As tax shelters lose appeal, municipal bonds gain glamour

With the demise of so many tax shelters, old reliable municipal bonds are suddenly chic. It's not just the tax exemption but also extraordinarily high yields that are giving muni bonds their glamour.

Confusion over tax reform has muni yields just under those of Treasury securities. This is important, because munis trading as high as 7.5 percent are exempt from federal taxes; Treasuries yielding 7.75 percent are not. Put another way, you'd have to earn 10.4 percent on a taxable investment to get the same kind of return you would with a muni if you're in the new 28 percent bracket.

Muni and Treasury yields usually are not so close. Tax-exempts traditionally pay 65 to 75 percent of Treasuries, not the 80 to 102 percent that exists today.

That won't be true much longer. The Public Securities Association, the trade group for muni bonds, says volume will be cut in half next year. Continued demand with shrinking supply will force prices up and yields down. ``Municipal bonds are undervalued compared to other investments,'' says Steven Hueglin, director of research at the municipal bond house of Gabriele, Hueglin & Cashman in New York. ``In the next two years I think munis will outperform stocks 2 to 1.''

Some municipals will fare better than others. Under tax reform, interest on munis to pay for private activities such as airports and housing will, with a few exceptions, be added to the investor's income to determine whether an investor is subject to the alternative minimum tax (AMT). These bonds will yield a quarter to a half of 1 percent more than fully tax-exempt bonds, predicts Sylvan Feldstein, vice-president and manager of municipal bond research at Merrill Lynch & Co. Only the wealthiest of investors will run across the AMT, so the majority of bondholders can buy private activity bonds and earn an extra half point in yield.

If you're not sure which category you're in, you may want to buy bonds issued before Aug. 7, 1986. These bonds are grandfathered, but you'll pay a little more than you would with a new issue. When you buy older bonds, focus on the yield-to-call, which is the best indicator of the bond's worth.

Tax reform adds a new twist with the debut of taxable municipals. Congress wiped out tax exemption for nongovernmental projects, including sports stadiums, convention centers, and parking facilities.

Taxable munis are expected to yield 1.5 to 2 percent more than Treasuries. That's not enough for the individual investor, says George Friedlander, head of municipal bond research at the New York brokerage of Smith Barney, Harris, Upham & Co. He says taxable yields are high enough only for investors who don't pay the full federal tax, like pension funds and overseas investors.

Taxables also have no real track record. ``The pre-reform investor bought a muni bond, not because he loved the sewer, but because the interest was tax exempt,'' says Dennis Holt, spokesman for the Public Securities Association. ``With taxable municipals, the investor is going to have to look at that sewer like he would DuPont, as if he were buying their stock.''

That might be difficult. Taxables aren't registered with the Securities and Exchange Commission, so there's precious little with which to judge a project. ``There's nothing to look at but a rating,'' Mr. Holt says.

Ratings are important whether the bond is taxable, tax exempt, or private activity. Moody's Investors Service and Standard & Poor's issue the rankings, and most advisers never recommend anything lower than A.

To protect against default, you may want to consider an insured bond. For just a quarter of a point in yield, the bond's rating jumps to AAA. A top rating will make the bond easier to sell later.

For more insurance, buy bonds in different sectors. That way your portfolio is diverse enough to earn a decent return. Most advisers recommend buying at least five bonds. Since munis are sold in minimum denominations of $5,000, you'll need at least $25,000. If you don't have that kind of money, or you simply prefer professional management over your own, you might want to consider mutual funds or unit trusts. Taxpayers in the 15 percent bracket are better off buying corporate bonds or some other investment, because at their level, tax savings from munis are minuscule.

If you buy muni bonds, think about how long you want to go out, that is, when you want the bonds to mature. Graydon Calder, president of Financial Planning Consultants in San Diego, advises staying within 10-year maturities to keep from getting locked into a lower rate should interest rates climb.

``If interest rates turn up, at least you can see the light at the end of the tunnel,'' Mr. Calder says. Of course, the longer you go out the higher your reward. Thirty-year munis are yielding almost as much as comparable Treasuries.

Falling interest rates have made muni bonds issued in recent years very attractive. Many are now trading at premiums at or above par. If you've watched your bond climb, you may be tempted to sell before the end of the year and pay this year's lower capital gains tax.

``If you have a security which you would sell in the next three to four years and the gain is at least 20 percent, it may pay to sell now,'' says Mr. Hueglin. With lower rates, it would take more than four years to earn back the difference between today's tax rate and next year's.

Capital gains are also an issue with bonds purchased at deep discounts that have since risen in value. If your increase is more than 10 percent, and the bond's life expectancy is less than 10 years, you should consider selling.

If you have no intentions to sell, and the bond's maturity date is in the distant future, most advisers recommend a hold strategy. That way, when the bond reaches maturity the only income you've earned is above-market interest, which is tax exempt. Says Mr. Friedlander: ``If you sell, you've created a capital gains tax you wouldn't have otherwise paid.''