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Avoiding Potholes On The Muni Route


Personal Business: SMART MONEY

AVOIDING POTHOLES ON THE MUNI ROUTE

With state income taxes on an upward march, tax-exempt municipal bonds have an almost irresistible appeal. But while munis are free from federal, and in many cases, state taxation, the muni market is rife with credit concerns and downgraded bond issues.

Muni bonds, the debt obligations of state and local governments, have long been considered safe investments, but "it's hard to make blanket statements about them anymore," says Nancy Utterback, a vice-president for municipal research with Kidder Peabody. As the fiscal crises of many states and cities escalate, downgraded munis outnumber upgrades by 3 to 1.

Essential-service revenue bonds, such as water, sewer, and electricity bonds, are stable bets. "In many cases, they're the least affected by local economic disturbances," says George Friedlander, managing director of fixed-income strategy for Smith Barney, Harris Upham. He likes the long-term bonds of the New York State Power Authority and the Los Angeles Dept. of Water & Power. They yield about 7.1%.

Utterback prefers the revenue bonds of Florida's Jacksonville Electric Authority and Utah's Intermountain Power Agency. The Jacksonville bonds maturing in 2012 yield about 7%; 30-year Intermountain Power Agency bonds yield about 7.25%. Because they're free from federal taxation, an equivalent taxable yield would top 10%.

Buying insured muni bonds is a good safeguard. If an issuer defaults, the bond insurer makes interest and principal payments. There has been some concern about whether the insurers have the assets to cover a raft of defaults, so check that the insurer is rated AAA by Moody's and S&P. "Unless problems get a lot worse, I'm still comfortable with the insurers," says Friedlander. "They have to meet a `stress test' to get an AAA rating." If you want "both belt and suspenders," he suggests, buy insured essential-service bonds, which yield about 7.1%. Similar uninsured bonds yield about 7.2%.

SHORT AND SWEET. The ultimate safe munis are "pre-refunded" bonds. Pre-res are backed by an escrow account of U. S. Treasury securities. Cash flow from the Treasuries pays off the bond interest and principal. Since many pre-res reach maturity in the next four years, they are a short-term investment. You can find a four-year pre-re yielding about 5.75%, equal to an 8.33% taxable yield for someone in the 31% bracket.

If you want to spread your risk, there's no shortage of muni-bond funds. There are 486 muni-bond funds to choose from, 295 of which specialize in single-state issues.Suzanne Woolley


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