(MONEY Magazine) – LOOKING FOR ACTION? SAY HELLO to bonds--muni bonds, that is. Sure, the new $55 million James Bond flick starring Pierce Brosnan has plenty of action. But the $1.2 trillion muni bond market offers its own version of excitement these days. The reason: Like Bond's famed dry martinis, the muni market has been shaken (not stirred) by congressional talk of tax reform--a move that could shrink or even wipe out munis' tax advantage.

And that, we're here to tell you, is the good news. How so? Well, the answer is that most observers believe the chances of a sweeping tax overhaul are remote. "Current fears are exaggerated," says Ralph Norton, managing editor of Investing for Income. "Debate will continue well beyond the 1996 election, and even then there will be a tremendous fight on many fronts against substantial changes."

And yet, the upheaval in the muni market has created some great deals for investors who know where to look. To help you select today's best muni investments, MONEY interviewed more than three dozen bond analysts, money managers and other specialists. Their advice on choosing individual bonds, mutual funds and unit investment trusts appears on these pages.

But first, here's some important background. While muni bonds generally yield from a few tenths to more than a percentage point less than Treasury securities of similar maturity, the fact that their interest is free from federal taxes has made them the richer choice for many investors, usually those in the 28% federal tax bracket and above. But in mid-March, House majority leader Dick Armey (R-Texas) and others began lofting various "flat tax" proposals that would in several ways diminish munis' appeal. (The Armey plan, for instance, would make Treasuries tax-free too.) At that time, 30-year AAA muni bonds were yielding a fairly typical 80% of what 30-year Treasury bonds paid (5.9% vs. 7.4%). But by early July that gap had closed so that munis were yielding 90% of Treasury yields (5.9% vs. 6.5%). The reason: Investors, increasingly fearful of munis' losing their edge, shunned them in favor of Treasuries (bond yields fall when prices rise). Today, long-term muni yields stand at 88% of Treasury yields, down slightly from the summer peak but still above customary levels in the low- to mid-80% range.

To many investment pros, that narrower-than-normal spread between muni and Treasury yields spells bargains. But while the highest yields (and thinnest spreads) are among bonds maturing in 30 years, MONEY recommends that investors stay away from these ultralong munis. Such issues are simply too vulnerable to changes in interest rates. And while a major tax makeover seems unlikely today, no one knows what will happen between now and the year 2025 when a 30-year bond matures.

At the other end of the spectrum, short-term municipals--those with maturities of up to five years--have not suffered from the tax reform talk. As a result, their yields are so low that they are attractive only for investors in the 36% federal tax bracket and above (singles with taxable incomes of $117,951 or more, $143, 601 for joint filers).

Therefore, say the pros, stick to the middle ground. That means buying either 1) high-quality muni bonds with maturities of eight to 15 years or 2) the tax-free funds and unit trusts that invest in them. "Intermediate munis offer the best values in the market today," says Richard Ciccarone, executive vice president of Everen Securities in Chicago.

For example, eight-year bonds rated AAA (the highest credit rating available) yield about 4.7%--the equivalent of a 6.8% taxable yield for investors in the 31% bracket (singles with taxable incomes of $56,551 or more, $94,251 for joint filers). By comparison, eight-year Treasuries are yielding 6.2%. At the long end of the intermediate range, 15-year AAA munis yield 5.4%, providing the taxable equivalent of 7.8% for a 31%-bracket investor, while 15-year Treasuries are yielding a federally taxable 6.3%.

Okay. Now that you've seen which bonds offer the best deals today, you'll have to determine how to buy them. Basically, you have three choices: mutual funds, unit investment trusts and individual bonds. In general, individual munis are suited only for investors who have at least $50,000 to deploy. Why do you need such a large stake? Because munis are typically sold in $10,000 blocks, and most pros say you should spread your muni money over at least five separate issues from states around the nation to protect your portfolio from economic troubles in one locality or region.

On the other hand, if you live in a high-tax locale such as New York, Massachusetts or California, you may want to forgo geographic diversification and concentrate some or all of your portfolio in bonds from your state. Such bonds' exemption from state and local levies can add as much as a full percentage point in after-tax yield. On balance, the extra payoff is probably worth the extra risk. But before making the decision, compare the after-tax yields of other munis with those of your state to be sure that you are getting a significant premium for that risk. And pros say you will still need $50,000 to buy separate issues, so that a default on any one bond won't wipe you out.

The following sections offer a more detailed look at your three muni options:

Mutual funds. The actively traded portfolios of munis available through mutual funds provide you with broad diversification and professional management for minimum investments of $1,000 to $3,000. Professional wisdom doesn't come free: Annual management fees reduce shareholder returns. But by choosing low-expense funds such as Vanguard's, you can keep annual expenses as low as 0.2% of your account's value per year. Muni funds do have drawbacks, however. Unlike individual bonds and unit trusts (see page 119), muni funds never mature and have yields that fluctuate. As a result, you can't rely on a steady income or getting your full principal back on a specific date. Nevertheless, for attractive tax-free income, low-expense no-load funds are a solid way to go.

For a core holding, Susan Belden, senior editor of the No-Load Fund Analyst ($195 a year; 800-776-9555), recommends $5.5 billion Vanguard Municipal Intermediate-Term (up 9% annually for the five years to Sept. 25; yield: 4.75%; 800-851-4999), managed by Ian MacKinnon, 47, and Christopher Ryon, 39. This portfolio of mostly high-quality issues has an average maturity of 7.8 years and an average duration of a low 5.6 years. (Duration provides a more accurate measure of a fund's sensitivity to interest-rate changes than does maturity. A fund with a duration of 5.6 years will lose roughly 5.6% of its value if interest rates rise one percentage point.) For more on Vanguard Muni Intermediate, see "Rating the 25 Biggest Funds" on page 128.

Belden says investors willing to assume greater risk in exchange for potentially higher returns might consider $1.1 billion Vanguard Municipal Long-Term (up 9.5%; yield: 5.43%). Managers MacKinnon and Jerry Jacobs, 37, have the portfolio's average duration at eight years. The fund's long-term focus produces a fund that's 24% more volatile than the average muni selection, according to the fund raters at Morningstar in Chicago.

You can get slightly higher yields--with little, if any, added risk--by dipping into the junkyard. Morningstar analyst Patricia Brady suggests $1.7 billion Vanguard Municipal High-Yield (up 9.6%; yield: 5.78%) and $929 million T. Rowe Price Tax-Free High-Yield (up 8.7%; yield: 5.88%; 800-638-5660). Although Vanguard High-Yield is classed as a junk bond fund, only 14% of its portfolio is rated below the investment-grade cutoff, BBB. However, managers MacKinnon and Jacobs increase the fund's yield by maintaining a duration of 7.7 years, longer than that of many of its peers. In contrast, T. Rowe Price Tax-Free High-Yield manager Stephen Wolfe, 36, likes buying junk bonds. About 29% of his holdings are below investment grade, and his fund's duration is 7.3 years. And while the junk holdings in these funds subject shareholders to increased risk of default, both funds suffered less than Vanguard Muni Long-Term in 1994 when interest rates rose, punishing bond prices. The scorecard: Vanguard Long-Term, down 5.8%; Vanguard High-Yield, down 5.1%; T. Rowe, down 4.4%.

Unit investment trusts. Like a mutual fund, a unit trust holds a collection of bonds--typically from 12 to 50 different issues. But unlike a fund, the trust simply holds its bond to maturity. That means you lock in your yield--4.5% or so on intermediate-term trusts lately--and get back your principal when the unit's bonds mature. Thus trusts give you the diversification and predictability you'd get from owning a portfolio of individual bonds--and you can buy them for as little as $5,000.

But there are drawbacks as well. Chief among them: the stiff sales fee, generally 3.5% to 5%. Plus, if you need your money before the trust matures, you will have to sell your holding back to the trust's sponsor or on the secondary market, usually at prices favorable to the buyer. As a result, financial advisers say that small investors not prepared to hang on until a trust matures are better off with mutual funds.

Individual bonds. If you have $50,000 or more to invest in munis, you can exert maximum control over credit quality and maturity by buying individual bonds. Such debacles as last November's Orange County bankruptcy may have made you wary of individual munis. But in fact, they are remarkably safe: Fewer than 0.5% of all munis have ever defaulted; the rate for AAA corporate bonds, for example, is 1.4%.

Beware, though: Shopping for individual munis is one of the trickiest exercises in all of personal finance. The market is vast: There are about 1.5 million different issues sponsored by more than 50,000 municipal entities. So it's unlikely that any two brokers will have the same bonds on hand. Still, it's a good idea to comparison shop at three or more dealers, asking for prices and yields on similar bonds--say, AAA issues from a particular state. Also, recent price quotes on more than 700,000 individual securities are available from Standard & Poor's/PSA Municipal Bond Service at 800-266-3463; for $9.95, you get prices and ratings on 25 separate issues. Expect to pay a broker's commission of 1% to 2%, which will be built into the bond's price.

Before you buy, be sure to ask about the bond's call provisions. Most bonds can be redeemed by the issuer before maturity--usually at a pre-agreed-upon price. Having a bond called can disrupt the reliable income you've been drawing and can force you to reinvest your cash at a lower interest rate.

When it comes to picking specific bonds, the safest of all are those issued by a state and backed by its full faith and taxing power. They're called general-obligation, or G.O., bonds, and no G.O. has defaulted since the Great Depression. That's why experts like Lauren Eastwood, director of research at Gabriele Hueglin & Cashman, a New York City bond dealer, recommend general-obligation issues such as AAA-rated State of Missouri G.O. (callable on Aug. 1, 2002; selling at $103.88 for each $100 of face value; yield to call: 4.6%).

Investors looking for higher yields might investigate revenue bonds, so called because they pay their interest and principal from the cash generated by a specific project such as a power plant. A good example: AA-rated New Jersey Wastewater Treatment Trust Loan Revenue (callable June 15, 2000; $110.75; yield to call: 4.7%). When choosing among revenue bonds, concentrate on issues rated AA or better, and always consider the reliability of the project's income. "Water and sewer bonds are dependable choices because they have a locked-in demand for their services," says Eastwood. But bonds floated to finance health-care facilities, for example, can be iffy. Says Paul Williams, director of research at John Nuveen & Co., the Chicago investment firm: "With hospital mergers and closings it's difficult to know without extensive research which institutions will survive and which won't."

You can also boost your yield by buying bonds that are insured against default. Regardless of its original quality, a bond backed by one of the country's three largest insurers--AMBAC, MBIA and FGIC--gets a AAA rating. Yet because of pricing quirks in the market, insured bonds typically have slightly richer yields than bonds that win the AAA rating on their own merits. For example, MBIA-insured Virginia Peninsula Regional Jail Authority Jail Facility Revenue (matures Oct. 1, 2004; $99.75) yields 4.8% to maturity, while AAA-rated Commonwealth of Virginia (matures June 1, 2004; $99) pays 4.75%. "Buying an insured bond is like wearing a belt and suspenders and getting paid extra to do it," says Jim Cooner, head of the tax-exempt bond management division at the Bank of New York. And while those are hardly words to set James Bond's heart racing, that's just the kind of talk fixed-income investors love to hear.