Municipals Stage a Recovery

Municipal bonds might be called the "comeback kids" of the bond world.

Many investors have been skittish about munis ever since the Orange County, Calif., bankruptcy debacle. Not only that: There's perennial concern that Congress might be tempted to reform the tax code, possibly creating a flat tax. If that happened, muni interest might lose its status as deductible income.

So why are many municipal bondholders smiling these days?

Bond supply and interest rates, says Richard Peterson of Securities Data Company in Newark, N.J.

Many municipalities are now refinancing or issuing new debt at lower interest rates than in the past few years, he says. That pushes up the prices of existing older bonds. And supply is growing modestly, he notes. In 1997, some $214 billion of new debt was issued, up slightly from about $180 billion in 1996. Mr. Peterson expects "modest growth" in new issues in 1998.

All this creates the greatest opportunity in municipal bonds since the early 1990s, according to A.G. Edwards & Sons. With the long-term Treasury bond now yielding about 6 percent, and possibly headed lower, muni yields continue to rise as a percentage of Treasury yields. Thus, yields on AA rated tax-exempt muni bonds are now about 90 percent of the yield on a taxable Treasury bond. Typically, the spread is closer to 82 percent.

The key point: After-tax return on Treasuries is lower than on munis.

Most analysts recommend that investors look for muni funds with average maturities in the intermediate range - seven to 10 years.