Tax talk has bonds in a tizzy

Tax-reform talk is turning the municipal bond market topsy turvy. For the first time ever, analysts say, most long-term municipal bonds now yield more than United States Treasury bonds. ``It's really amazing,'' says S. E. Canaday Jr., manager of municipal underwriting at John Nuveen & Co. ``Today you can buy a very good municipal with a yield at 7 or 8 percent, and long-term governments are at about 7.45 percent.''

As a rule, high-quality municipal bonds -- because of tax savings -- sell at interest rates lower than government bonds'. Last year, tax-exempts sold at yields about 20 percent less than Treasury yields, Mr. Canaday says.

That gap started to close in March. And for the first time, two weeks ago, the Bond Buyer index tracking the average yield of 20-year municipal bonds climbed above the yields on 30-year Treasury bonds. The cause?

``People are confused, concerned about the implementation of tax reform,'' says George D. Friedlander, a municipal bond analyst at Smith Barney, Harris Upham & Co. ``They're not sure what the worst case is; therefore they don't play.''

As Congress haggles over the tax reform bill, investors have been scared off by uncertainty over which municipal bonds will be tax free. To attract buyers, local governments are being forced to boost the interest rates they pay on these bonds above the normal levels.

Cities and states hawk municipal bonds to raise money for general needs and public-works projects. They're especially attractive to high-tax-bracket investors, since interest is free from federal tax (state and local taxes, too, if purchased by a resident).

In 1985, individuals bought about half of the munis sold. By some estimates, that share has plunged to 25 percent.

Friedlander, and many others, are touting these high yields as an unusual munil bond buying opportunity. ``It's not as bad as investors perceive it to be,'' he says. ``And prices are so cheap now, I don't see us getting cheaper relative to taxable bonds.''

Professionals and institutions are taking advantage of the high yields, says Gerald E. Pelzer, chief financial officer at Clayton Brown & Associates, a municipal underwriter. ``We're seeing some banks and mutual funds doing a little more buying now.''

The risk, of course, is that if interest rates go up, investors will be locking in less than the highest returns. The consensus outlook is that rates may slip a tad lower, then move slightly higher by year-end. But even if rates rise, many long-term municipal bonds have a gap of one-half to a full percentage point to close before they return to their traditional 20 percent discount to Treasury bonds.

``Yields are just so much higher than standard relationship, you've got a 100-basis-point [one percentage point] cushion for inflation or whatever else should happen,'' says Canaday at Nuveen.

It should be noted that only the long-term municipals are selling at relatively high yields. Reflecting concern over an increase in interest rates, munis with one- to 10-year maturities are yielding less than similar Treasury bonds.

Adding to individual buyers' hesitancy is concern that if the Senate proposal becomes law, the top individual tax rate will drop from 50 percent to 27 percent. That would reduce the value of municipal bonds. But muni returns will still beat the after-tax returns on Treasuries, especially in high-tax states, analysts say.

Mr. Pelzer gives the example of a long-term Treasury bond yielding 8 percent and a muni at 7.6 percent. With a 27 percent tax rate, the after-tax return on the government bond would be 5.6 percent, ``giving you a 2 percent better return for the high-quality municipal bond. If you have $100,000 invested, that's $2,000 more. I think people will make the decision to go with the high-quality municipal bond.''

Tax-reform concern caused the market for new munis to dry up earlier this year. Then it exploded in April, hitting a record high for the month. Two reasons: As interest rates hit six-year lows, many cities and towns issued bonds before rates turned up. And a deluge hit when the Senate Finance Committee OK'd a version of the tax bill that reversed a House version that would have made many munis taxable retroactive to last Jan. 1. The Senate cleared the way for some bonds issued this year to qualify as tax exempt.

How long will the yields on municipals remain in the stratosphere?

Until demand picks up, the market-watchers say. And that isn't likely to happen until a tax overhaul bill becomes law. Senate majority leader Robert Dole (R) of Kansas said earlier this week that the bill would be debated on the Senate floor next Wednesday. If it passes, a House-Senate conference panel will meet to resolve the bills' differences. Guesstimates say a final vote will be in August.

Meanwhile, the ambiguity over the tax status of municipals keeps yields pumped up, a potential boon to investors. But state and local governments must pay more to finance construction of their schools and sewers.