Muni Bonds Are in Bloom

Returns are up, but few investors have noticed

Muni bonds have been staging a comeback performance to an empty house. In its best showing since 1992, an 11.5% one-year total return for general muni debt by far outshines a faltering equities market and most other investments, too. Nonetheless, investors hauled $14.4 billion out of muni bond mutual funds last year.

Now, as the news of their performance has filtered out, flows have begun to reverse--but only slightly. About $1 billion headed into the muni bond fund sector in January, 2001, still a mere "trickle," in this $270 billion muni fund market says Robert R. Pariseau, portfolio manager of $3.3 billion in munis for USAA in San Antonio, Tex. "One of the big questions is whether investors will show up in force," says Pariseau. "Considering how well the sector has performed, it hasn't exactly been a feeding frenzy."

TAX-FREE TICKET. Investors may be missing out on a good meal ticket. With the stock market still reeling and corporate credit quality deteriorating, municipal bonds are in a good position to repeat last year's stellar turnout. Municipal bonds--which pay for such things as bridges, roads, schools, and commercial projects--are free of federal tax and often from state and local tax in their state of issuance. Because of the tax exemption, they yield less than Treasuries. In the past two months, that gap narrowed to 0.68 percentage points from 1.06 points, making munis a real buy.

Sure, some skeptics are voicing concerns. A flood of new municipal issues this year could depress prices. The economic slowdown could ultimately pinch some municipal budgets. And President Bush's $1.6 trillion tax proposal could cut marginal tax rates and therefore reduce the edge munis have over taxable bonds. Still, these worries are probably overdone, and to the extent that they are real, they've likely been discounted in the muni bond prices already.

Here's how munis work their magic: A first-rate general obligation muni with a 10-year maturity and a current yield of 4.45% translates to a tax-equivalent yield of 7.37% for those in the 39.6% bracket (even more if it's a bond in a taxpayer's state of residence). That compares with a taxable 6.15% yield on a generic investment-grade corporate, and a 4.89% 10-year Treasury yield. And investors don't have to be in the top tax bracket to reap rewards, either. A AAA, 30-year municipal bond insured by Financial Guarantee Insurance Co.--say, Atlanta's Water & Wastewater Revenue or Jefferson County (Ala.) Sewer Revenue bonds--trades at a taxable equivalent yield of 7.32% for investors in the 28% bracket. Says Timothy M. Heaney, a portfolio manager of $1.6 billion in muni assets for Phoenix Investment Partners, "You'd have to buy a bond of below investment grade to yield that on an aftertax basis."

Roughly $40 billion in new muni bonds have already come to market through the end of February. Add to that a "monstrous" calendar of new issues slated through midyear--higher than the past two years, reports George D. Friedlander, a fixed-income strategist at Salomon Smith Barney. Friedlander's take is that more issues means better product at higher yields relative to taxable bonds. Colleen Woodell, a Standard & Poor's director in public finance, adds that even when supplies rise, defaults are a historical rarity. "You can count the defaults since 1985 on one hand," Woodell says. In fact, S&P's upgrades have exceeded downgrades for the past 19 quarters.

The unforeseen can happen. It's true that Heartland Funds made headlines last October when two high-yield, or "junk," muni funds lost 70% of their value overnight. Managers had found on re-evaluation, that almost half the funds' holdings were either in or near default status. The Milwaukee firm now faces a class-action lawsuit and a Securities & Exchange Commission review. Says USAA's Parsineau: "It pays to have a higher-quality portfolio and to be well diversified." Consider Olympia, Wash., where the earthquake will likely affect bondholders there. Last year a 13.06% gain ranked the state's single-state muni funds No. 1.

The impact of President Bush's new tax plan on munis could be problematic. Right now, for people in the highest tax bracket--39.6%--munis are attractive because even though the alternative minimum tax kicks in, that rate is a much lower 28%. Bush's proposal would reduce the top bracket to 33%, narrowing the AMT gap. Muni bonds would then be less competitive relative to taxable alternatives, he says. The good news, Friedlander points out, is that the Bush plan, if it's passed, will take six years to phase in. He adds, there's no question that the AMT will be "fixed."

In the end, municipal bonds are designed mainly to provide income and stability. In today's troubled markets, those are the investments most likely suited to steal the show.

By Mara Der Hovanesian

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