The new permanent ingredient in `muni' bonds: volatility

The stock market took a tumble last year. Everybody remembers that. The municipal bond market, however, tumbled twice: once in the spring and again in the fall. Outside of the ``muni'' bond business, these drops in bond prices didn't get much attention.

A lot of notice was given, however, to a recent Supreme Court decision that said Congress can tax the interest on state and local bonds. Immediately after the decision was announced April 20, bond prices fell, but recovered later in the day.

While most analysts agree the court's decision is almost meaningless for now, because Congress is very unlikely to use this power, other changes in the muni bond markets bear closer attention.

The Supreme Court decision ``was kind of a non-event,'' says James Couture, senior vice-president at Clayton Brown & Associates, a bond brokerage in Chicago. Congress already has the freedom to tax municipal bond interest but has simply chosen not to use it, he said.

``The muni market has been operating under legislative authority rather than judicial authority for a number of years,'' Mr. Couture observed. ``Congress has allowed the municipal market to grow. they have put in and taken out restrictions at their will.''

Even if Congress did decide to tax municipal bond interest, the gain would not be worth the turmoil it would cause these bond markets and the uncertainty it would bring on states, counties, and cities, says Ian MacKinnon, senior vice-president at the Vanguard Group in Philadelphia.

While a future Congress ``is going to look far and wide to expand the tax base and reduce the national debt ... the amount of revenue that could be derived from the municipal market isn't terribly large,'' Mr. MacKinnon said.

About $80 billion of new municipal bonds will be issued this year, and they will generate less than $7 billion in interest, he notes. If all this were taxed, the federal government would only get about $2 billion in revenue.

Considering that states and cities are being asked to carry more of the financial burden while the federal government carries less, and that much of the nation's infrastructure, including bridges, roads, and sewers, needs replacing or repair, any action making bonds to finance these projects less attractive seems very unlikely.

``If there were any risks of a new door being opened [by the Supreme Court decision], you might see a rush to buy muni bonds that could be grandfathered under old laws,'' MacKinnon said. ``Second, you'd see a stepped-up calendar of new issues. Neither of those is happening.''

Far from a stepped-up calendar of new issues, the number of new issues has been falling steadily in recent years. In 1985, states, cities, and towns floated $204 billion of municipal bonds, according to MacKinnon. In 1986, that number fell to $142 billion and last year to $100 billion. This year, MacKinnon estimates, only about $80 billion of these bonds will be put on the market.

A major reason for the lower volume is the 1986 Tax Reform Act. It severely restricted - eliminated, in many cases - the tax-free status of ``private purpose bonds'' issued for things like shopping plazas, pollution control projects for businesses, and industrial development areas.

In fact, the big reason for the heavy volume in 1985 was the expected 1986 tax law.

MacKinnon says that ``1985 saw a rush to get into the market before the effective date of the legislation.''

While changes in the tax laws are one factor affecting municipal bonds, other changes in these markets have brought on more than their share of uncertainty for investors. Last year's two turbulent periods, for example, ``did wash out some investors,'' says Richard Ciccarone, vice-president for fixed-income investments at Van Kampen Merritt Inc.

Many others, however, have stayed - also because of Tax Reform. ``Muni bonds are one of the few tax shelters left,'' Mr. Ciccarone says. ``Tax-exempt rates versus taxable rates are very attractive right now.'' A top-rated municipal issue is currently yielding about 7.4 or 7.5 percent, he says.

Most of those who are still in municipal bonds and municipal bond mutual funds are now well aware of the new rules of volatility that apply here and in most other investments today.

``None of the markets - stock, bond, or even government bond - is any longer immune from large swings on an intraday basis,'' Mr. Couture at Clayton Brown says. ``It's not that long ago that a 25-point dip [in the Dow Jones industrial average] put a lump in everybody's throat. Today, people only begin to take notice when it goes down 100 points.

``The same sort of thing is happening in municipal bonds. We've entered a period where volatility has been greatly increased.''