financial Services.

The next issue of Mr. Berry's newsletter will have 50 new funds, he reports, ``and a lot of them are going to be single-state tax-exempts.''

In many of these states, tax reform will increase the the local tax burden for some people. Because the state tax bill is often based on income after federally allowed deductions, fewer federal deductions will mean a higher adjusted income and, thus, a higher state income tax.

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At the same time, a lower federal tax rate, without a corresponding cut in state income tax rates, will mean that a greater percentage of the total tax dollar will go to the states. These changes, fund managers say, combined with the unusually high returns now offered by municipal bond funds, makes them much more attractive.

``In California, we have an 11 percent top income tax,'' Berry says. ``With the top federal rate coming down from 50 to 28 percent, 11 percent sounds much more severe.''

Actually, it is more severe. Under the old tax law, a Californian paying the top state tax of 11 percent and the top federal rate of 50 percent had a total tax burden of 61 percent. The state tax represented 18 percent of the total.

But with a federal tax rate of 28 percent, the total federal-state tax burden becomes 39 percent, if that 11 percent California rate is not changed. Thus the state tax bite will account for 28.2 percent of the total.

``Basically they're a good value,'' Sheldon Jacobs, editor of the No Load Fund Investor, says of double tax-free funds. ``But if your state tax is not that high, you'll have to consider whether to go with a single state vs. a general muni bond fund.'' Yields on general municipal bond funds, which invest in municipal securities from all over the country, are about 1 percent higher than for single-state funds, Mr. Jacobs says.

Also, when the top tax rate goes down to 28 percent, tax-free investments may not pay as great an after-tax yield as taxable securities. With a mutual fund, however, you can get in now, take as much advantage of current tax law as possible, then get out easily if the new tax law makes another strategy better for you.

``The guy that is just looking to buy a couple thousand dollars' worth is going to get beaten to death when he wants to sell'' straight municipal bonds, Berry says.

Tax-free muni funds may also start appealing to people who once looked for tax savings through tax shelters, many of which have been sharply curtailed in recent years, and all but completely eliminated by tax reform.

``So many other types of shelters are being eliminated, muni bonds are going to be one of the few options available,'' observes Craig Cunningham, product manager of state tax-free funds at Fidelity Investments in Boston. The company now has double tax-free funds in eight states and plans to announce several more in the near future, he said.

New money has been flowing into these funds so fast, Mr. Cunningham says, that their net asset values (NAV), or share prices, have risen 2 or 3 percent in just the last few weeks. As more money comes into the funds, it has to be invested, which means more competition for the available pool of municipal bonds. This pushes up the price of those bonds and, consequently, the funds' net asset values.

Meanwhile, as bond prices and NAVs increase, yields on the bonds and the funds declines. After paying about 8 percent earlier this year, yields on single-state muni funds are in the neighborhood of 6.4 to 6.9 percent.

Yields may decline further as more money comes in and - after tax reform takes effect - there are fewer bonds available. The tax bill narrowed the definition of the type of bond that can be considered tax free, which could mean a 25 percent reduction in the supply, municipal bonds experts say. This could bring the after-tax return on municipal bonds closer to taxable Treasury bills and corporate debt issues.

But as more people discover the relative increase in their state tax burden, muni bond funds, with their low minimum investment and easy access to money, will continue to attract investors and savers.

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