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STOCK WATCH / Frederick M. Muir

Muni Bonds Deadly for Investors Now

May 24, 1987|Frederick M. Muir

The gyrations of the nation's stock market averages are fascinating to many Americans. To some, they're even meaningful.

But while the Dow Jones Index gets the headlines, the real action lately has been in the bond market.

And nowhere is the volatility more dramatic than in the once staid, stable and conservative market for municipal bonds.

This backwater of the fixed-income group has become exceptionally prone to big ups and downs in recent years as mutual funds have made the market accessible to most of the nation's small investors. For as little as $500 in many cases, investors can get into munis through some of the more than 75 specialized bond funds. And recently, that means that they have been able to lose a lot of money in municipal bonds.

Ralph Norton, editor of the Huntington beach-based newsletter Muni Report, says that in the past two months, municipal bond funds--representing about $140 billion--have dropped nearly 10% in value. That compares with the much smaller decline of about 5% to 7% in Treasury bonds.

Norton signaled his clients to get out of the market on March 24 and still is advising investors to get on the sidelines and out of harm's way.

"The fundamentals continue to show a lot of weakness," said the 28-year-old muni bond specialist, a graduate of both Dreyfus and Fidelity Investments. "We think (the market) will get softer in the near term."

The plunge in bond prices is due both to investor fears of an upturn in the rate of inflation and to the drop in the value of the dollar on international markets.

When the general bond market began heading south, the muni bond market dropped below the Equator. One reason for that overreaction is that more than 70% of all municipal bonds are owned by individual investors or by mutual funds that are in turn owned by small investors, Norton said.

And when these investors panic, the market can move much more quickly than the market for Treasury or corporate bonds, which are held primarily by large institutions.

As shaken investors redeem their mutual fund shares, managers are forced to liquidate millions of dollars in muni bonds, further driving down the prices. And that persuades still more investors to liquidate. It's the snowball effect; and without doubt, it has sent a chill through the municipal bond market.

The most telling evidence of the severity of the sell-off is that municipal bonds now are out-yielding Treasury securities--reversing their historic relationship. Because municipal bond interest is exempt from federal taxes, investors typically are willing to accept a lower rate of interest because it is the after-tax return they are interested in.

An average municipal bond currently yields about 9.4%, while 30-year Treasury bonds are yielding about 9.02%, Norton said.

But because the munis' interest is exempt from federal taxes, their effective after-tax yield is better than 14%.

'Bleeding at Slower Rate'

Still, Norton says, it's not worth jumping into the muni market just yet.

"All it means is that you'll be bleeding at a slower rate; you'll still die" if you stay invested in bonds, he said.

Eventually, the market will stabilize, though Norton is not sure when. His advisory service, which tells clients when to get in and out of the market, watches two indicators: an index of 10 municipal bond mutual funds and an index of 40 most actively traded muni issues.

When both indexes move below their 40-day average, that triggers a sell signal. When they both rise above the average, that triggers a buy.

For the average investor, Norton recommends a few generally available benchmarks for judging the market: watch for changes in the 30-year Treasury bonds and federal funds rates, both of which are quoted daily in The Times.

Until the market improves, Norton advises investing funds in safer and more stable tax-exempt money market funds. These funds, similar to muni bond funds, invest in municipal securities, but only in very short-term notes that are always held to maturity. Therefore, they typically are not subject to drops in their principal value when interest rates shift.

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