Insurance cushion for municipal-bond funds: Is it needed?

Recent rates of about 10 percent tax-free interest availalbe on municipal bonds (an average of 20 municipal bonds reported in US Financial Data from Federal Reserve Bank of St. Louis) have attracted interest from high-bracket taxpayers.But high yields traditionally reflect high risks. Previous concerns about the financial stability of New York City and the more recent problems of Cleveland highlight an increasing uneasiness among investors in tax-free securities.

To counter the risk, actual or perceived, managers of certain municipal tax-free bond funds are insuring their portfolio. As a result, shareholders in the funds are insured against loss of dividends when due and loss of principal when the bonds mature.

One of the first municipal bond funds to secure insurance is the First Trust of Insured Municipal Bonds, 300 West Washington Street, Chicago, Ill. 60606. This initial series was offered in 1974. Since then, 39 underwritings totaling result of the insurance feature, First Trust's portfolio is rated AA by Standard & Poor's, one of the major bond rating firms.

MGIC Indemnity Corporation is the insuring agency and is part of the same MGIC operation that insures home mortgages. The premium paid by funds for insurance ranges from 0.20 percent to 0.25 percent of the average net assets of the insured fund portfolio. Only insured bonds may be included in the fund. The insurer reviews bonds to be included in the portfolio and approves only those bonds with the four highest quality ratings by the rating firms, such as Standard & Poor's and Moody's Investor Service. There are other conditions that must be met for bonds to be insured.

Two costs are associated with the insured municipal bond funds. First, the insurance policy premium of as much as 0.25 percent of the asset value is paid from the earnings. Thus, about 1/4 point is substracted from the yield, in addition to the management fee and other expenses normally charged. Second, insured municipal bond funds will likely pay a smaller yield, because bonds acceptable to the insuring organization will be less risky and thus carry a smaller coupon. A smaller yield is a cost that should not be ignored.

Insuring a municipal bond fund appears to be redundant, as one of the primary benefits from investing in a fund rather than individual issues is the diversification. A shareholder owns a slice of many issues in the fund's portfolio.If one issue should fail, the loss will presumably exert only a minimal effect on a shareholder's yield. Further, an investor gains the benefits of professional management with the resources to investigate the creditworthiness of tax-free bond issuers. Update

Thank you for your information on stock purchase warrants. Do you know of any mutual fund that invests largely in stock purchase warrants? L. L.

One or two mutual funds invest some cash in options, but I know of no fund that invests in warrants. If a reader knows of a fund, write me and I will pass the information along.

Readers are invited to send questions to Moneywise, Box 102, Mercer Island, Wash. 98040. Only a selection of such questions covering topics of general interest can be answered here and no question can be individually acknowledged. References to specific stocks, funds, or other investments in this column are intended for the general information of readers and not as an endorsement or recommendation by The Christia n Monitor.m