Municipal bonds offer savings on income tax and good value.

Municipal bonds are one of today's popular investment topics for two good reasons. First, tax-exempt municipal bonds offer investors the chance to maximize after-tax returns. Second, the municipal market has recently offered some exceptional values as a result of a temporary rise in interest rates.

What are municipal bonds? They are debt obligations issued by states, cities, towns and other non-federal government entities to raise money to build roads, schools, bridges, sewers, hospitals and other projects. As with other types of bonds, the municipal issuer agrees to repay the principal at a specific future date and in the interim to pay interest to its lenders, namely the bondholders.

In most cases, thanks to a law enacted in 1913, the interest paid on municipal bonds is usually not subject to federal income tax. (If you're a candidate for the Alternative Minimum Tax, however, you have to include interest income from certain municipal securities when calculating your taxable income.)

In many cases, the interest is exempt from state and local income taxes, too. This makes municipal bonds especially attractive to individuals in the higher tax brackets.

The value of tax-exempt interest is measured in terms of its taxable-equivalent yields, which tell you the rate of interest an investor in your tax bracket would have to earn on a fully taxable investment to equal the tax-free yield of a municipal bond.

For example, if you are in the 36-percent federal tax bracket, you would have to earn close to 9 percent on a taxable investment to get the same after-tax return you'd get from a tax-exempt municipal bond paying 5.75 percent. If you're at the top 39.6-percent rate, your taxable equivalent yield on the same municipal investment jumps to 9.5 percent.

When you factor in state and local income taxes, which can push your total tax rate to nearly 50 percent, the taxable equivalent yields get even higher.

In the taxable bond market, you might have to settle for lower credit quality to earn a yield of 9 percent or more, but in today's municipal market, you generally won't have to compromise credit quality for yield. Insured AAA-rated municipals, which carry a promise from an underwriter to fulfill the issuer's principal and interest obligations in the event of a default, now offer yields that are very close to lower-rated municipal securities.

Like all bonds, the value of municipals fluctuates with interest rates. If interest rates decline, bond values increase, meaning your municipal bond might be worth more than you paid for it, giving you an opportunity to realize a capital gain if you choose to sell before maturity. (Unlike municipal bond interest, capital gains on municipal bonds are fully taxable.) On the other hand, if interest rates go up, bond values drop, which may result in a loss if you sell the bond before maturity.

You can manage interest rate risk in different ways. For example, if you define your investment time frame and then select a municipal bond with a maturity to match, you can adopt a "buy and hold" strategy. By planning to hold the bond until your principal is returned at maturity, you can lock in today's yield without having to worry about future price fluctuations.

Or, you might construct a "laddered" portfolio of municipals by purchasing several bonds with staggered maturities. This way, if rates are rising, you will always have some principal coming due to reinvest at higher yields. On the other hand, if interest rates are declining, your longer-term bonds are increasing in value, giving you the opportunity to realize a capital gain.

If you're looking ahead to future goals, such as retirement or education funding, consider a laddered portfolio of zero coupon municipal bonds with maturities that coincide with your retirement years or the start of your tuition bills.

These bonds are sold at a deep discount from face value and pay no current interest. However, when the bond matures, you receive the full face value. The difference represents the tax-exempt interest on the obligation which has compounded over the life of the security. If you buy a zero coupon municipal at a discount from its original offering price, you may also have a taxable event. Consult with your tax advisor for special rules. (Retirement-oriented investors take note: Municipals don't belong in tax-deferred retirement accounts. Use those vehicles instead to defer your tax liability on fully taxable investment returns.)

It should pay to act soon. Changing dynamics in today's municipal market are creating opportunities that may not last for long. Although municipal prices fell when interest rates rose in the first half of 1996, this market is likely to rally soon, as investor demand outpaces a diminishing supply of new bonds.

New-issue volume has dropped off significantly in recent years, lowering the outstanding supply of municipal bonds. With more investors trying to buy fewer new bonds, a period of rising prices and lower bond yields should develop.

Furthermore, I believe the recent increase in interest rates is a cyclical interruption in a long-term trend toward lower rates. That means today's higher yields on municipal bonds represent a buying opportunity that seems even more attractive when you consider this changing supply/demand equation.

In short, you may want to consider shifting some of your assets into municipal bonds, given the present environment. You may stand to gain immediate benefits in terms of lower tax bills and higher tax-free income. In addition, chances are good that you'd be "buying low" now to create the possibility of "selling high" some time in the future.

Encin is an investment executive in the Pasadena office of PaineWebber Inc.