Originally created 06/27/99

Many choices abound with municipal funds

NEW YORK -- Whenever they get into a wrestling match with the tax rules covering mutual funds, the thought strikes some investors that the time has come to consider municipal bond funds.

Munis once were regarded as the province of the wealthy few. But in today's economy, they have a much broader appeal to anyone interested in the tax-free income these bonds provide.

At a time when municipal yields run above 90 percent of what you can get on taxable U.S. government bonds, they can make sense for anyone among the millions of middle- to upper-middle-income investors faced with a marginal federal income tax rate of 28 percent or more.

But the decision isn't as simple as the basic math may make it appear. Once you have decided that a packaged muni investment fits your needs, you still must determine whether an open-ended muni fund will work better for you than a closed-end muni fund, with a fixed number of shares traded in the secondary market, or a muni unit trust sold by one of several brokerage firms.

Got it narrowed down to open-ended funds? Then you need only pick one or two of them from a field of more than 1,800 different funds: National, single-state, long-term, intermediate-term, short-term, insured or noninsured, high-yield or high-quality.

To some degree, the choice must depend on your individual circumstances. But there are some general guidelines that can be used to simplify the process.

National funds offer you the advantage of geographical diversification, which protects you should regional or local troubles depress the bonds of any given state or local government. That sort of thing has happened within recent decades in places as far apart as New York and Orange County, Calif.

If you live in a high-tax state, though, a single-state fund may offer you a significant yield advantage by sparing you state and local taxes, as well as a federal income tax burden.

"Choose a single-state fund if you live in a high-tax state," suggests Steve Chung, an analyst at Morningstar Inc. in the firm's monthly newsletter Morningstar FundInvestor. "Otherwise, go national."

Quality and maturity choices depend on how aggressive you want to be. A high-yield muni fund may offer you a better income payoff, if you are willing to bet that a diversified portfolio provides sufficient armor against the risk of defaults on individual bonds.

Similarly, a long-term fund may hold the prospect of a better return, if you are willing to brave its greater exposure to fluctuations in interest rates, compared with short-term or intermediate-term funds.

No matter what your preferences on these variables, advisers recommend that all investors pay attention to a fund's expenses. "Costs are important for all bond funds, but especially for muni offerings," Mr. Chung said.

"In any given year, the difference between the highest- and lowest-returning muni funds can be just a few percentage points. A small cost advantage goes a long way."

Said Jonathan Pond, a financial-planning expert in Watertown, Ma., "Fund expenses do matter."

An extra wrinkle of muni investing concerns the alternative minimum tax, which can wind up pinning some investors with a tax liability on "tax-free" income. Some muni funds expressly avoid bonds that are subject to the AMT.

"A once-in-a-decade opportunity for municipal bond investors occurred late last year when municipal bond yields equaled Treasury bond yields," Mr. Pond said in his Quarterly Investment Review newsletter.

"Usually, muni yields are somewhere around 80 percent of the equivalent maturity Treasury bond yield to account for the muni's federal tax-free status. While the yield gap has widened during the past several months, opportunities still exist.

"Municipal bonds continue to be attractive for those few of us left who still think there's a place for bonds in a portfolio."

Mr. Chung said, "If municipal bonds aren't the biggest bargain in the markets today, they're close."


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