(MONEY Magazine) – By now, most investors know that last year's tax reform made tax-advantaged investing a tougher game. But it didn't dampen the fundamental appeal of one special kind of tax-favored investment: municipal bond mutual funds that invest in the issues of only one state, thus producing interest income that is exempt from federal, state and, in some cases, local taxes as well. For many high-bracket investors in high-tax states, so-called single-state funds are the nearest investment left to a day at the beach. Indeed, they assume added attractiveness now because reform, while lowering federal rates, ) generally means that state and local levies will constitute a greater portion of your total tax. And these funds don't just generate tax-free income, lately between 6.5% and 7.4% on average; they can also produce substantial, if taxable, capital gains. No wonder the funds are hot. Last year's $14.3 billion increase in single-state fund assets represented a 124% jump from 1985, the largest percentage gain among all fund categories tracked by the industry's Investment Company Institute. But single-state share values, like those of all bond funds, can also fall, as they did by 7% or so in many cases in the early spring of this year. And choosing among single-state funds is not a simple matter of comparing yields or total returns (interest income plus capital appreciation). The shopping is far more complicated than that, and single-staters don't make sense for many investors. If you are in the 28% federal tax bracket or lower this year (taxable incomes of up to $27,000 for individuals and $45,000 for couples filing jointly), you are hereby excused. The after-tax yields produced by single- state funds won't generally be large enough to make them worth your while. Alas, even if you clear the 28% hurdle -- an ambiguous distinction for sure -- your state may throw up yet another obstacle. It may tax your fund income even if it is generated by in-state bonds. Illinois, Iowa and Wisconsin do. In such an instance, a higher-yielding corporate or Ginnie Mae fund may be your best choice. In the District of Columbia, New Mexico and Utah, in-state and out-of-state muni bond income is tax-exempt, so there is no added benefit from limiting your tax-free fund choice to a single-stater. Thus your better bet is a conventional muni bond fund, sometimes called a national muni fund, that diversifies its investments among many states. Such funds were recently yielding 7.2% to 7.8% on average. Seven states -- Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming -- levy no state income tax, which eliminates any need for a single- state fund. But oddly enough, homegrown funds have caught on in two of those states anyway: Florida and Texas. ''It's a matter of pride,'' says Tom Moles, manager of the Seligman group's 20 single-state funds, including one for Florida investors. ''People want to own issues from their home state, even if it doesn't have any tax advantage over a conventional municipal bond fund.'' We are therefore left with about three dozen states whose residents could benefit from single-state muni bond funds. Of course, that is assuming a single-state fund is offered. In mid-1987, 195 such funds were on the market, but they covered only 25 states, the District of Columbia and Puerto Rico. That's up from three as recently as 1981. High-tax states with large populations such as California, Massachusetts, Michigan, Minnesota, New York and Ohio have the most choices. According to Lipper Analytical Services, Californians alone are offered 40 municipal bond funds, which account for roughly half of the $29 billion invested in single-staters nationwide. But the following states also have at least one single-state fund: Arizona, Colorado, Connecticut, Florida, Georgia, Hawaii, Indiana, Kentucky, Louisiana, Maryland, Missouri, North Carolina, Oregon, Pennsylvania, Rhode Island, South Carolina, Texas, Virginia and West Virginia. For residents of these states (and others where the funds will eventually come), here is a primer: Who needs them. If your state has such a fund and you are intrigued, you should first determine whether the yields currently offered by your state's entries beat the after-tax yields for you on funds in which the income is either wholly or partially taxable. The box below will help you through the two-step process. One caveat: if you are among the 1% or so of taxpayers who are subject to the alternative minimum tax, you will need to do additional research. Specifically, you must find out if the single-state fund you're interested in invests in recently issued private-placement muni bonds, most of which produce income that is subject to the AMT. If it does, the fund's after- tax yield for you could be only 96% or so of what it would be if the income was truly totally tax-exempt. That 4% margin could make a difference in a close comparison of yields. How to shop. A bond fund cannot stand on yield alone -- and perhaps least of all a fund that puts all its eggs in one state's basket. You must consider a host of other variables. Prime among them is total return, which is the only measure that tells you whether your fund is making money for you. In the 12 months to Aug. 1, single-state bond funds posted total returns of 5.9% to 7.2% on average. But when interest rates rise, as they did this spring by a percentage point or so, bond fund shares lose value. Single-state funds can be particularly hard hit. The main reason is that the funds' managers trade the bonds of only one state and thus deal within a comparatively restricted universe of buyers and sellers (not to mention issues). In April, for instance, Ohio funds gave back 7.2% on average, California entries 7.1% and New York shares 7%, compared with 6% for the average -- and usually more broadly diversified -- national muni bond fund. The typical national tax- exempt fund holds 115 issues or so. Some single-state funds own fewer than 30. You can check a fund's annual report to see how many issues it holds. A greater number generally means that a fund manager will have more flexibility in bond trading, and clever swaps can curb losses when the bond market gets grizzly. You can attain greater protection of capital by investing in either of two alternatives: single-state muni bond unit trusts or single-state funds with shorter maturities. Unit trusts, which are sold by such prominent packagers as Lebenthal, Nuveen and Van Kampen Merritt, are best for long-term investors who are willing to lock into a bond portfolio for five to 30 years. The packagers assemble a portfolio of at least 12 bonds and sell shares -- called units -- for as little as $1,000. Since the bonds are held to maturity, you are guaranteed the return of your principal (barring a catastrophe for the portfolio) if you do not sell out before the trust matures. Meantime, you collect yields that are currently comparable to those on single-state funds. Trusts commonly charge 4.9% in front-end loads. Single-state funds that keep their average bond maturities under 12 years or so cushion capital in another way. Because their bonds involve shorter commitments, they fall less than longer-term funds when interest rates rise. Unfortunately, few such limited-term single-state funds exist. Among them are Park Avenue New York Tax Exempt-Intermediate (recently yielding 6%), Limited- Term Municipal-Californ ia (yielding 5.8%) and Benham California Tax Free- Intermediate (yielding 6.2%). An increasingly appealing alternative in jittery times is a single-state municipal money-market fund. More than 40 such funds were available recently, most of them for investors in populous states like New York and California. Because the funds invest in short-term municipal paper generally of 120-day maturity or less, your share price will remain steady. Single-state municipal money-market funds lately yielded only 3.3% to 4.9%, but they could net highly taxed investors more than national tax-exempt or taxable money-markets. The quality question. In evaluating a single-state fund, as with any bond fund, keep in mind the quality of its holdings. The higher the quality, the lower the yield -- and the lower the likelihood that the fund's portfolio will be damaged by default. Also, higher-quality funds characteristically fall less during a prolonged rise in interest rates. Most single-state funds put at least 80% of their portfolios in investment-grade issues -- those rated between BBB and AAA by Standard & Poor's and Moody's, the major credit-rating services. Funds with lesser-quality standards can expose you to interest-rate and credit risks you might prefer not to bear. Note too the types of bonds a single-state fund invests in. A fund that spreads itself among so-called revenue bonds that finance hospital, utility, housing and education projects will be more balanced and stable than a fund that is heavily concentrated in just one type of enterprise. To ease the minds of especially cautious investors, fund groups like Dreyfus, Franklin and Vanguard offer insured single-state funds. The insurance protects against default on interest payments and insures timely repayment of the bond's principal. But insurance does not shield investors from fluctuations in the value of fund shares. And though it's smart to value safety, Sheldon Jacobs, editor of the NoLoad Fund Investor (P.O. Box 283, Hastings-on-Hudson, N.Y. 10706; $82 for 12 issues), points out: ''If your fund is diversified, the cost of the insurance in terms of a lower yield is probably more than the impact any one failure in the portfolio could have.'' The risk of a rash of defaults is almost infinitesimal. The crux is that while single-state funds may represent the nearest thing to a tax-free payday for fund investors, the task of picking them is, well, taxing.

BOX: The math test: Do single-state funds pay for you?

The basic question for an investor is whether a single-state muni bond fund will pay more, after taxes, than a fund that is wholly taxable or partially so. The two-step answer involves seemingly daunting arithmetic, but nothing beyond today's fourth-graders. Don't give up -- we'll give a clarifying example to help you. Your first step is to figure what a fully taxable bond fund would have to deliver to match the payout of a single-state fund. The number is known as the taxable-equivalent yield. The key to the calculation is figuring your effective state tax rate -- the percentage you pay in state taxes after deducting those taxes on your federal return. (If you live in a municipality with a local income tax, add your local tax rate to your state tax rate in the first calculation below.) First determine your effective state (and local) tax rate. It equals: Your nominal state -- plus any local -- tax rate times (1 minus your marginal federal tax) Next, calculate your combined state and federal tax bracket. It equals: Your effective state tax rate plus your marginal federal tax rate Now you are ready to compute the taxable equivalent yield -- the amount that a taxable fund would have to pay to equal the after-tax yield of a single- state fund. It equals: The single-state fund's yield divided by (1 minus your total tax bracket) Okay, to make the whole process clear, let's assume you are an unmarried Massachusetts resident with a taxable income in 1987 of $33,000, placing you in the 35% federal marginal tax bracket. Your state rate on interest income is 10%. To determine your effective state rate, you multiply 0.10 by 0.67 (1 minus 0.33). The product is 0.067. You then add this effective state rate to your federal marginal rate (0.067 plus 0.33) to get your combined tax bracket: 39.7%. Lately, Massachusetts muni bond funds have been yielding 7.1% on average. Dividing that yield by 0.603 (1 minus your total tax bracket of 0.397) gives you a taxable-equivalent yield of 11.77%. So a taxable bond would have to yield 11.77% to equal the tax-exempt payout of your home state fund. But you are not quite finished: you still need to find out if a muni bond fund that does not restrict itself to your state's issues, and thus produces income that is subject to your state's tax, is a better buy. What you are after here is a number known as the out-of-state equivalent yield: the payout needed on a national muni fund to match the yield on a single-state fund. Your effective state tax rate (explained above) is again a key. The equivalent yield needed on a national muni bond fund equals: The single-state fund's yield divided by (1 minus your effective state tax rate) One more example: Say you are the same Massachusetts taxpayer described above, but now you want to know whether your 7.1% home-state fund is a better deal than a national muni fund (paying 7.2% on average lately). You divide 7.1 by 0.93 (1 minus your effective state tax rate of 0.067). Thus a national muni bond fund would have to yield 7.6% to match your 7.1% in-state fund.