Sales of tax-free municipal bond funds have exploded in the past few months, and fund companies say there's probably more to come as investors worry about President Clinton's promise to raise the top income tax rate from 31 percent to 36 percent - and 39.6 percent for the wealthiest.
Even without the prodding, the sector has been successful.Cranking out tax-free income year after year, stodgy municipal bond funds now hold $192 billion, up from just $49 billion in 1987, when the 1986 Tax Reform Act slammed the door on most ways to shelter income from taxes, according to Morningstar Inc., mutual fund researchers in Chicago.
But today's rock-bottom interest rates pose a risk for muni investors that rates might rise and reduce the value of their investment, and new options in the once straightforward muni fund sector have complicated matters more. So here is some guidance to help investors sort through the more than 500 muni bond funds on the market:
Municipal bond funds invest in the bond and note issues of states and municipalities. The issues, which are used to finance public projects and services, are backed by the taxing power of the issuers or by revenues from toll roads or other projects.
The chief appeal of these funds, of course, is that their income is free from federal income taxes (although you owe taxes on any capital gains). So while they may yield less than taxable funds, you keep more after taxes are paid.
A fund's "taxable equivalent yield" shows how much a taxable investment would have to pay to match the yield of a tax-free fund. To calculate, divide the stated yield by 1 minus your federal tax rate. The taxable equivalent yield for a long-term muni bond fund yielding 5.33 percent - the average for such funds in December - is 7.40 percent (5.33 divided by 1/81 - .28)), or 7.72 percent for taxpayers in the current top bracket.
Also, interest on issues of specific states is free of state and local taxes for state residents.
Some funds, however, own "private purpose" paper, issued by municipalities to finance nonessential projects, like student loans. Interest on private-purpose paper is free from federal income taxes but subject to the alternative minimum tax, a flat tax owed by some people with large amounts of deductions or tax-preferred income.
To compensate for the tax liability, private-purpose paper normally pays slightly more than regular issues.
While most people view muni funds as solid investments, they carry a clear risk right now. In general, bond fund prices fall when interest rates rise, and the longer the term, the steeper the fall. Most muni funds carry maturities of more than 20 years.
While the top-performing muni funds over time are those with longer maturities, the interim interest-rate risk may be too much for conservative investors or people who might need their money soon.
By cropping the maturities, you can cut the risk. If interest rates rise 1 percentage point, the share price of an intermediate-term fund should drop only 3 percent, compared with 7 percent for share prices of longer-term funds, says John Rekenthaler, editor of Morningstar Mutual Funds.
Paying sales loads for these shorter-term muni funds makes no sense because you can essentially forfeit a full year's yield. Paying loads for longer-term funds also reduces their return.
Adjusting top-performing Vista Tax-Free Income's 12.3 percent average annual return for three years to account for its 4.5 percent upfront load brings it down to 10.6 percent, below all three of the top-performing no-load muni funds.
The biggest growth area in the muni fund market is single-state muni bond funds. Because they invest solely in issues of a single state, their income is free of federal, state and local income taxes for residents of that state.