Tax Bite Coming on Realized Muni Gains

The powerful bull market in municipal bonds this year is setting up some investors for a year-end tax surprise.

The surprise will come when shareholders get tax bills on their investments in muni-bond funds, which everyone knows are supposed to be tax-free.

Well, not exactly.

A fund’s total return has two components: the yield paid by the underlying bonds and any appreciation or depreciation in the bonds’ prices. Only the yield skirts taxation. Gains resulting from market fluctuations are subject to taxation, while losses are deductible.

“We get more questions from shareholders on this issue than anything else,” said John G. Taft, president of Voyageur Asset Management, a Minneapolis-based fund family that specializes in muni-bond products. “It’s an area where there has been a lot of confusion.”

Investors could be more bewildered than usual this year, since muni-bond funds are more popular than ever and the taxable gains are larger than average.

Muni-bond prices rise as interest rates fall. They can also rise along with investor demand after a hike in individual tax rates. Both factors have come into play in a big way for municipal securities lately.

“This year, funds are sitting on bigger gains than in most years past,” says Lacy B. Herrmann, president of Aquila Management Co., a New York firm specializing in tax-free funds.

Through Sept. 30, the average muni-bond portfolio had returned 9.9%, reports Morningstar Inc., the Chicago fund-tracking company. A little less than half of that came in the form of tax-free interest--the rest resulted from taxable gains on the bond holdings. In 1992, by contrast, the funds returned 8.7% on average, of which roughly 6% was tax-free dividends.

*

But of any capital gains component, just a portion will be immediately taxable. Investors face taxes only on the portfolio’s “realized” gains, on which the manager actually locked in a profit by selling bonds or having them called away.

It’s possible for managers to sit on bonds with unrealized appreciation for many years. But when a fund locks in a gain or loss, it has to pass them on to shareholders. The amount of taxable profits will depend largely on the fund’s “turnover ratio”--a measure of how frequently a manager actually buys and sells.

*

A turnover of, say, 10% means the manager replaces only 10% of the bonds each year on average, while 100% would mean the entire portfolio gets turned over within a year.

Whenever a bond is “called” or forcibly redeemed by an issuer, that too can result in a realized gain or loss.

Ironically, says Herrmann, realized taxable gains on muni-bond funds could be more of a problem during a year when there’s a significant drop in the bond market. The reason: Some fund managers would switch into short-term bonds for defensive reasons; in doing so, they would have to sell some of their long-term holdings, realizing gains along the way.

Most fund companies should be able to provide you with information about a fund’s realized and unrealized gains.

In addition, Morningstar Mutual Funds, a comprehensive research report found in many libraries, now provides an estimated current tax liability for each fund it reviews. Morningstar figures that about 9% of the assets in a typical muni-bond fund would have to be paid out as taxable profits, assuming all holdings were sold today.

The above discussion deals only with the tax impact of trading done by the portfolio manager. In addition, investors need to remember that every time they personally buy or sell shares in a municipal fund, there could be a taxable gain or loss.

The same goes for any checks you write against your muni-bond portfolio. Since this would involve a sale of shares, it’s a taxable event.

*

In general, taxable gains should be viewed as desirable, as their presence means the value of the fund has increased. But investors looking at the sizzling performance numbers being reported by municipal funds these days should keep in mind that only part of the total return will skirt taxation.

*

Even more important, investors should realize that double-digit returns are highly unlikely in the future without further drops in interest rates. With the bulk of the interest-rate decline now behind us--and with most tax-free funds yielding only a bit more than 5%--there’s less of a chance for exceptional performance.

*

The Boston-based Keystone Group is introducing what apparently will be the first mutual fund to focus on the Western Hemisphere.

The new Keystone Fund of the Americas has latitude to buy stocks and bonds in the United States, Canada and Latin America, with the idea of capitalizing on growing trade ties and economic development in the New World.

The fund’s portfolio manager, Gilman C. Gunn, has freedom to invest in pretty much any nation in the hemisphere. His current favorite is Mexico, which he rates as “the most attractive market by far.”

What he likes are the country’s stable government, free-market economic policies and world-class companies in many industries. Whether or not the North American Free Trade Agreement passes, “Mexican companies are preparing for a more competitive environment, and will continue to do so,” he says.

And with stocks trading at only 10 times expected 1994 earnings, the Mexican market is cheap, he says.

Gunn expects to start out with roughly 30% of the fund’s stock and bond holdings in Mexico, followed by 20% in the U.S. and roughly 5% each in Venezuela and Canada.

The American holdings will include companies doing a large amount of business in Latin America, such as Motorola and Bank of Boston.

The new fund (800-343-2898) goes on sale today and will carry a maximum 5.75% sales charge.

Full Cycle

Tax-exempt yields on municipal bond mutual funds have declined to their lowest point since the late 1970’s. At current yield levels, shareholders aren’t likely to earn double-digit total returns without a further drop in interest rates.

Fund yields: 1978: 5.3% 1982: 10.1% 1993: 5.5%

Note: 1993 yields are through August. All yields reflect the funds’ income ratios.

Source: Morningstar Inc.