THE HIGHEST, SAFEST TAX-FREE INCOME Despite the looming recession, you can still earn the equivalent of a taxable 10% from municipal bonds by following a few dependable strategies.
(MONEY Magazine) – Not long ago, if you wanted to shelter your income from taxes, you could choose from a long list of tempting investments. There were rental properties, oil and gas limited partnerships, fully deductible Individual Retirement Accounts -- even jojoba bean fields and windmills. Then came the write-off wrecking ball known as the 1986 tax reform law, followed by the collapse of the oil and gas industry in the Southwest and the downturn in real estate. Today, about the only shelters still standing are municipal bonds -- debt issued by cities and states to pay for local projects and services. And what shelters! Top-quality muni bonds currently offer yields of roughly 7%, free from federal income taxes and sometimes state and local taxes too. Those returns are the equivalent of about 10% from taxable investments for anyone in the 28% or 33% marginal tax bracket (taxable income exceeding $32,450 for couples; above $19,450 for singles). If you're among them, you can't earn as much from any other investment without taking considerably bigger risks. Munis' attractions have made them hot investments in an otherwise dismal year for investors. Individuals now own almost $450 billion of tax-exempt issues -- a 6.4% increase in a year. Investors have bought the bonds directly, through municipal bond mutual funds and in packaged trusts, which are fixed portfolios of munis whose shares, called units, are sold by brokers. Trouble is, in their eagerness to grab tax-free income, some investors have unwittingly let brokers and financial planners steer them into low-quality munis, funds and trusts. Says James Lynch, president of Lynch Advisory Services, a Santa Fe municipal bond analysis firm: ''People are buying up almost anything offered them.'' (For examples of an aggressive muni fund and misleading pitches by brokers, see the boxes at right and on page 132.) Unfortunately, this reckless rush into munis comes at a time when the finances of many states and municipalities are in terrible shape. Only 34% of munis on the market today graded by Standard & Poor's, the bond rating service, are of the highest quality -- AA or better. The causes: regional recessions, the disappearance of federal revenue sharing, and years of overspending and undertaxing. As a result, states, cities and other local government agencies today face a total budget deficit of $30 billion -- the highest in 40 years, according to Joel Vernick, an analyst at David L. Babson & Co., an investment advisory firm in Cambridge, Mass. The current fiscal strains have caused Standard & Poor's to lower its grades on $38 billion in bonds in the first six months of 1990, compared with only $24 billion in all of 1989. Among the recent losers: Philadelphia (now rated CCC by Standard & Poor's, down from BBB-), New York (now A, down from AA-) and Denver's 1984 and 1985 airport bonds (BBB, down from A-). ''More than $280 billion in municipal bonds -- about one-third of the market -- is in the process of becoming the junk bonds of the '90s,'' says Lynch. Despite the fiscal tremors, you can still get tax-free income safely, provided that you keep in mind these four rules: -- Buy only top-quality bonds, ones rated at least AA, or shares of funds and trusts that invest in them. The issuers of such bonds are highly unlikely to default even in a deep recession. Moreover, many muni analysts believe that yields on low-rated bonds aren't high enough to compensate you for their risks. -- Stick with intermediate-term bonds, those maturing in five to 10 years, or the shares of funds and trusts that hold them. Longer-term bonds maturing in 20 or 30 years are more readily available, but their prices are also more volatile. A two-point spike in interest rates, for example, would shave 21% off the value of a 20-year municipal bond, compared with only 8% off a five- year bond.
-- Hold munis to maturity for steady tax-free income rather than trading them in hopes of capital gains. Since many municipal bonds do not trade often, you might get a lousy price if you sell. Also, money managers advise small investors against trading bonds in an attempt to profit from swings in interest rates -- something that few professional investors consistently do successfully. ''Treat your municipal money more like savings, and do your trading in the stock market,'' says Harold Evensky, a Miami financial planner. Even if you're fortunate enough to make a profitable muni trade, your gain will be taxable. -- Diversify your muni holdings to boost protection against defaults. If you plan to invest less than $50,000, you can get diversification by buying shares in a fund or units in a trust. Only if you can invest at least $50,000 should you consider individual bonds; you need that much to diversify among at least five issues and to attract the full attention of an experienced broker. With those four points to guide you, you're ready for the strategies and recommended investments that follow.
When you invest a minimum of $1,000 or so in an intermediate-term bond fund, you buy shares in a portfolio of 75 to 300 tax-exempt bonds. Usually you can cash in your shares without charge, though some funds levy back-end fees that begin at 5% of your redemption and decline to zero over five years. The chief attractions of muni bond funds: diversification and professional management. As Ralph Norton, editor of the monthly newsletter the Muni Fund Bond Report (617-721-4511; $95 a year), points out, fund investors ''can let the fund manager worry about the credit quality of bonds and the risk that an issuer will call in its bonds early.'' Munis have two serious drawbacks, though. First, management and operating costs cut shareholders' yields, often by up to a full percentage point a year. And second, because funds are actively managed, they have no maturity dates. Thus while holders of individual bonds or trust units can count on getting their original investments back when bonds mature providing there are no defaults, fund investors who redeem shares can lose money if the bonds in the portfolio fall in value. ''Many people don't understand that since a muni fund has no maturity date, it is not a true fixed-income investment,'' says Christine Carter Lynch, wife of James Lynch and editor of the Lynch Municipal Bond Advisory newsletter (505-984-9199; $250). Some tips for choosing an intermediate-term municipal bond fund: -- Look for a no-load fund with low annual expenses. Some funds have front-end sales charges that can take as much as 5% of your investment, or exit fees that can swallow 5% of your redemptions, or 12b-1 fees, which can nick your return by 1.25% -- a year. You'll find the fees described in a fund's prospectus. Almost certainly a muni fund with a high expense ratio, which is its management and operating costs expressed as a percentage of the fund's assets (recent national average: 0.8%), must take more risks over the long term for a return comparable to that of a fund with a lower expense ratio. Unlike equity fund managers, whose savvy stock picks can sometimes offset high fees, muni fund managers have fairly limited investment options. As a result, Norton says, ''it is nearly impossible for such funds to make up for the burden of high expenses through superior performance.'' Financial advisers interviewed by MONEY favor these top-performing no-loads: Vanguard Municipal Bond-Intermediate Term Portfolio (800-662-7447; current yield 6.9%, up 26% since 1987); T. Rowe Price Tax-Free Short-Intermediate (800-638-5660; 5.8% yield; up 17%); and Fidelity Limited Term Municipals (800-544-8888; 6.6% yield; up 21%).
-- Avoid funds that invest only in munis issued within a single state. True, income from these funds is free from federal and state taxes if you are a resident of the state. And in heavy-tax states like New York and California, these funds offer taxable-equivalent yields as high as 11.4%. But single-state funds are narrowly diversified, making them riskier than portfolios of bonds from across the country. If your state slips into a deep recession, the value of your single-state fund shares could be devastated. -- Also avoid high-yield funds. Commonly known as junk muni funds, they invest as much as 80% of their portfolios in unrated bonds and debt rated BBB or lower and are now yielding about 7.5%, almost half a percentage point more than top-quality muni funds. In times of recession, such risky issues would be among the first to default. ! -- And shun closed-end funds. They are the newest way to invest in munis -- more than 45 closed-ends, with assets of $15 billion, have been launched since 1987 -- and they get a hard sell from brokers. But many closed-end investors end up buying a dollar's worth of assets for more than a dollar. Here's why: unlike open-end funds, which continually issue new shares, closed- ends offer a fixed number that trade on exchanges like stocks. So the share price is determined in part by demand for the shares. Currently, the shares of more than 20 funds sell for higher prices than the per-share value of their net assets.
Investors who want the same steady tax-free income offered by funds but with far less risk to their capital might consider unit trusts (minimum investment: usually $1,000). A trust holds a small, fixed number of bonds until maturity -- about two to three dozen on average, a fraction of the number in a fund portfolio. Because trusts have maturity dates by which all of the bonds in the portfolio are redeemed, you will get your full principal back if you don't sell prematurely, as long as none of the bonds default. An experienced broker can find you trusts that will mature in six to 12 years; brokers typically charge commissions of 2% to 5%. (For advice on finding a broker, see the next section on individual bonds.) Intermediate-term trusts now yield between 6.7% and 7%. If you need to sell your units before maturity, you can generally unload them with a call to your broker. Of course, the price you get for your units may be higher or lower than what you paid for them, if the trust's bonds have risen or fallen in value since you invested. If you hold your investment until maturity, your total costs -- including commission -- are likely to be lower than they would be in a muni fund. Chief reason: because trust administrators don't actively manage their portfolios, they charge low annual fees, typically 0.1% to 0.2% of assets. ''The lower fees mean that, if held to maturity, unit investment trusts can outperform muni funds on a total-return basis,'' says Steven Hueglin, executive vice president of Gabriele Hueglin & Cashman, a New York City-based bond brokerage.
Lack of active management can sometimes be a drawback, however. For example, a trust administrator rarely replaces a bond that is redeemed early by its issuer. You will get your share of the principal back, but your monthly income from the trust will drop. ^ Muni bond experts offer the following tips for unit-trust investors: -- Be cautious about investing in an old trust holding long-term bonds that are due to mature in a few years. You might wind up paying a price based on the original holdings of the trust even though some bonds have been called in by their issuers or sold by the trust administrator. -- Make sure all the bonds are top grade, because the number of holdings in the trust's portfolio will be small. You may have to settle for A-rated bonds, though, since AA bonds are scarce. -- Look for trusts whose bonds are insured to maturity. Trusts can pay private insurers to guarantee interest and principal payments. That reduces yields by about three-tenths of a percentage point but may be worth the cost for the peace of mind you get in return. The best guarantee is insurance to maturity. This coverage stays with the bonds even if the trust must sell them early. Sponsors usually sell new trusts through brokers for a few weeks before closing them to additional investors. So financial advisers suggest that rather than looking for a specific trust, you ask your broker for the latest nationally diversified, insured trust offered by reputable sponsors such as Municipal Investment Trust Fund, Nuveen and Van Kampen Merritt.
Your cash works hardest when you buy individual bonds (typical minimum investment: $5,000 per bond), since no management fees cut into your return. There are two types: General-obligation (G.O.) bonds are backed by the full taxing power of the state or municipality. Revenue bonds, which are slightly riskier, are issued to pay for highways, sports arenas and other projects and are funded by income from them. Investing in individual bonds requires being your own portfolio manager, but you can get guidance from a skilled bond broker. Normally, he or she will pocket a commission of between 1% and 3% of the bond's value. A knowledgeable broker will steer you away from issuers who might suddenly run into trouble and default. Your best source for such a pro is a regional brokerage house, since those firms specialize in muni bond issues. Advisers interviewed by MONEY recommended four regional brokerages: Clayton Brown & Associates in Chicago, Gabriele Hueglin & Cashman in New York City, Legg Mason in Baltimore and Sutro & Co. in San Francisco. Some local offices of national brokerages also have brokers who are well informed about bonds in their regions. Before buying any bond, be sure the broker gives you its prospectus, also known as the official statement, and carefully read the section about investment risks. In addition, you might consult Moody's Directory, a two- volume blue monster, available in most public libraries, that describes the financial strength of issuers. You could even get annual reports from top- performing mutual funds to see which bonds their managers have been buying. Some munis are privately insured to guarantee payment of principal and interest; this turns any bond into one rated AAA. You need not buy just insured bonds, but since the insurance only cuts your yield by roughly three- tenths of a point these days, you might consider them. Be sure your broker confirms that the bonds would have been rated A or better without insurance. Bond analysts say that some of the best muni values are in pre-refunded premium bonds. These bonds arise out of a strategy used by states and municipalities to reduce the cost of servicing old bonds from the early 1980s, when interest rates were in double digits. The issuers float a second series of bonds and invest the proceeds in U.S. Treasuries, which are timed to mature on the date when the old bonds can be redeemed early. This gives the old issues, now called pre-refunded premium bonds, the security of U.S. Treasury backing. Two of Hueglin's favorites: Jacksonville, Fla. Electric Authority (current yield: 6.45%), to be pre-refunded in October 1994, and New York City Dormitory Authority (current yield: 6.6%), to be pre-refunded in July 1997. One smart way to diversify a bond portfolio is through what's known as laddering. With this technique, each bond you buy matures in a different year. So if rates have risen when a bond comes due, you can reinvest the proceeds in a bond paying the new high rates. Should rates drop, part of your portfolio will still be earning interest at the earlier higher rates. MONEY asked two advisers to suggest $50,000 portfolios containing five diversified munis rated AA or better, with laddered maturities. Harold Evensky's recommendations pay an average current yield of 7.08%, or $3,610 a year. His portfolio includes two general-obligation bonds, the Nevada G.O. of August 1996, yielding 6.7%, and the District of Columbia G.O. of June 1997, yielding 7%, plus three revenue bonds: the District of Columbia Housing Finance of June 1997, yielding 7.2%, the New Jersey State Revenue Agency of October 2003, yielding 7.4%, and the University of Wyoming of June 2000, yielding 7%. James and Christine Lynch chose bonds paying an average current yield of 6.4%, or $3,460 a year. Their portfolio includes two general-obligation bonds, the Georgia G.O. of March 1993, yielding 6%, and the Tennessee G.O. of June 1997, yielding 6.45%; two revenue bonds, the Intermountain Power Agency of July 1999, yielding 7%, and the pre-refunded Jacksonville, Fla. Health Facility of June 1995, yielding 6.55%, and the short-term Texas tax and revenue anticipation note of August 1991, yielding 6%. No matter how you buy munis -- directly, through a mutual fund or in a unit trust -- your investment is likely to be one of your fondest. After all, how many other purchases can increase your net worth and, at the same time, let you escape the tax man?