Pre-refunded municipal bonds ... a well kept secret for short-term investors.

Two months after April 15, investors can now appreciate the effects of the most recent income tax increase. It's hard to open a newspaper business section or a business magazine without seeing an article on the advantages of tax-free investing. Many investors with short-term parameters have not taken advantage of the tax-free municipal market. Opting to stay clear of the credit considerations associated with municipal bonds, safety-conscious investors have stuck with Treasury Bills and Notes. If you are one of those people, you may be interested in an alternative opportunity: Pre-refunded Municipal Bonds.

A pre-refunded municipal bond (often called a "pre-re") is a bond that the issuer has decided to redeem (call) from the bond holder prior to its maturity date. The early redemption feature is one that appears in most bond issues and is limited to specific dates outlined in the bond's official statement. The call feature gives the issuer the ability to lower their overall interest expense by retiring existing bonds with high interest (coupon) rates. Most calls occur during periods of low and/or falling interest rates. A tax-free bond issuer will distribute new bonds at lower rates and pledge the proceeds of the new issue to retire (pre-refund) outstanding bonds at their earliest possible call date. In many instances, the issuer will use the proceeds of the new bond issue to purchase Treasury securities that mature in conjunction with the call date on the bond being retired. When this occurs, the "pre-refunded" bond is said to be "escrowed to maturity in government bonds" and as such takes on the credit quality of the underlying treasury security.

The buyer of an "escrowed to maturity pre-refunded bond" is picking up the credit quality of a government security with the tax-advantage of the municipal security. When you add these two features together, the safety conscious investor is provided with an investment vehicle that has the potential for providing a higher after-tax yield on a conservative and short-term investment. A look at the numbers will help illustrate our point.

At the time of this writing, the yield on a two-year Treasury Note is 5.85%. The investor must pay a federal tax on the interest income. If we assume that an investor is in the 31% federal tax bracket, the after-tax yield on this investment is reduced to 4.04%. (This number is derived by multiplying the pre-tax yield by the sum of 100 minus the tax bracket or 5.85% x .69).

By comparison, a municipal bond that has been "pre-refunded" to mature in two years is yielding 4.82%. The interest earned on this security is exempt from Federal and State taxes. The benefit of the "pre-refunded" bond is an increase in yield of .78 percent or 78 basis points. On a $100,000 investment the increased income is $780 per year tax-free.

With interest rates beginning to rise, many short-term investors may return to Certificates of Deposit which are federally insured (up to $100,000 per depositor) and offer a fixed rate of return. However, most banks have lagged the market in raising rates on deposits and as a result, "Pre-refunded bonds" continue to be attractive on a yield basis. (It is important to note that we encourage investors to utilize bank deposits for a portion of their short-term portfolio.)

Like every investment opportunity, "pre-refunded" bonds have certain characteristics that may be confusing to the investing public. One such characteristic is a price premium. Bonds available for purchase in the "pre-re" market are almost always high coupon bonds that trade at premiums.

A premium occurs when the stated rate of interest (coupon rate) on a bond is above the level currently being paid in the market for an investment of equal length. Another consideration is that all fixed-income investments are interest rate sensitive. A change in market rates of interest may cause price fluctuations that could effect your return if the investment is liquidated prior to term.

INVESTMENT                   MATURITY         YIELD           AFTER
                                                            TAX YIELD

Certificate of Deposit        2 Years         5.64%(*)        3.38%(**)
Treasury Note                 2 Years         5.85%           4.04%
"Pre-re" Municipal Bond       2 Years         4.50%           4.50%

* an average of the 100 highest rates being paid by banks across the country.

** based upon a 31% Federal Tax Bracket and a 9% California State Tax Bracket.

*** some municipal bonds may be subject to Alternative Minimum Tax.

**** all rates expressed as yield to maturity and based upon prevailing rates
on May 26, 1994.

The benefit of pre-refunded bonds in terms of increased yield is well worth the effort it takes to understand them. One last word of wisdom: the pre-refunded municipal bond market is not a cut-and-dried environment. There are a variety of features that may make a pre-refunded bond perform differently than the way it appears at first look. To ensure that your investment will perform properly, work with someone who specializes in pre-refunded bonds and has access to a variety of bond information systems.

Mr. Isaacs has been a securities broker since 1984. He is currently licensed with Linsco Private Ledger (Member NASD/SIP) and provides investment services at Mercantile National Bank in Century City.