Bonds Have More Fun

Think munis aren't all that exciting? This one may change your mind.

Magazine Contributor

August 1, 1999 4 min read

This story appears in the August 1999 issue of . Subscribe »

Now that you've made your fortune in the stock market, it's time to make those profits work for you in a tax-free kind of way. It's time to think municipal bonds.

Municipal bonds haven't gotten the ink they've deserved lately. Two big reasons: They're not hot, and they're not sexy--they're merely bonds. Boring, pay-twice-a-year, tax-free debt instruments that used to be just for the old and the rich. But now, due to a variety of economic factors--like supply and demand, and yields--tax-free "munis" aren't just for fuddy-duddies any more.

The big selling point of municipal bond investing is that the income it gererates is typically free from federal and state taxes. Buying individual issues of municipal bonds, however, can be costly. Brokers will say you need at least $25,000, and sometimes up to $100,000, to get into the game. That's where municipal bonds come in.

Muni bond funds offer investors a way to invest in tax-free municipals with little money--as low as $250--and still reap some tax-free rewards. I said "some" tax-free rewards because the way mutual funds are designed, all capital gains, interest and dividend income gets passed on to fund shareholders. So, as a tax-free muni bond fund shareholder, that means you could be subject to paying a capital gains tax on your investment if bonds held in the portfolio are sold at a profit. Then if all bonds held in the fund's portfolio are public-purpose bonds, there won't be any tax to pay on the interest they provide, but interest income from other types of munis may be subject to some taxation.

Susan Keenan manages Alliance Capital's municipal bond department and has been the portfolio manager of the Alliance Municipal Income Fund-National Portfolio since its inception in 1986. The types of muni bonds she keeps have long maturity dates--out 20 or more years. So the interest rates they pay are higher.

"When looking at a municipal bond fund product, people focus more on the income component," says Keenan. "We're buying 30-year bonds, but we're not going to own those bonds for 30 years. Our job is to take advantage of inefficiencies in a highly fragmented marketplace." Keenan also likes insured municipals. At press time, nearly 57 percent of the bonds in the fund were AAA-rated.

Keenan's investment style has worked so far. Alliance's long-term track record shows the fund was ranked No. 4 out of 265 funds for the first quarter of 1999; No. 57 out of 258 similar funds for the past year ending March 31, 1999; No. 5 out of 146 funds for the past 5 years; and No. 11 out of 75 funds for the past 10 years, according to Lipper Analytical Inc.

With yields on tax-free securities and taxable securities as close as they are today, these funds can be a fit for many investors. But to be on the safe side, check with your tax advisor to see which one will provide you with more income.

So many investors have seen huge appreciations in their stock portfolios, it's probably a good time to take some money off the table and buy munis, says Keenan. This is really a capital preservation investment product.

Dian Vujovich is a nationally syndicated mutual fund columnist and author of 101 Mutual Fund FAQs (Chandler House Press). For free educational mutual fund information, visit her Web site, http://www.diansfundfreebies.com