A Less Taxing Investment

The stock market is on a tear; Treasury bonds are bursting with profits; even junk bonds have scrambled to the top of the heap.

So why take a look at plain vanilla, safe-as-Sunday, municipaI bond funds?

Those may, in fact, be some of the best reasons to check out a muni fund.

If your portfolio has prospered from stocks and other bonds, and you're ready to pocket your profits, a muni fund looks like a reasonable place to park them.

They offer measurable levels of safety, and yields accumulate free of federal and, often, state taxes.

Keep in mind, though, that muni bond funds won't create much conversation fodder when your friends start boasting about their latest investment triumphs.

They have been as out of favor, this year, as index equity funds are fashionable. In fact, investors are taking more money out of muni bond funds than they are putting dollars in.

Municipal bonds are debt instruments issued by state and local governments. They generally carry no federal or state taxation.

This was supposed to be the year when muni bonds snapped back.

The supply of the bonds themselves is down, which means prices should be rising and earlier talk in Washington of eliminating the tax benefits faded away.

But 1997 has been tough on the muni group of almost 1,000 funds, in part because the stock market continues to steal their thunder.

According to the Investment Company Institute, for the first five months, the amount of investor dollars put in muni bond funds has shrunk $3.1 billion to $253 billion. The outflow follows a similar decline last year.

"This may be a good time for investors to start looking at municipal bonds again," says John Woerth, a spokesman for Vanguard Group.

Many investment portfolios are out of balance because of the run up in stock prices, Mr. Woerth notes, and investors need to "rebalance their holdings" towards their original weighting of stocks and bonds.

"Muni bond funds represent a very good investment for many people," says Mark Wright, an analyst with Morningstar, a financial reporting group in Chicago.

They offer rare tax breaks for small-to-medium-sized investors, he notes, which can be particularly attractive in high-income-tax states such as New York and California.

Single state funds buy bonds issued in just one state and pay interest that is usually free of state and federal taxes. Interest from national municipal bond funds, which own bonds from several states, is free from federal, but generally not state, taxes.

"Muni bonds can be a good investment for purposes of diversification and for reasonably safe, tax free income," says Sheldon Jacobs, of the No-Load Fund Investor.

To determine if a muni bond fund makes sense for you, compare your after-tax return to another type of bond fund.

For example, if a muni fund pays 5 percent versus 6 percent on a corporate bond fund, which fund works better for someone in the 28 percent tax bracket?

Divide 5 percent by 0.72 (100 minus the 28 percent tax bracket). The answer, 6.94, is your after-tax return. So the corporate fund needs to yield 6.94 percent to measure up.

Over time you will even do better, says Richard Harper, an investment strategist with bond house John Nuveen & Co., of Chicago. Studies by Nuveen show that over 20 years, a person in a high tax bracket (Nuveen used 31 percent) would have made an annualized, after-tax return of 8.50 percent on investments in municipals, compared with 5.62 percent on corporate bonds and 5.18 percent - both after-tax - on Treasury issues.

Wright particularly likes funds issued by Vanguard (800-523-8552) and USAA group (800-531-8319). Both have low expense ratios and solid returns.

Other funds favored by analysts include:

* Excelsior Long term Tax Exempt, up 6.09 percent through July 25. Minimum investment: $500 (800-446-1012).

* Eaton Vance Muni Bond (A Shares), tops in the group, up 8.38 percent through July 24. Minimum investment: $1,000. (800-225-6265.)

* Group, with three muni funds. Minimum investment for each: $2,500 (800-368-1030.)

Tip Sheet

Bonding With Munis

* "Most municipal bond funds are about the same," says Mark Wright of Morningstar. So "look for a fund with the lowest expense ratio."

* Invest in bond funds for the long haul. If you want to trade bonds actively, to take advantage of interest rate changes, buy individual issues from a broker.

* Don't invest in them for a tax-deferred retirement account, such as an IRA, since they are already tax sheltered.

* For the highest yields, try a junk bond fund rather than a high- yield muni fund. Returns will be higher, although so will risk.

* If you live in a high tax state, consider a single-state muni fund. The Franklin Group, for example (800-342-5236), has some 40 single-state muni funds.