Investors are dealing with this dilemma by pouring money into muni bonds-then worrying about it. Since the bondmarket crash of 1987, the number of muni mutual funds has risen from 279 to 492, reports the Investment Company Institute. Assets now stand at $132.5 billion.

But muni bonds aren’t right for everyone. And you may not be getting as large a tax-exempt yield as you believe.

Who should buy munis? Any fixed-income investor in the 28 percent tax bracket and up. You’ll earn more from a muni than from a comparable Ginnie Mae, corporate bond or Treasury, after tax. In the 15 percent bracket, however, munis pay less than you’d net from a taxable bond.

Should you buy individual bonds or bond mutual funds? If your goal is supersafety, and you’re not experienced with bonds,go for newly issued, triple-A, five- to 10-year issues held to maturity. Minimum purchase: $5,000. Get “call protection” for the life of the bond or at least 10 years; this stops the issuer from redeeming the bond if interest rates fall. Don’t risk low-rated bonds like housing and hospital issues.

Older triple-A bonds, already on the market, sometimes offer higher yields. But watch out. Some brokers quote you a huge " current yield" (what you earn from the interest payment) without warning you that, the way the bond works, you’ll probably lose part of that yield in the end. For the true yield, get the “yield to the call date” and the “yield to maturity.” One good buy: a “pre-refunded” muni, which is backed by Treasuries and currently pays up to 0.3 percentage points more than other triple-A issues. If you’re a speculator, try the tax-backed bonds of low-rated states.

Forget individual bonds, however, and buy mutual funds, if you want instant access to your money. Funds can be sold at any time, at market value. By contrast, small amounts of individual bonds are tough to unload at a decent price. The risk in mutual funds is that the payback isn’t certain. When interest rates rise, fund values fall-with no fixed date when you will get your money back.

How do the yields of mutual funds stack up? Stop me if you’ve heard this one, but some of the ads can mislead a novice. If you don’t know how bond funds work, and don’t read footnotes, you might think that the tax-exempt yield is higher than is actually the case.

Take a recent ad for Fidelity’s High Yield Tax-Free Portfolio. For the year ending in March, the ad says, the fund returned 10.54 percent. But that’s not all tax-exempt. I had to ask Fidelity for a special calculation to learn that the tax-exempt yield was actually 7.27 percent. The rest was a taxable capital gain. Fidelity’s assistant treasurer, John Costello, points out that, in the ad’s footnotes, it says that the total return includes capital gains. He presumes that investors know, therefore, that some part of the yield is taxable. Some investors would. But then, some wouldn’t.

The best bond funds carry no sales charges and levy low annual fees (Vanguard costs under 0.3 percent a year). Don’t buy funds with upfront sales loads. Even if their yield appears high, it drops when adjusted for their cost.

Should you buy a fund that owns only the bonds from your own state? Yes, if you pay high state taxes and your state is sound. But add a nationally diversified fund if your state is in trouble. When a state is downgraded by a rating agency, the value of its bonds (and bond funds) drops.

When you buy munis from another state, you usually owe state taxes on your interest earnings, but no federal taxes. That’s why munis offer better diversification than federally taxable Treasuries, says Christine Carter Lynch of the Lynch Municipal Bond Advisory in Santa Fe, N.M.

But why, oh why would Texans buy the state funds offered, at a sales charge, by the Franklin and Premier mutual-fund groups? Texas still has no income tax. Muni buyers there will earn more from no-load national funds.

Should you buy insured bonds? For top-quality bonds, you needn’t bother. With an insured bond, an insurance company guarantees your principal and interest payments. But triple-A credits rarely fail, especially over five or 10 years. If you like the extra peace of mind, insured bonds yield around 0.3 percentage points less than comparable uninsured bonds.

But skip the coverage newly offered by the Bond Investors Association in Miami Lakes, Fla. You pay $5 per bond (0.5 percent per $1,000) to cover bonds you already own. But the insurer can cancel on one year’s notice. If a bond’s rating starts to slip, your “protection” may vanish. As my son might say, “Lame, guys, lame.”

You can’t keep a strong fund down. Among 465 municipal bond funds, the following five made the Top 30 List-not only for periods shown, but for the past five years as well.

Fund Total Annual Return * 1 year 3 years Vanguard Municipal Bond-Long Term 9.6% 9.8%

General Muni Bond 9.3% 10.2%

Vanguard Municipal Bond-Insured Long Term 9.3% 9.6%

SAFECO Muni Bond 9.1% 9.6%

SteinRoe Managed Municipals 9.1% 9.3% ..L1.-

  • INCLUDING TAX-FREE INCOME AND TAXABLE CAP AND ADJUSTED FOR SALES CHARGES. SOURCE: INVESTABILITY, INC., CHICAGO.