Munis: A Strong Market, Just As Long As...

Think it'll be a good year for municipal bonds? There are a stack of reasons to say yes: Limited supply should drive prices upward, high yields should lure buyers, and strong state finances should protect bond payments.

But tread carefully. Also in the mix is the possible elimination of munis' tax advantage, federal spending reductions that could hurt states and localities, and local resistance to higher taxes that could be used to back bonds. There is also the chance that the economy could weaken, damaging municipal credit quality. "The municipal market is on firm ground--as long as the outlook for inflation and the economy stays in the range it's in," says Paul C. Williams, vice-president and manager of investment strategies and research at John Nuveen & Co.

SCARCE COMMODITY. As in 1995, the supply of new municipal bonds will be limited. Experts expect $155 billion or less in new long-term issues--about the same as the roughly $150 billion issued during 1995. Those new issues will be more than offset by the bonds that will mature during 1996--some $150 billion to $175 billion, Williams says. Scarce supply could drive muni prices higher. Already, says James J. Cooner, senior vice-president and manager of tax-exempt bonds for Bank of New York, "anybody who's in the market every day buying bonds would appreciate that it is getting harder to buy particular types of bonds at the right price."

The relative health of state and municipal finances also helps. The National Governors' Assn. says that states' fiscal condition is better now than it has been since the late 1980s. And yields on muni bonds are extremely high relative to those offered by Treasuries. Yields on long-term munis are approaching 90% of those on Treasuries. That means the aftertax yields on munis are as much as 30% higher for investors in high-tax states.

Yet all these positives could be overshadowed by a major potential problem: the flat tax. The prospect of a fundamental reshaping of the tax system that would eliminate munis' tax advantage has kept muni returns below those on taxable bonds in 1995. And a federal commission that is studying tax-law changes is expected to recommend a flat-tax system in 1996. Some say major tax reform is unlikely in an election year. But worries about a possible change could continue to depress muni prices.

Reductions in federal spending are also worrisome. The cuts could hurt states and localities--and taxpayer resistance to higher local taxes would make things worse. "My real concern is...expenses will get bucked down to states and municipalities, and then we'll have an economic slowdown," says Richard J. Moynihan, who oversees Dreyfus Corp.'s $27 billion in tax-exempt funds. "Those municipalities are going to have to pay the piper at that point."

For those willing to wade into this market, it's best to play it safe. Experts recommend revenue bonds, particularly from states such as California and Texas, where the economies are improving. For New Yorkers, Christopher M. Dillon, a vice-president in municipal market strategy at J.P. Morgan & Co., points out that many bonds from that state are scheduled to be issued in December. That could cause a dip in prices.

MANY RISKS. As for types of bonds, Bank of New York's Cooner recommends munis that are issued to finance water and sewer projects. Such essential projects are more likely to continue to be funded even during a fiscal crisis. Nuveen's Williams likes transportation bonds, noting that a number of major airport bonds, including those for the Denver airport, have been upgraded.

Whether to buy insured bonds or bonds that earn high ratings on their own merit is a matter of some debate. Bank of New York's Cooner says some AAA-rated insured bonds now offer higher yields than some uninsured AA-rated bonds, and investors should take advantage of that. But Dreyfus' Moynihan says insured bonds may be less liquid, and therefore harder to sell.

That's just one risk among many for the muni market in 1996, which is likely to be unusually fraught with both good and bad news. It will be a year to keep an especially close eye on your portfolio--and on Washington.

Before it's here, it's on the Bloomberg Terminal.