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The Bargains in Muni Bonds

Do you think that the flat tax, proposed by Malcolm S. "Steve" Forbes Jr. when he was a presidential candidate, is just a flash in the pan? Then you might want to think about putting some money into tax-exempt municipal bonds.

Fear of the flat tax has helped put a damper on muni trading. Relative to other bonds, prices on tax-exempts are attractively low and yields are high, says Richard Lehmann, president of the Bond Investors Association in Miami Lakes, Fla.

A flat tax itself wouldn't discombobulate munis. What worries investors is Forbes's companion proposal that all interest income be free of tax. At present, munis carry lower yields than Treasuries, certificates of deposit and comparable corporate bonds and still beat them after tax, for investors in the 28 percent bracket and up.

If CDs and Treasuries also were fully tax-exempt, safety-minded investors might choose them, instead. Their yields probably would drop a little, and when yields decline, the price of existing bonds and bond funds goes up.

To try to retain muni bond investors, sellers would have to provide higher yields. That would reduce the market value of existing muni bonds and bond funds.

But one investor's worry is another's opportunity. For example, take a 10-year, top-quality muni now yielding 4.9 percent tax-free. That's the same net return you'd get from a 7.3 percent taxable bond, if your combined state and federal tax bracket were 33 percent.

But a 10-year Treasury today (on which no state income taxes are due) is yielding only 6.05 percent. So after tax, munis offer 1.25 percentage points more. If you're in the 43 percent state and federal bracket, munis offer a 2.54 percentage point advantage, says Mark Donohue of the brokerage firm Gabriele, Heuglin and Cashman in New York. I'd call that a gift. The odds of munis losing their special tax advantage are minute.

There are two ways of buying municipal bonds: as individual issues or through muni bond mutual funds. Smaller investors generally choose funds.

But if you're truly conservative, and interested primarily in keeping your principal safe, individual holdings may make more sense. Choose high-quality bonds, with solid protection against early calls (a bond is called when it's redeemed prior to maturity).

But buy bonds only if you're sure you can hold to maturity. In those intervening years, the prices of bonds will rise and fall. If you sell before maturity, you'll have to take the price the market offers. But at maturity, you will get your principal back (assuming there is no default).

Most muni bond mutual funds, by contrast, never have a date for when your principal will be repaid. Fund values rise and fall with the market. How much you net depends on when you buy and when you sell.

The mutual funds do have some advantages. You often can invest for $1,000 or less. You can reinvest your interest automatically, at the tax-exempt rate being earned by the fund. And you get a lot of diversification.

Nevertheless, you may care more about sure return of principal. You need at least $5,000 to buy an issue of individual munis, and for that sum there's zero diversification. But an insured, AAA-quality muni may be safe enough. Some investors feel better with $25,000 in five different issues. With larger purchases, you pay a lower percentage commission.

Here are three rules for buying individual bonds:

· Be sure you can hold to maturity -- for example, by buying 10-year bonds, not 30-year bonds. If you tried to sell a $5,000 lot before maturity, you'd be offered a discount (a "haircut") of 2 percent to 3 percent under the going market price, Donohue says. On a $10,000 lot, the haircut might run 1 percent to 1.5 percent.

· Reinvest every dime of your interest income, if you don't need the money to live on. That keeps your nest egg from losing its purchasing power.

· Buy newly issued bonds. You'll pay the same price that the big, institutional buyers do. Individuals pay higher prices when they buy bonds that have been on the market for a while, although a good broker can find you some good buys among these issues, and at a fair price.

Some brokers, however, sell older bonds at abusively high prices or rook you on low prices when you sell. To check a broker's price if you want to sell, sign up for the Standard & Poor's/PSA Municipal Bond Service at 800-BOND-INFO, which provides the approximate buy/sell prices charged to institutional investors. Cost: $9.95 for 25 price quotes. With that information, you might be able to get yourself a better deal.