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A less taxing way to invest: the yields on municipal bond funds are tempting--and tax exempt, too.

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 into 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. Checkwith the fund before buying if the AMT is a concern," says Berry.

 12-Month Total
Name Ticker Yield Return *

Muni National-long-Term

Eaton Vance National Municipals A EANAX 6.03 10.02
First Investors Insured Tax-Ex II A EIITX 3.37 7.92
TIAA-CREF Tax-Exempt Bond TCTEX 3.53 7.87
Fidelity Spartan Municipal Income FHIGX 4.31 7.61
Schwab Long-Term Tax-Free Bond SWNTX 3.91 6.73

Muni National-Intermediate

Strong Intermediate Municipal Bd Inv SIMBX 3.56 7.47
Evergreen Intermediate Muni Bd A ESTVX 3.50 6.63
State Farm Tax Advantaged Bond A SFTAX 3.87 7.34
Harris Insight Tax-Exempt Bond N HXBAX 4.28 6.65
Delaware Tax-Free USA Intermediate A DMUSX 3.67 7.36

 3-Yr. 5-Yr.
 Annualized Annualized
 Total Total
Name Return * Return *

Muni National-long-Term

Eaton Vance National Municipals A 6.40 6.79
First Investors Insured Tax-Ex II A 6.24 7.71
TIAA-CREF Tax-Exempt Bond 5.93 NA
Fidelity Spartan Municipal Income 5.82 7.01
Schwab Long-Term Tax-Free Bond 5.68 6.96

Muni National-Intermediate

Strong Intermediate Municipal Bd Inv 6.81 NA
Evergreen Intermediate Muni Bd A 5.91 7.14
State Farm Tax Advantaged Bond A 5.87 NA
Harris Insight Tax-Exempt Bond N 5.76 7.49
Delaware Tax-Free USA Intermediate A 5.62 6.50

 Initial Phone
Name Purchase Number

Muni National-long-Term

Eaton Vance National Municipals A $1,000 800-225-6265
First Investors Insured Tax-Ex II A 1,000 800-423-4026
TIAA-CREF Tax-Exempt Bond 2,500 800-223-1200
Fidelity Spartan Municipal Income 10,000 800-544-6666
Schwab Long-Term Tax-Free Bond 2,500 800-435-4000

Muni National-Intermediate

Strong Intermediate Municipal Bd Inv $2,500 800-368-3863
Evergreen Intermediate Muni Bd A 1,000 800-343-2898
State Farm Tax Advantaged Bond A 250 800-447-0740
Harris Insight Tax-Exempt Bond N 1,000 800-982-8782
Delaware Tax-Free USA Intermediate A 1,000 900-573-4640



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Title Annotation:Mutual Fund Focus
Author:Korn, Donald Jay
Publication:Black Enterprise
Geographic Code:1USA
Date:Dec 1, 2004
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