What's Christmas Without...Muni Bonds?

Amid all your other holiday shopping excursions, you might want to visit the municipal-bond market. While munis might not currently be on your list, there are several reasons why they should be. First, to offset any hefty stock gains and reduce your taxes, you might consider selling some money-losing munis and reinvesting the proceeds in different bonds. Second, if you are trying to stick to an asset-allocation formula, buying munis can help you rebalance the fixed-income portion of your investment portfolio, which is now probably out of whack, because of the booming equity market. Finally, the end of the year can simply be an opportune time to find good, cheap issues.

Munis already in a portfolio can come in handy for investors concerned about high capital-gains tax liabilities on their stocks. A strategy called tax swapping would allow you to unload a municipal bond that has declined in price and use the loss to offset your equity gains, thereby softening your tax bite.

NET OUT. Say you bought a municipal bond at par five years ago, and it's now trading at 95. On a $10,000 investment, that's a $500 loss. At the same time, you have at least a $500 gain on a stock and want to sell while prices remain high--a prudent move. The $500 loss and equivalent gain net out each other to result in no tax consequences. One caveat: All tax swaps must be executed by Dec. 31--but the trade doesn't have to clear by then. Call a number of brokers to get the best sales price on your bonds. Bids will be close, but sometimes you can get a half point better: On $100,000, that's $500 in your pocket--not your broker's.

Now that you've sold one of your muni bonds, you'll need to buy at least another one to maintain the fixed-income portion of your portfolio and your asset-allocation mix. The end of the year is the right time to rebalance your investments. "The volume and availability is strong in the secondary muni-bond market because of tax swapping," says Scott Rykert of Stoever Glass, muni-bond traders in New York.

Some bond-market watchers expect a rally early next year because many munis issued in the 1980s come due on Jan. 1, 1997, and investors need to buy new bonds to replace the old ones. What's more, "municipals didn't share in the Treasury rally of this past year, and assuming a continued low-interest-rate environment, there will be a strong demand for munis next year," predicts Neil Budnick, director of public finance at MBIA Insurance.

While the municipal-bond supply is growing moderately, at a 3% to 5% annual pace, demand is robust and is outpacing supply. In a recent MBIA survey, 61% of the muni brokers questioned said they would sell more municipal bonds if the supply were available. Of course, issuers will benefit because rates will fall, but buyers will pay higher prices for less yield. So it's best to lock in the higher yield now and happily watch as the bonds are likely to become pricier.

Even for the basic investor who has no tax maneuvering to do, "it's a good time to buy municipal bonds because they're cheap compared with other fixed-income investments such as preferred stock or other taxable paper," says John Hallacy, director of municipal-bond research at Merrill Lynch. Yields on AAA 30-year munis are about 5.4%, or currently about 84% of the yields on taxable Treasury securities.

The yield is lower for shorter maturities. For instance, an AAA 15-year muni yields about 5.11%, or 80% of Treasuries. For people with a marginal tax rate of 39.6%, that's the taxable equivalent of an 8.46% 15-year bond. In today's low-inflation environment, the real, tax-adjusted return is still a strong 2.10%. In addition, "it's getting harder and harder to find good yield with low risk," says George Friedlander, a fixed-income strategist at Smith Barney, "especially when you consider the Standard & Poor's 500-stock index is yielding 2%, the lowest ever."

TEXAS TAXES. Municipal-bond returns may look skimpy compared with those on stocks, but you may find comfort in a recent study by Chicago's John Nuveen & Co., the largest specialist in municipal bonds. It shows that for an aftertax, inflation-adjusted portfolio over the past 20 years, municipals performed second only to equities, according to Paul Williams, vice-president and manager of investment strategies and research at Nuveen. Equities had an average aftertax, inflation-adjusted return of 5.02% over 20 years of dollar-cost averaging. Municipals' 2.88% return beat out corporates' 0.84%, Treasury bonds' 0.37%, and Treasury bills' -1.30%. While the stock market's higher returns may be a lure, diversification is imperative in any investment portfolio, and municipal bonds can provide that variety.

As bad as the supply-and-demand imbalance is now, many expect the situation to worsen after the New Year. That makes now a better time to be looking. Jim Lynch, editor of the Lynch Municipal Bond Advisory newsletter, recommends bonds from the income-tax-free states of Texas and Washington if you're trying to diversify your muni portfolio outside your home state. Munis from high-income-tax states such as California and Minnesota sell at a premium, with lower yields than bonds from income-tax-free states.

Other locales to consider: New York and Florida, where the supply is heavier--and yields may be higher--than in other states. "Major refunding issues are expected for New York City, so it could give you unusual values later this month or early next year," says Bob Chamberlin, the director of municipal research at Dean Witter Reynolds.

Puerto Rico issues provide good value because they are double-exempt in all states, but you should be willing to do extra research associated with investing in a U.S. commonwealth. While it's always wise to buy bonds from your home state--because they're exempt from taxes--you'll still want to buy out-of-state issues to broaden your portfolio.

Lynch urges investors to avoid hospital revenue bonds because of the industry turmoil, and certificates of participation, which are non-voter-approved financings. Also pass up electric revenue bonds: That fast-changing industry is subject to more credit volatility.

Before you go out on a muni-bond buying spree, consider a few tips. Stick with AAA-rated issues or even safer "prerefunded" or "escrowed to maturity" bonds that are backed by Treasuries to avoid worrying about credit risk. Prerefunded bonds often trade above par, but the higher yield should help make up for the loss of principal when the bond is called or comes due.

CAVEAT EMPTOR. It's best to buy bonds with different maturities for diversity. And if you need liquidity, then a municipal-bond mutual fund might be more appropriate. Make sure there are no hidden call provisions in an individual bond, and check to see if the bond might figure into the alternative minimum tax. In the next year, more municipal bonds are expected to be subject to this tax, where the tax-exempt interest is added back to your adjusted gross income. Definitely take time to comparison-shop. You will usually get better prices from a bond dealer than from a stockbroker. It should be possible to keep the commission to 2% or under.

Of course, it's a lot more fun to spend your days shopping for holiday presents than municipal bonds. Nevertheless, you'll enjoy the gift of lower taxes and a balanced portfolio well into the New Year with a good municipal-bond strategy.

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