Tax exempt Municipals

MUNICIPAL bonds have become Everyman's tax shelter. The federal government does not tax the interest you collect on most of them, and if the bonds are from your home state, you probably will escape state and local taxes, too. This exemption is not the only reason to buy munis. They also yield high interest. Often they pay about 80% to 85% as much as U.S. Treasury bonds do, but your income from Treasuries is not exempt from federal taxes. In May 1989, AAA general obligation municipals were paying around 7.3% which was some two points higher than the compounded annual rate of inflation.

But do not rush out and sell your tax free bonds. Even if your tax rate falls, your return from municipals could still be quite good. For example, if you were in the 33% tax bracket for your 1989 income, a top rated municipal yielding 7.3% would have paid you the equivalent of a 10.9% taxable yield. If you were in the 28% tax bracket, your yield would have been 10. 14%.

Municipals have the usual risk: if interest rates climb, the prices of the bonds fall. Then, if you had to sell off your investment to raise money, you would get less than you paid for it. Another risk is that the state or city agency that issued the bond could go broke and default on its payments of principal and interest. To avoid this danger, small investors should stick with the highest quality bonds those rated AAA or AA by Moody's or Standard & Poor's.

You can buy individual bonds from a stockbroker; as discussed, he or she usually will require you to purchase at least $5,000 worth. But it is unwise to buy them unless you plan to hold them until they mature and the issuer pays you back the full face value. If you sell out earlier, you could lose as much as 5% of the value of your bond on sales commissions and the spread between the higher "asked" price at which the broker sells you the bond and the "bid" price at which he will buy it from you. You are at the broker's mercy for what he will pay because the vast majority of municipal bond prices are not even published in newspapers.

One new investment is a tax free municipal bond that has no certificate. Buying or selling this bond is merely a computer transaction, and your record of ownership is a monthly brokerage statement. One plus is that the interest is paid directly into your brokerage account on the day it is due. You do not have to wait for a check to arrive or clear. And there are no worries about certificates being lost or stolen.

Another fairly new wrinkle in tax exempt securities is the single state municipal bond fund or unit trust. You usually pay no federal, state or local taxes on the interest from this investment. Residents of high tax New York and California have been buying single state funds for years, and investor demand has been rising throughout the country. Single state funds or trusts are available in more than half the states, including Connecticut, Massachusetts, Michigan, Minnesota, Ohio, Pennsylvania and Virginia.

Such funds give you the advantage of diversification: you get different bonds, all issued by agencies within one state. The higher your tax bracket, of course, the more you can benefit from a single state tax exempt fund.

You can reduce your risks as well as your cost by buying shares in a municipal bond fund or a unit trust, whether single state or not. Probably the best tax exempt investments for most people are the shares of no load tax exempt bond mutual funds. For annual management fees and expenses of only about one half of 1% of your investment, the funds give you a share of a professionally managed portfolio of bonds that you can sell at any time.

You can buy funds directly from mutual fund companies. Their toll free numbers and addresses are found in advertisements in the financial press. The municipal bond funds with the highest total returns for the 12 months ending May 31, 1989, were Financial Tax Free Income Shares, with a total return of 18.35%; Chubb Investment Funds Tax Exempt, 17.70%; and Aetna Series Trust Municipal Bond, 16.59%.