Municipal bonds for small investors

Schools, streetlights, and hydroelectric dams aren't paid for by community bake sales. Million-dollar public projects are financed by municipal bonds -- tax-free securities once bought mainly by banks, insurance companies, trust funds, and the rich.

In fact, one Wall Street wag labeled municipal bonds "welfare for the wealthy." But in 1976 Congress enacted legislation allowing mutual funds to invest in municipals and pass along the tax-exempt status to shareholders. Thus were born municipal bond funds have leaped from obscurity to over $3 billion in assets today. But the future no longer glints with promise; like other investments involving long-term commitments of money, the outlook for performance of munifunds is uncertain.

In 1980 America's 42 municipal bond funds sold $1.78 billion in shares, 4.3 percent more than they did in 1979. But the growth took place early in the year: November sales were barely one-third of what they were in the same month a year before. The question is whether the stillness is the quiet space before a blue dawn or the calm before the proverbial storm.

It's a reflection of problems in the municipal bond market as a whole.

"We haven't seen much volume," says George Friedlander, a vice-president in municipal bond research at Smith Barney Harris Upham. He suspects that if the volume of trade in municipal bonds picks up, prices will drop. "It's a quetion as to how they can handle volume. I'm not too optimistic about it."

The rise of muni funds has coincided with shifts in the big picture of municipal bond trading. In the early 1970s commercial banks bought 95 percent of all new issues. By 1975, according to the Investment Company Institute, the banks were focusing their assets elsewhee and bought only 15 percent. Purchases by institutional investors stayed about the same, so bond funds arrived on the scene just as the "household" sector (individual investors) of the municipal market was booming. As a result, municipal fund officials say they're helping state and local governments as well as making tax-free cash for the little guy.

"We don't feel that institutions are in the market, and somebody has to buy them [municipal bonds]," says David Foster, a capital markets analyst at Salomon Brothers.

The strong demand over the past decade for business credit has drained assets banks once allotted to buying bonds.

"Their business is to make loans, not invest in bonds," says Frank P. Wendt, chairman of Bond Fund John Nuveen Inc. "Individuals take up the slack in the market."

Mr. Wendt adds that "we usually say an individual should be in a 30 per cent tax bracket to invest in municipal bonds."

Others think bonds funds aren't just for those privileged enough to be in a high tax bracket. "Not with our lovely tax system," argues Smith Barney's George Friedlander.

At year's end top-rated long-term municipals were paying up to 9.5 percent -- an attractive rate when the tax-free status is tacked on. With such enticement, why are bond fund sales so weak?

"The biggest problem with the household sector is that until there is some kind of easing in the inflation rate, people are going to be wary of going long, " says Mr. Friedlander.

He adds that he still thinks bond funds will "do quite well."

Other experts attribute reluctance to uncertainty about the municipalities, which issue the bonds. "Proposition 13" tax cuts and the unknown urban policy of President Reagan may make the next year a troubled time for city finances.

One category of fund still attracting money is the tax-free money fund (also known as "short-term investment fund"). These fund put their money in tax-exempt securities, some created by municipalities especially for this market , that mature relatively quickly.

Launched a year ago, the tax-free money funds have quickly become the Rolls-Royces of the mutual fund world. A good investment only for investors in at least a 50 percent tax bracket, the funds accounted for over one-third of all mutual fund sales in 1980 if other money market funds are excluded.