Municipal bonds: the choice of wise investors.

When Presidential candidate H. Ross Perot disclosed details of his investment portfolio, as required by law, they reflected the holdings of a successful entrepreneur. As expected, they included high-tech stocks and venture capital investments. Many observers were surprised, however, to find that Mr. Perot's bedrock investment of choice was municipal bonds.

What prompts this savvy capitalist to find municipal bonds attractive? And how can you fit them into your own investment strategy?

FACTS AND FEATURES

Municipal bonds are issued by state and local government entities: cities, towns, water districts, state agencies, industrial development authorities. The basic denomination for purchase is $5,000.

Most municipals fall into two broad categories--general obligation and specific-use.

General obligation (GO) bonds are supported by the issuer's full taxing authority. Theoretically, a state could raise taxes as needed to service its GO bonds. For this reason, many conservative investors prefer GOs. Of course, the additional implied safety means the yield paid is a bit lower than on other bonds of equal credit rating.

Specific-use bonds are backed by a limited source of revenue, such as bridge tolls and water bills. Because these bonds aren't guaranteed by an issuer's full taxing authority, many investors assume they carry higher risk. But, in the municipal bond market, differences in risk are small indeed and are often more theoretical than real. For instance, if bridge toll revenue is inadequate, the state is not likely to let the bondholders eat a loss, because the state knows it will have to borrow again for new bridges.

Municipal bonds are attractive to investors for a number of reasons. First, they carry a unique and compelling feature: The interest they pay is free of federal income tax. And if you purchase a bond originating in your state of residence, it's also free of state income tax. This two-pronged tax relief provides plenty of incentive to consider these debt obligations.

Second, as government issues, municipals have enjoyed a nearly default-free history. They've defaulted in less than one-tenth of 1 percent of all instances, and these defaults are generally limited small, specific-purpose bonds in isolated cases.

Third, like other types of bonds, municipals are usually assigned ratings by Standard and Poor's, Moody's, Fitch's and others to help investors judge the quality of the bond. The absence of a rating, however, doesn't automatically mean the bond is of poor quality. Sometimes a credit-worthy issuer, such as a school district, is too small to pay for a credit rating or finds it can sell its bonds without a rating.

One caution: If you discover a bond has no rating but is labeled "bank qualified," don't assume the bond is high quality. "Bank qualified" means the bond meets certain criteria within the Tax Reform Act of 1986 that allows the interest it generates to be tax free. The term has nothing to do with credit quality.

Finally, companies like the Municipal Bond Insurance Association (MBIA), the Financial Guaranty Insurance Company (FGIC), and the American Municipal Bond Assurance Corporation (AMBAC) insure the bondholder against default. Bond issuers that need to enhance their credit rating to sell bonds often apply for this bond insurance. The issuer pays the insurance premium, and the bonds are then rated AAA. The insurance typically guarantees timely payment of principal and interest. If the issuer defaults, the bondholders won't see their principal prior to maturity, but, in the interim, interest is paid on time.

A LOOK AT THE MATH

The most convincing argument for municipal bonds is found in the figures. If you purchase a new S-percent bond for $10,000, you'll earn $500 per year in tax-free income. What is that worth? If you're in a 28-percent tax bracket and your state imposes an additional 4-percent state income tax, your combined bracket is 32 percent. To walk away with 5 percent from a taxable investment, you would have to earn 7.35 percent in taxable interest.

To come up with 7.35 percent, known as the taxable equivalent yield, apply this formula: the bond interest rate divided by (1 minus your tax bracket). In this example, that's .05 / ( 1 - .32) = .05 / .68 = 7.35 percent.

Very often, municipals will trade at taxable equivalent yields higher than CDs or Treasuries and equivalent to corporate bonds of equal credit rating. And, at times, municipals will trade "cheap" to taxables, meaning that their taxable equivalent yields are much higher than they should be relative to taxable bonds. Since the interest is tax-free, you don't have to add it to your other income when filing your tax return. So, you save again, as tax-free income won't push you into a higher tax bracket.

Continuing the figure comparisons, investors know that the long-term return on common stocks in the United States over the past 50 or 60 years has been between 10 and 11 percent per year. For that reason, common stocks are considered pretty good vehicles for building wealth. What many people fail to realize, however, is that this 10 to 11 percent is a pretax return, whether the return is from dividends or capital gains. Reduced to reflect the taxes that must be paid, this return drops to between 6.8 percent and 7.5 percent. (I recognize the tax is often postponed because the securities are held for many years.)

But, when you consider the risk involved, municipals may be a better investment than common stocks. The question: Would you rather take a greater risk for an average return of 7.25 percent after taxes or opt for a nearly risk-free return of 6.5 percent?

THE TOP 10 BOND CHOICES OF A PORTFOLIO MANAGER
Gallea's Favorites                           Why?
1. Industrial Development Bonds       Not well understood.
                                      Many investors shun
                                      them, creating excellent
                                      value.
2. Money Market Preferreds            Superior yields to tax
                                      -free money funds,bought
                                      and sold at par. Very
                                      few investors are even
                                      aware of them.
3. State Mortgage Agencies            Great yields, excellent
                                      credit quality, more
                                      stable in price.
4. Premium Bonds                      A lot of people don't
                                      want to pay a premium
                                      for bonds. This creates
                                      value for the savvy
                                      investor.
5. Short-term Notes                   Superior after-tax
                                      yields to six months and
                                      other short CDs for high
                                      tax bracket individuals.
                                      Many investors don't
                                      even consider them.
6. Prefunded Bonds                    Backed by an escrow of
                                      U.S. government
                                      securities, they carry
                                      AAA credit ratings. A
                                      slam dunk.
7. General Obligation State Bonds     Backed by the unlimited
                                      taxing authority of the
                                      state. That's not a bad
                                      backing for the bond.
8. Double-Barreled Bonds              Backed by two sources:
                                      the project issuing the
                                      bonds and another
                                      government authority.
9. Private University Bonds           A generally excellent
                                      secondary market. There
                                      always seem to be alumni
                                      who want to buy the
                                      bonds.
10. Pollution Control Revenue Bonds   Issued on behalf of
                                      electric utilities to
                                      finance pollution
                                      control equipment. Not
                                      well understood but
                                      usually offering
                                      excellent value.

INVESTMENT STRATEGIES

Though municipals may seem simple and safe, many carry obscure terms of prepayment that, if activated, can present a nasty and expensive surprise to the unaware. You should consider such conditions as mandatory and optional puts, sinking funds, and prerefundings. State mortgage bonds, for instance, are attractive because they're usually callable at par and so carry the best price stability. But a sudden call can leave an investor poorer and wiser if he's paid a premium (more than the face value) for the bond. So, if you're unfamiliar with municipal bonds, you may want to find a good broker who specializes in municipals.

Most investors should buy bonds with the idea of holding them to maturity. Since municipal bonds are traded strictly over the counter, with many small or inactive issues, bid-ask spreads and transaction costs make them poor trading vehicles.

Laddered portfolios work best. In a ladder, you stagger your maturities and roll over new money to the farthest maturity in your ladder. By laddering, you'll have money due regularly for reinvestment, but you'll average the longest maturity in yield. This longer maturity will almost always be the highest yield available.

For instance, if you create a three-to-l2-year ladder, your initial investment will spread maturities over three to 12 years. As you invest new money, you'll always buy the 12-year maturity. After three years, you'll have money rolling over each year to be repositioned. (You should also limit each purchase to 5 percent of your total portfolio, with no more than 20 percent to any one issuer.)

Next, decide on a minimum credit rating for your portfolio. (Your broker's statement should show the credit rating on every bond.) More venturesome investors will go as low as a BBB, seeking their higher yield. Conservative investors will stick with AA and AAA bonds. If a bond in your portfolio drops below your minimal accepted rating, sell and replace it.

Don't hold your bonds in a safe-deposit box. You aren't at risk by having your broker hold them, and you can be assured of being informed about call provisions or tender offers. Also, your coupons will be cashed for you automatically. With "book entry" issuance, many bonds now exist only in electronic memory. No paper is actually issued.

Even if your broker holds your bonds, keep informed about call dates, sinking funds, credit ratings, and put features. Any one of these may give you an opportunity to "swap" into a better position. In a swap, you simultaneously sell your bond and purchase a replacement. Since there are two transactions, if you're using a broker, he or she will often swap for you at a reduced commission rate. For instance, if you know a bond may be called away next year, you may want to swap out of it now, while you can still get a premium for it.

Like all investors, I've had experiences with bonds that influence my thinking. Therefore, I suggest you consider the following when building your portfolio:

* Three-to-10-year ladders, for long-term investors. Shorter terms give away yield, and longer terms have increased price risk should interest rates rise. For terms under five years, buy A-rated or better; for longer terms, buy AA. These maturities leave room for a credit downgrade, while retaining an investment grade bond.

* Longer-term bonds, if they provide a call feature within your ladder horizon. Say you have a 20-year bond with an eight-year call provision. Typically, somewhere between eight and 12 years out, the bond will be called away. Then you can enjoy a 20-year yield with a shorter expected maturity.

* Insured bonds, but limited to one-third of the portfolio. While all the major municipal bond insurers continue to earn AAA ratings when they insure, other insurers are private corporations without government guarantee. So don't place too much money in insured bonds.

* State mortgage agency bonds typically pay a high yield. Callable, they tend to trade close to par value.

* Good medical care facility bonds, especially geriatric facilities, are worth considering. But be careful with these because many hospitals are operating in the red.

* School districts are worth a look, as are state GOs and power authorities. Consider, too, non-state issuers like Puerto Rico, Virgin Islands, and Guam, which are state tax-exempt.

* Bonds subject to AMT, or the alternative minimum tax, trade at higher yield levels and are therefore timely.

* Short-term, floating-rate market bonds are among the least known and most profitable. Called by different names (variable rate demand notes, put remarketing programs, money market preferreds, select auction variable rate securities), these short-term municipal issues are purchased when you need a high current yield and liquidity. Typically, these issues trade at a yield 50 to 60 basis points (.6 percent) higher than municipal money market funds. They're bought and sold at par, and the issuer absorbs the investment banking cost to maintain the issue. The interest rate is typically reset weekly or monthly, and interest is paid monthly. Minimum denominations are usually $50,000. Investors would do well to consider these issues instead of traditional municipal money market funds.

* Municipal money market funds are my last-choice consideration for short-term, liquid investment.