HIGHER-YIELD HIGH-TAX MUNIS: PROJECT BONDS CAN SOCK TOP-END INVESTORS

In the yield-starved municipal bond market, some fund companies are trying to prop up dividend payouts with a maneuver that could leave shareholders with higher tax bills and lower net returns.

The tactics involve the use of so-called AMT bonds, a type of municipal bond issued to finance stadiums, airports, housing and industrial development projects. The interest on these bonds — and part of the income from mutual funds that invest in them — is subject to the alternative minimum tax. That can quickly eliminate the advantages of munis, which investors buy to provide tax-free income. No one knows for sure how many muni investors are subject to the AMT, but some say the number could be significant.

Boston-based Putnam Investments Inc. isn’t in that camp. In a proxy mailed late last month, it asked shareholders in four closed-end funds with $456 million in assets — California Investment Grade Municipal Trust, Investment Grade Municipal Trust II, Investment Grade Municipal Trust III and New York Investment Grade Municipal Trust — to allow it to double the percentage of AMT bonds that can be held in the funds to 40% from 20%. The measure, slated for an Oct. 1 vote, would also make the AMT bond restriction a “non-fundamental policy,” under Securities and Exchange Commission guidelines, enabling fund trustees to exceed the 40% cap without going back to shareholders for permission.

By increasing AMT bond holdings, a fund could push borderline taxpayers into the AMT category. The AMT — at its top 28% rate — would easily wipe out the slim yield advantage AMT bonds offer. The Putnam proxy acknowledges that the increased use of AMT bonds would require shareholders subject to the AMT to include a greater percentage of the fund’s dividends as taxable income. Still, a senior Putnam official argues the move would provide better diversification.

Most use them a little

To be sure, using AMT bonds to boost yields in municipal funds isn’t new. Last year, fully three-quarters of all municipal bond funds held AMT bonds, according to Lipper Analytical Services Inc. in New York. But though some funds, such as Van Kampen’s Trust for Insured Municipals, load up 61% with AMT bonds, the average municipal fund holds just 15%, according to Lipper.

Still, the use of AMT bonds is likely to increase as higher-yielding bonds are called and managers have to replace them with newer, lower- yielding issues. In the past year, for example, fund trustees at conservative Vanguard Group approved including AMT bonds in the company’s municipal funds.

A senior Putnam official says the company’s AMT proposal isn’t aimed at helping to maintain dividend payouts. “It’s driven by investment diversification,” says Jerome Jacobs, managing director and chief investment officer of Putnam’s tax-exempt income group. “We’re seeking the level of investment flexibility that we think is appropriate for these particular portfolios and is consistent with industry standards.” He says given the current spread — around 0.10% — Putnam doesn’t immediately plan to hike its AMT bond allocation.

Mariana Bush, a closed-end fund analyst in Washington with Everen Securities Inc., isn’t buying Mr. Jacobs’s diversification argument.

“They are trying to increase the earnings of the funds to bump up the yield,” she says, noting that two of the Putnam funds are paying out more in dividends than they collect in interest coupons. So far, the funds have accomplished this feat by dipping into reserve accounts they had built up from previous years.

“At some point, they will erode that reserve,” says Ms. Bush. “By increasing the AMT percentage, they’re going to be able to raise the earnings a little bit, but it’s not going to fix the problem.”

Ms. Bush estimates Putnam’s Investment Grade Municipal Trust III fund has already exhausted its dividend reserve and that a 16% dividend cut is imminent. Such a cut would trim the fund’s 6% yield to 5.1%, well below the average 6% payout of comparable funds. She doesn’t expect Putnam’s Investment Grade Municipal Trust II to consume its dividend reserve until before yearend, when it may be forced to slice its 6.4% dividend to 5.7%.

Mr. Jacobs wouldn’t comment on her assessment.

Putnam plays down the tax implications of the proposal. Though the company hasn’t actually polled its shareholders, it insists that very few are subject to the AMT. “The only way to get exposed to AMT is to be a very high net-worth individual with a large amount of passive income,” says Mr. Jacobs. “It’s basically a non-issue for 99.9% of shareholders of tax-exempt funds.”

But contrary to assertions by Putnam and other firms, like Chicago-based John Nuveen Co., the AMT hits a growing number of ordinary working people, especially those living in high-tax states like New York and California — where two of the Putnam funds are focused.

more all the time

And there are more AMT taxpayers all the time. Single and joint filers can fall prey to the full 28% AMT rate with $175,000 in household income.

“The reality is that more people than ever before are finding themselves subject to the AMT,” says Gary DuBoff, a principal with Ernst & Young LLP’s personal financial counseling practice in Chicago. He estimates it affects a third to a half of his financial planning clients.

A spokesman for T. Rowe Price Associates Inc. in Baltimore says the company suspects that the portion of AMT taxpayers in its municipal bond funds is “fairly high,” though it hasn’t surveyed investors.

Being subject to the AMT triggers taxes on capital gains and restricts miscellaneous itemized deductions and deductions for state and local taxes and home equity loans that aren’t used to buy or repair a home.

If the heightened AMT holdings push more shareholders over the AMT edge, the fund firms may have more than yield spreads to worry about.