Tax-Exempt Funds Aren’t All Equal

It’s too late to cut the taxes you’ll pay on 1989 income. But now is a good time to figure out how to keep more of your 1990 income. One option is a tax-exempt mutual fund.

To call itself tax-exempt, the Securities and Exchange Commission requires one of two things: A fund must earn at least 80% of its income from securities whose interest payments are exempt from federal income tax, essentially bonds and notes issued by state and local governments, or 80% of the fund’s assets must be invested in such securities.

Tax-exempt bond funds invest in securities with lives of more than a year: bonds for long-term projects such as schools and highways. Tax-exempt money market funds invest in securities with lives of less than a year--for example, IOUs issued by a state government anticipating the receipt of tax revenue.

Nearly 500 tax-exempt bond funds and more than 200 tax-exempt money market funds are monitored by Lipper Analytical Services.

About 50 tax-free bond funds and 30 money market funds invest only in California. For state residents, these funds offer a double tax exemption: Their dividends are free from state as well as federal taxes.

If you’re considering tax-exempt funds, try to answer some questions: Will a tax-free fund actually leave you with more money than a taxable fund? Should you invest in a tax-exempt money market fund or a tax-exempt bond fund?

You can usually get the highest income from general, insured and high-yield municipal bond funds. These invest in bonds with long maturities, meaning their principal becomes due and payable many years into the future. (Long-term bonds can have maturities has long as 40 years, but the average in long-term mutual fund portfolios is about 15 to 25 years.)

Long-term tax-exempt bonds are the most volatile, with values rising sharply when rates fall and falling sharply when rates rise. Of course, the shares of mutual funds that invest in these bonds behave the same. As a result, these funds are best for investors who have a long-term perspective or can afford the market risk. The alternative is to invest in bonds with shorter maturities or in money market funds, whose prices don’t fluctuate at all.

Just because you can save on taxes doesn’t mean a tax-exempt bond fund is the best way to go. Key factors are your tax bracket and the difference between rates on taxable bonds and those on tax-free bonds. (See the accompanying table comparing tax-free and taxable yields.)

If you’re comparing the yields of a national municipal bond fund and a California fund, remember that Sacramento wants a share of your income from other states’ securities even if the federal government doesn’t. (You are entirely exempt from California tax only if a fund is 100% invested in California tax-free securities.)

In addition to potential income, consider the credit quality of a fund’s portfolio; that’s the risk that issuers may default on interest or principal payments.

General long-term funds, the biggest category of tax-exempt funds, typically invest in “investment-grade” securities--those rated in the top four grades by Moody’s Investors Service (Aaa, Aa, A, Baa) and Standard & Poor’s (AAA, AA, A, BBB). More aggressive ones may be more heavily invested in A and Baa/BBB bonds to earn more income, while more conservative ones may avoid Baa/BBBs.

There is minimal credit risk when a fund invests in securities for which interest and principal payments are covered by municipal bond insurance. Insurance usually raises bonds’ ratings to Aaa/AAA, reflecting the credit quality of the insurance companies that write the policies.

Then there are high-yield municipal bond funds. These bear little or no resemblance to the taxable high-yield--or junk--bond funds that recently have performed so poorly. Unlike the taxable funds--which are concentrated in corporate bonds whose credit ratings have been lowered and new, low-rated issues--tax-exempt funds hold relatively few sub-investment grade municipal bonds.

There are two key reasons for this:

* Few municipal bonds are given low ratings. Of 16,117 state and local government issues rated by Moody’s--excluding those enhanced by bond insurance or letters of credit--only 163 are rated below Baa.

* The difference between yields on investment-grade bonds and lower-grade bonds has narrowed significantly. Whenever this happens, fund managers upgrade the quality of their portfolios, feeling that they’re inadequately compensated for credit risk.

If high-yield tax-exempt funds aren’t concentrated in speculative securities, how can they earn high yields? It’s not easy. They may load up on Baa/BBB bonds and securities whose issuers didn’t have them rated. Benham’s California High-Yield Portfolio, for example, is 40% invested in non-rated securities, many of which are bonds backed by special assessments and whose quality may be comparable to investment grade.

When assessing a fund that invests in tax-exempt securities of only one state, diversification is especially important. Check that a fund is invested in a large number of securities issued by a wide variety of government agencies that are spread geographically across the state.

In California, even such diversification may not be enough, notes Ian MacKinnon, head of Vanguard’s Fixed Income Group. The reason: earthquakes. Almost every major city sits on a fault line. So his company, like some others, offers an insured fund in California. “Insurance provides an extra layer of protection,” MacKinnon says.