THE UNNOTICED RISK IN MUNICIPAL BOND FUNDS TODAY

The attempted bankruptcy filing by Bridgeport, Conn. this summer
alerted fund investors to the risks of default in municipal bond
funds. But shareholders may be less attuned to a more subtle danger:
illiquidity, or the risk that your fund won't be able to sell its
holdings quickly without stiff losses. ''The issue of liquidity could
not be more important,'' says New York University professor and
municipal bond expert Robert Lamb. ''When many people want their cash
back in a hurry, a fund usually has to sell at a loss.''
That's just what happened in April 1987 when a
1.5-percentage-point jump in interest rates exacerbated the seasonal
surge in redemptions by shareholders raising cash to pay taxes. The
result: investors pulled more than $3 billion out of munis, and share
prices dropped 5% in just five days. With municipal credits looking
shakier every week -- more than $19 billion of muni bonds had been
downgraded by Moody's Investors Service through June 30 -- it's not
hard to imagine a string of defaults triggering a similar panic this
year or next.
Liquidity risk steepened in the late 1980s after two groups of
important players backed out of the muni market. One faction
consisted of several major bond dealers, including Salomon Bros. and
L.F. Rothschild, who abandoned the muni business after concluding
that it wasn't profitable. Previously, the firms had helped keep
the muni market active by buying and selling bonds no matter which
way prices were moving.
Goldman Sachs and other major firms remain in the business, but
muni experts worry that dealers are less willing than they once were
to buy when munis are tumbling. ''The remaining dealers are not
willing to step up and provide liquidity, because they've been burned
in the past,'' says money manager Peter J.D. Gordon, former head of
T. Rowe Price's tax-exempt funds.
The other big players to pull out of the muni market were banks
and insurance companies. Before the 1986 Tax Reform Act greatly
reduced the tax breaks that Zmade munis appealing to them, banks and
insurers controlled as much as 45% of the $680 billion muni market.
Their share is now down to about 30%. Mutual funds and unit trusts
have filled most of the gap. But with fewer banks, insurers and
brokers still in the market, there won't be as many ready buyers if a
shareholder panic causes funds to start unloading en masse.
To minimize your own liquidity risk, consider focusing on funds
with high cash reserves (5% of assets or more), which can help
managers meet redemptions without dumping bonds. (You can discover a
fund's cash level by calling the fund.) Since cash holdings don't pay
as much income as bonds, however, a large cash hoard tends to reduce
a fund's yield by a few tenths of a percentage point.
An alternative would be to stick with highly diversified muni
funds that own bonds with maturities of less than 10 years. Though
such bonds tend to have yields one-half to one full percentage point
less than their long-term counterparts, the intermediate bonds are
more actively traded and should be easier to unload quickly. Two
funds that fit the bill: SteinRoe Intermediate Municipals (up 25.5%
over three years; 800-338-2550) and Vanguard Municipal- Limited Term
(up 24.6%; 800-662-7447).