Municipal Bonds May Get Boost As Tax-Reform Prospects Sag

Thanks to the presidential election of 1996, the municipal-bond market is suddenly looking more attractive.

Phones are ringing more often on muni bond trading desks now that significant tax reform appears unlikely right through 1997. For the universe of municipal bonds - those issued by local and state agencies - that delay is not an unhappy development.

Late last year and early this year, municipal bonds were pummeled by apprehensions that a new Republican-led White House might "reform" the nation's tax code in a way that would eliminate or reduce the financial advantages of these bonds for some investors. GOP primary contender Steve Forbes talked about enacting a "flat tax." And Bob Dole has made tax reform a linchpin of his presidential agenda.

But if polls are to be believed, President Clinton will win a second term. That means there will probably be only minor fiddling with the tax code next year, experts say. That assumption, coupled with a lower supply of new municipal-bond underwritings, is giving a price boost to the bonds.

Despite a less-than-stellar year for municipal-bond mutual funds in 1996 - both in terms of returns and money flows into the bonds - munis can be advantageous for many investors.

"Most of the old tax shelters have now been taken out of the tax code," says David Blitzer, chief economist at Standard & Poor's Corp. in New York. "Municipal bonds represent one of the few [ways] left for average investors to offset high taxes."

Average returns on muni-bond funds this year have paled alongside the performance of many other types of bond funds, such as junk-bond, emerging-market, or world-bond funds.

Municipal-bond funds, for example, posted an average return of 2.13 percent during the third quarter, ending Sept. 30, according to Morningstar Inc., a financial information firm in Chicago. By contrast, world-bond funds averaged a return of 4.55 percent. And many specialty bond funds did even better: According to Lipper Analytical Services Inc. in New York, emerging-market bond funds posted double-digit gains. Moreover, stock funds as a whole beat the muni funds during the quarter, and have done so throughout 1996.

Little wonder, then, that muni funds continue to post net outflows. The only month in 1996 to show a positive net inflow was June, when a net $198 million of new money poured in. But since Jan. 1, more than $5 billion has flowed out of municipal bond funds.

Assets in muni funds are now down to $246 billion, compared with $253 billion at the beginning of the year, according to the Investment Company Institute, a trade group in Washington. And while equity funds continue to be created, muni funds are disappearing. There are now 993 funds, compared with 1,010 on Jan. 1, according to the ICI.

Still, municipal issues can represent a good investment if you live in a high-tax state, are in a high federal tax bracket, or just want diversification, says Lacy Herrmann, chairman of the Aquila Group in New York, which offers a number of single-state muni-bond funds. (People buy single-state municipal funds because interest income from them is often free of state as well as federal taxes. With national muni-bond funds, investors are generally exempt from federal taxes but not state taxes - except for whatever portion of fund assets happen to be in investors' home states.)

A recent plus for the munis is that "federal regulators appear to be tightening their oversight of municipal bonds," to prevent a reoccurrence of the Orange County bond default and several other major defaults in the early 1990s, says John Tompkins, who writes a financial column for the "Money Talks" electronic magazine on the Internet's World Wide Web.

Finally, a decline in public debt offerings is expected to help push up yields for muni funds - a classic case of investor demand chasing smaller supply.

In 1994, for example, new public debt underwriting reached $162 billion, according to Securities Data Company, a financial information firm in Newark, N.J. The level fell to $156 billion in 1995. This year, the level is at $130 billion, through Oct. 8.

Mr. Tompkins says that some new, offbeat revenue offerings are posting yields of 18 percent or more, to compensate investors for their higher risk of default.