As tax shelters go atumble, tax-free municipals stand firm

The Congressional Wrecking Company has done its job. Almost everything that once called itself a tax shelter is now a pile of rubble. But poking up through the cloud of dust created by the Tax Reform Act of 1986 is the old reliable municipal bond, now one of the few legitimate ways to generate tax-free income.

For several months, worries about what Congress might do to municipal bonds pushed up muni yields to nearly record heights, compared with taxable investments like corporate bonds. Concerned that Congress would severely restrict the types of tax-free bonds they could issue or that future bonds might be partially taxed, states and cities have been issuing a flood of new bonds to beat any deadline.

Before Congress got working on tax reform in earnest, muni yields were about 75 percent of the return on corporate bonds. Now, they're closer to 90 percent.

Well, the outcome wasn't as bad as the muni-watchers feared, and investors should be able to find some good deals in the mini marketplace. While most analysts think munis will come down a bit, yields are not expected to go much lower than 80 percent of the rate paid for good corporate bonds.

``There was so much controversy during that period,'' recalls Ann Detmer, product manager of Fidelity Investments' Tax Free Fund. ``People weren't too eager to buy. They weren't sure what they'd be like after tax reform.''

Since Congress passed the tax bill, however, ``the market has been reacting and values have gone up.'' Thus, while yields have slipped a bit, bond prices, which move in the opposite direction to yields, have edged up.

While Congress did make some changes, one thing has not changed: Basic, public-purpose municipal bonds will remain free of federal taxes, and probably free of state taxes if you live in the state where they were issued.

One of the things Congress did change affects bonds issued after Aug. 8 of this year. The government refers to some municipal bonds as ``non-governmental.'' While they are issued by local governments, the money is used for purposes that are not strictly governmental, that is, the final product may not be available to all residents. This might include an industrial park, subsidies for builders of low-income housing, or an airport terminal.

Income from these bonds will be taxable only to individuals subject to the alternative minimum tax, explains John Sebastian, executive vice-president of Clayton Brown & Associates, a bond broker.

Generally, the only people who have to worry about the alternative minimum tax (AMT) are in upper-income levels and have other sources of ``preference'' income, such as accelerated depreciation from limited partnerships, or who have donated property that has increased in value.

For everyone else, Mr. Sebastian says, these bonds, already being called AMT bonds or ``taxable municipals,'' represent ``a good value. They produce a yield higher than other municipals; as much as half a point more.''

Because some upper-income investors can't use these bonds, cities and states have had to offer higher yields to get others to invest, he says.

``Very few people really are subject to the AMT,'' Sebastian notes, and they will not have any problem investing in these bonds.

Even though rates on municipals are fairly high relative to taxable investments, many people still shy away from them. They recall when munis paid much more, notes Gerald Guild, manager of fixed-income investments at Advest Inc., a brokerage.

``It's hard to buy something yielding 8 percent today when you could have gotten 13 percent two years ago,'' he says. ``But you have to look at history.''

``People forget that in the fillip of the bond market of '81 through '84 we had long-term bond yields up to 15 percent. But until 1976 we had never seen the US government pay more than 8 percent since the Civil War.''

Thus, Mr. Guild says, while muni yields may go up again -- a little bit -- they aren't apt to go up enough to greatly disappoint anyone who buys now.

For investors who don't have enough money for a diversified bond portfolio, the answers are either a municipal bond mutual fund or a unit trust. A unit trust is a fixed portfolio of bonds that does not change until the bonds mature. It usually has a front-end sales charge but also a slightly higher yield; a unit trust is best for people who can hang in for the long term.

Returns on muni bond funds are smaller, and they can be eaten up by management fees, front-end or back-end loads, or hidden charges. So look for a fund with no loads or charges.

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