A Less Taxing Way To Invest

Investors looking to increase their portfolio’s yield without holding junk bonds might want to take a look at long-term bond funds. According to mutual fund research firm Morningstar, long-term bond funds were yielding a respectable, if not dazzling, 4.5% as recently as September.

There is a catch, though. If you hold these funds in a taxable account as opposed to a tax-deferred retirement plan, its yields must be shared with Uncle Sam. In a 28% tax bracket (taxable income over $70,350 on a joint return in 2004), for example, a 4.5% yield would shrink to a mere 3.24%. Tax payers in a higher bracket would net even less after taxes.

The solution? Consider municipal bond funds, which hold tax-exempt bonds issued by state and local governments. The interest on these bonds generally won’t be subject to income tax and this tax shelter is passed on to mutual fund investors. Long-term muni funds recently paid a 3.9% yield, which would put high-bracket investors ahead after taxes. “The case for buying municipal bond funds is pretty favorable,” says Scott Berry, a senior analyst at Morningstar. “Given where yields are now, there’s no reason to choose taxable bond funds if you’re in a high tax bracket.”

What’s more, municipal bond funds might be a good choice if the country is indeed entering a period where interest rates head north, as many analysts expect. “Municipal bonds may hold up better than other bonds as rates rise,” says Michael Tankersley, a certified financial planner with Investment Management Advisors in Birmingham, Alabama. “The overall economy is rebounding and the states are doing well. This is good news for muni bonds.” With state and local tax revenues on the rise, it’s more likely that municipal bond issuers will fulfill their promises to investors.

Assuming you find municipal bond funds appealing, you have several decisions to make. First, you must choose among long-, medium-, and short-term muni funds. “Yields are higher on long-term funds, and long-term returns will likely be better,” says Berry. “It’s true that you could see some volatility in long-term funds over the next year or two if interest rates rise, but long-term investors may be best served in long-term funds.”

Berry’s picks include Fidelity Spartan Municipal Income (FHIGX), Franklin Federal Tax-Free Income A (FKTIX), Vanguard High-Yield Tax-Exempt (VWAHX), and Vanguard Long-Term Tax-Exempt (VWLTX).

Stephen Overstreet, a certified financial planner with Financial Planning Offices in Winter Springs, Florida, prefers to avoid the volatility of long-term funds. “You shouldn’t invest solely for high yields,” he says. “You should be more concerned with total returns.”

Long-term bond funds are likely to lose value when interest rates rise, therefore the principal you lose might outweigh the extra yield you receive with a long-term muni fund. Intermediate- and short-term muni funds, on the other hand, won’t go down as much in a rising interest rate environment. “In particular, I recommend Vanguard Intermediate-Term Tax-Exempt (VWITX) and Vanguard Limited-Term Tax-Exempt (VMLTX) funds to clients. These funds have low expenses so they can pay more to investors. They won’t shoot out the lights for you, but they’ll provide steady income and help to stabilize your portfolio,” says Overstreet.

Recently, these two Vanguard funds were yielding 4.1% and 3.0%, respectively, tax-exempt, which compares favorably with intermediate- and short-term taxable yields. Vanguard’s limited-term fund has a lower yield because it holds bonds with a shorter maturity, which means it will hold more value if rates move up. In 1999, the last year interest rates rose sharply, Vanguard’s intermediate-term fund lost only 0.50%, while the limited-term fund managed to gain 1.47%.

Municipal bond funds can be sliced into short-, medium-, and long-term vehicles, and they can also be

diced into national and single-state funds. A resident of Ohio, for example, will owe taxes to Ohio on income from a national muni fund. That investor, however, can avoid state and federal income taxes by investing in a fund that only owns municipal bonds issued in Ohio. “If you are in a high-tax state, such as California or New York, you’ll be better off, after-taxes, with a single-state muni fund,” says Berry.

Investors in municipal bond funds have yet another option: Invest in a high-yield muni fund. As the name suggests, you can get higher tax-exempt yields (recently, the average was 5.2%) if you’re willing to put money in

to riskier bonds. “High-yield municipal bond funds might make sense for a small part of your portfolio,” says Overstreet. Tankersley concurs, noting that an improving economy will likely hold down state or municipal defaults, which are the main risk in the high-yield bond market. According to Morningstar, American Funds High-Income Municipal Bond A (AMHIX), which leads the category in five-year return and yields 4.7%, is a “prudent way to navigate a volatile investment arena.”

Now a word of caution: Whichever type of municipal bond fund you choose, you should consider its ownership of bonds that are exposed to the alternative minimum tax (AMT). The AMT requires taxpayers to add back certain allowable deductions and adjustments when calculating their income tax, including state and local income taxes; property taxes; and some investment and medical expenses. If the deductions add up to a disproportionate share of your income, you could be hit with the AMT. “The AMT is becoming a bigger issue, and more investors are [getting] caught in the AMT trap,” says Berry. “Some municipal bond funds buy AMT bonds to increase their yields. For investors who pay the AMT, a portion of the yield can be taxable, which can defeat the purpose of buying a municipal bond fund.” If a fund has 40% of its assets in AMT bonds, for example, 40% of its distributions might be taxable. “Fortunately, there are muni funds that hold few or no AMT bonds. Check with the fund before buying if the AMT is a concern,” says Berry.

Now a word of caution: Whichever type of municipal bond fund you choose, you should consider its ownership of bonds that are exposed to the alternative minimum tax (AMT)

TOP MUNI NATIONAL LONG-TERM AND MUNI NATIONAL
INTERMEDIATE RETAIL FUNDS BY 3-YR RETURN

Name	Ticker	12-Month Yield	1-Yr. Total Return*	3-Yr. Annualized Total Return*	5-Yr. Annualized Total Return*	Minimum Initial Purchase	Phone Number
Muni National — Long-Term
Eaton Vance National Municipals A	EANAX	6.03	10.02	6.40	6.79	$1,000	800-225-6265
First Investors Insured Tax-Ex II A	EIITX	3.37	7.92	6.24	7.71	1,000	800-423-4026
TIAA-CREF Tax-Exempt Bond	TCTEX	3.53	7.87	5.93	NA	2,500	800-223-1200
Fidelity Spartan Municipal Income	FHIGX	4.31	7.61	5.82	7.01	10,000	800-544-6666
Schwab Long-Term Tax-Free Bond	SWNTX	3.91	6.73	5.68	6.96	2,500	800-435-4000
Muni National — Intermediate
Strong Intermediate Municipal Bd Inv	SIMBX	3.56	7.47	6.81	NA	$2,500	800-368-3863
Evergreen Intermediate Muni Bd A	ESTVX	3.50	6.63	5.91	7.14	1,000	800-343-2898
State Farm Tax Advantaged Bond A	SFTAX	3.87	7.34	5.87	NA	250	800-447-0740
Harris Insight Tax-Exempt Bond N	HXBAX	4.28	6.65	5.76	7.49	1,000	800-982-8782
Delaware Tax-Free USA Intermediate A	DMUSX	3.67	7.36	5.62	6.50	1,000	800-523-4640
SOURCE: MORNINGSTAR INC. MORNINGSTAR MAKES EVERY EFFORT TO ENSURE THE COMPLETENESS AND ACCURACY OF THIS DATA BUT CANNOT GUARANTEE IT. *RETURNS THROUGH AUG. 31, 2004