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A sexy bond fund. Sounds like an oxymoron, right? But as things continue
to look rather ugly in the stock market with the economy shifting into a
lower gear and high-tech companies warning about disappointing results, one
type of fixed-income fund is starting to get some admiring looks from
investors. Exempt from most taxes, municipal-bond funds can actually
offer higher yields than funds made up of federal government bonds --
the most popular kind of bond investment.
True, Treasuries are the safest investments in the land: The U.S. going bankrupt anytime soon is about as likely as France adopting English as its official language. But muni bonds --
which cities and local agencies issue to raise cash to build
everything from sewers to schools -- run a pretty close second in the
creditworthiness department.
Jack Malvey, global fixed-income strategist at Lehman Brothers in New
York, says when one Internet entrepreneur in California he knows
was looking for a place to sock away a big chunk of the $30 million he
got from cashing out of his company, the millionaire turned to munis. "The muni sector does have appeal," Malvey says. "The most conservative market is the U.S. muni market after Treasury bonds."
EXTRA APPEAL. Many munis, like Treasuries, do not incur local or state income taxes. What munis have over Treasuries, though, is exemption from
federal income tax. On Dec. 8, the 10-year muni bond was yielding about
4.60%, or about 87% of the 5.30% that the 10-year Treasury bond was
offering. On the same day, the 30-year muni bond, meanwhile, was
yielding 5.37%, or nearly 98% of the 30-year Treasury bond's 5.50%.
But when a muni's tax-exempt status is accounted for, it gets a lot more
appealing. For taxpayers in the top 39.6% tax bracket, the tax
equivalent yield of a 10-year muni bond rises to 7.62%, while a 30-year
jumps to 8.89%. Factoring in the break from state taxes would push up
these tax-equivalent yields even further. (A formula for calculating the
tax-equivalent yield given an investor's tax rate is found at the bottom
of this story.)
"When you take the tax consequence into account, the munis offer a
better return to most investors," says Thomas Doe, president of Concord (Mass.)-based Municipal Market Advisors, a research and analysis firm for
institutions and wealthy investors. "When most individuals look at muni
bonds, they just look at the yields. Once they realize the tax-exempt
advantage, they become more interested."
EXTENDED FUNK? The stock market's performance year-to-date has been
lousy. As of Dec. 8, the Standard & Poor's 500-stock index, a broad stocks
gauge, was off 3.33% since Jan. 1. The tech-stacked Nasdaq composite
index, meanwhile, was down a troubling 19.41%. With an economic slowdown
in the works, the stock market may not emerge from its funk anytime
soon.
Yet despite the outlook for equities, investors are not exactly
sprinting to the safety of fixed-income funds -- at least not just yet.
At the end of October, nearly $15.6 billion had flowed out of muni-bond
funds for the year, according to the Investment Company Institute, a
mutual funds trade grade group.
But fund managers are anticipating a pickup in interest in muni funds. "We have not seen outflows for some time," says Steve Permut, a
California-based vice-president and senior portfolio manager at American
Century Investments. "With the volatility in the equity market, we will
start to see inflows. Munis definitely have a firmer tone."
NOT FOR EVERYONE. Permut's American Century:CA High Yield Municipal (BCHYX) recently was
yielding 5.20%, or about 10.31% on a tax-equivalent basis for investors
in the top income tax bracket. The fund, which receives S&P's highest ranking of five stars, requires an initial investment of
$5,000 and levies an annual management fee of 0.54%. The annual fees associated
with bond funds, meanwhile, were at an industry average of about 1.09%
in 1998, which was the last year the ICI surveyed these costs.
Muni bonds aren't for everyone. But as a rule, the higher
the tax rate investors must pay, the more they stand to benefit from a
muni fund. Those who don't get a big bill from Uncle Sam at the end of
the year could be better off sticking with Treasury funds.
Where investors live should also be considered when shopping for a muni
bond fund. Individuals residing in a high-tax state such as New York
should look at a single-state fund that holds only New York muni bonds.
This way, they could avoid paying local, state, and federal taxes on the
dividends. New York residents who bought California muni bonds would be
exempt from paying federal taxes on the dividends, but they would have to pay
New York State and local taxes.
Multistate bond funds, meanwhile, are an option for investors in a low-tax state such as Iowa. They can enjoy the benefits of greater
diversification, unlike investors in high-tax states, as they don't have
to worry as much about their state and local tax burdens.
CALIFORNIA DREAMIN'. "You have to look at the relative yield offering of securities in the
state and those outside the state and adjust for the tax rates," says
Christine Thompson, Boston-based portfolio manager of Fidelity Spartan
California Municipal Income (FCTFX). "For investors outside of
California, they could probably do better in the long run looking at
other national securities."
Thompson's Fidelity Spartan California Municipal Income fund also gets
S&P's five-star rating. Through October, the fund in 2000 boasted a
total return, which includes appreciation and dividends, of 9.21%,
according to S&P's mutual-fund tracking service AdvisorInsight.
Thompson's fund requires an initial investment of $10,000 and has an
annual expense ratio, or fees related to the fund, of 0.49%.
California munis have clearly outperformed. The
economic boom has generated a ton of wealth in the Golden State,
resulting in not only new issues of bonds by municipalities wishing to
make improvements but also in a surge in demand from investors for
places to invest. The strong demand has pushed down yields -- as issuers
need to provide less of an incentive to attract buyers -- which in turn
has driven up the prices of the bonds, boosting overall returns, says
Ian MacKinnon, managing director at the Vanguard Group and head of the
firm's fixed-income group.
FUND DOWNSIDES. MacKinnon's Vanguard California Tax Free:Ins Long Tm TE (VCITX) was
recently yielding 4.84%, which works out to 8.06% on a tax-equivalent
basis for an investor in the top income tax bracket. The fund requires
an initial investment of $3,000 and has an expense ratio of 0.18%, which
is among the lowest in the industry.
As MacKinnon points out, investing in a bond fund has downsides compared with
buying muni bonds directly through a broker. First, investors must pay the mutual-fund fees. Second, because funds may
represent a basket of hundreds of bonds that mature at different times,
a bond fund never really actually matures. Investors could be in trouble
if they needed to pull out the exact amount that they put into a fund on
a specific date. The value of a fund's shares can fluctuate.
But MacKinnon also believes that individuals investors, if they wanted
to invest directly in muni bonds, would need more than $1 million
dollars to be sufficiently diversified. With a muni-bond fund, "you get very broad diversification with strong amounts of money to be invested," MacKinnon says.
CAP-GAINS CONCERNS. Mutual funds in general can take some of the edge off
investing by leaving the management to Wall Street professionals.
Through funds, investors also get the benefits of liquidity and
diversification –- not only in terms of credit risk but also in terms of
bond maturity. Longer-term bonds tend to have higher yields as a means
to compensate individuals who agree to lock up their money in an
investment for a greater period of time.
Capital gains on mutual-bond funds, like those from other funds, are
subject to state and federal taxes. Fund managers say they do what they
can to minimize these taxes on profits from the sale of bonds. But they
also say they're looking to maximize the value of their shareholder's
investments. "The way that we manage our funds is to be very aware" of capital gains
implications, Thompson says. "Our bottom line focus is to manage for
total returns."
The bottom line for investors: Muni-bond funds can be attractive
investments, but individuals will probably want to determine the specifics of their tax responsibilities before deciding just how attractive
they truly are.
TAX-EQUIVALENT YIELDS:
To determine a tax-exempt fund's tax-equivalent
yield, S&P offers this handy formula: Divide its yield by 1 minus your federal tax rate. If you're in
the 28% bracket, you divide by 0.72; the 31% bracket by 0.69; the 36%
bracket by 0.64 and the 39.6% bracket by 0.604.
Copyright 2000, by The McGraw-Hill Companies Inc. All rights reserved.
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