For example, an investor in the 28% tax bracket who makes 7% on a taxable bond will keep 5.05% after taxes. That will be a better investment than any tax-free bond that returns less than 5.04%

For reasons other than taxes, however, tax-free municipal bonds may make goods buys. In a report titled " The Compelling Case for Municipal Bonds," being offered free to anybody who asks for one, the brokerage firm of Merrill Lynch & Co. predicts bonds will outperform stocks in the next few months, and municipal bonds will be the best performers.

Among the reasons: A shrinking supply of bonds and lower interest rates, in the opinion of Tom Sowanick, Merrill Lynch's chief fixed-income strategist. I don't make predictions or recommendations, as you know, but I thought this would be a good time to talk about municipal bonds and answer some of your questions on the subject.

First, some basics. Municipal bonds, or "munis," are issued by local governments to finance their operations or build or repair facilities such as schools or sewerage treatment plants. Interest from municipal bonds is exempt from federal income tax and may also be exempt from state and local taxes.

The "coupon" rate is the annual interest rate the bond pays on its original face value. Therefore, if you buy a new $5,000 bond that pays 5% interest, you get $250 every year. When the bond matures, you get your $5,000 back.

You can also buy or sell existing bonds before they mature. If interest rates have risen since the bond was issued, the bond will be worth less than face value. If interest rates have fallen, the bond will be worth more.

You can figure it out. Say interest rates have gone up from 5% to 6% since you bought the $5,000 bond. Anybody who buys the bond from you will still get $250 a year in interest. But who'd want your bond at $5,000 if the new bonds are paying 6%, or $300? You would get about $4,166 for your bond, which at 6% would produce $250.

That's what's called the "interest rate risk," the chance that your bond will go down in value if interest rates go up. Of course, they go up in value if rates go down, as Merrill Lynch predicts. And if you hold a bond to maturity, you get back what you paid.

Another risk is credit risk - that the government agency that issued he bond won't have the money to pay you the interest, or give you back your money at maturity. Ever heard of Orange County? Investors lost a staggering $1.7 billion when the California county went into bankruptcy.

Still, defaults are extremely rare. The industry trade group, the Public Securities Association, estimates that only 0.5% of all municipal securities issued since 1940 have defaulted, that is, missed a regularly scheduled payment.

"Even then, many investors were eventually paid in full," said Ron Ens, an assistant vice president from Moody's Investor Service, a credit rating agency that assigns ratings to bonds, ranging from AAA for highest quality to C, the worst.

Moody's is publishing a quarterly newsletter, "Moody's Outlook on Municipals," offered free at least through 1996 to anyone who calls (800) 639-0112.

The newsletter does not recommend any bonds, but rather gives individual investors information to help them make their own decisions. It also includes a quarterly rating update and a list of some of the new bonds coming to market. I rate the newsletter AAA, and I suggest you give it a try if you are at all interested in municipal bonds.

"Almost three-quarters of the $1.2 trillion of municipal debt outstanding is owned by individual investors," Ens said. "They consume information. We want to put the research for the most knowledgeable bond analyst directly into the hands of these investors."

Tax avoidance and safety, Ens said are the main benefits of investing in municipal bonds. The higher an investor's tax bracket, of course, the greater the benefit. The possibility of a flat tax, still being debated in Washington, would lessen their appeal. But in the opinion of Merrill Lynch, bond yields are high enough to compensate for this new "tax reform risk."

For safety, Ens said , investors should buy bonds from at least four to five issuers. That would take at least $20,000, however, as bonds usually sell in units of $5,000. An option that requires a much lower investment is a unit investment trust, akin to a mutual fund but with a fixed number of shares and a fixed portfolio that does not change. Investors usually pay a sales charge to buy unit trusts. Or they can buy regular municipal bond funds, which are actively managed. There is rarely a sales charge for a bond mutual fund, but investors pay an ongoing management fee. Another disadvantage is that a bond fund never matures, which increases interest rate risk.

- Humberto Cruz

 Investing Game, Fixed-Income Investor Newsletter January 1996

Reprinted by permission: Tribune Media Services