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April 25, 2012

Against a backdrop of falling interest rates, municipal bonds delivered solid returns in 2011 and have seen that strong performance continue into 2012. In a recent interview, T. Rowe Price Tax-Free High Yield Fund Manager Jim Murphy discussed the factors that have made munis so attractive for bond investors.

Munis Avoid Defaults and Draw Investors Back

After predictions of mass defaults in 2011 did not come to fruition, the municipal market benefited from what Murphy termed "a tremendous inflow of new cash." On the other hand, the supply of new municipal issues last year was down sharply from 2010, meaning that more investors were seeking investment opportunities among fewer choices. That supply/demand imbalance was good news for municipal bond prices.

Murphy emphasized that when the tax advantages of municipals are taken into account, their yields are currently competitive with both Treasuries and corporate bonds. Even though bond yields are down across the board, munis continue to draw interest from investors looking for income while trying to limit their tax liability.

Credit Concerns Are Currently Minor, and Fundamental Research Keeps Risks Low

Despite dire headlines about a few defaults by municipalities such as Harrisburg, Pennsylvania, Murphy notes that the municipal default rate in 2011 was in line with its historical average: less than 1%. Still, budgets for municipalities remain strained. Among municipal securities, general obligation bonds are considered more vulnerable than revenue bonds, which make up the majority of the Tax-Free High Yield Fund's portfolio.

Murphy explains that he and his team prefer revenue bonds, which are tied to essential services, because "people tend to pay their utility bill, people tend to pay their water bill, and you have a much more durable revenue stream backing those bonds." In addition, Murphy says that the rigorous research that goes into selecting bonds for the fund has consistently paid off in helping to lower risk.

Tax Advantages Make Munis a Strong Fit for Many Portfolios

Murphy does not expect municipals in 2012 to match the impressive returns they earned in 2011. But he does anticipate a good year, with returns coming mostly from yields rather than bond price increases. He believes that if the Federal Reserve sticks to its stated course of keeping interest rates low for the next couple of years, "munis will do just fine."

When asked if investors should consider municipals as a permanent part of their portfolio rather than an occasional tactical investment, Murphy's answer was a resounding "yes." For investors in a medium or higher tax bracket who are looking for income, he says, municipals should be a significant part of their fixed income allocation—as much as 30% or 40%. And within munis, Murphy recommends a high yield fund like his for those who have a longer time horizon and higher tolerance for risk: "I would say they should have 10% or 15% of their muni allocation in tax-free high yield."

Some income may be subject to state and local taxes and the federal alternative minimum tax. Yield and share price will vary with interest rate changes, and investors should note that if interest rates rise significantly from current levels, bond fund total returns will decline and may even turn negative in the short term. In addition, high-yield bonds carry a significant level of credit risk.

Copyright 2014, T. Rowe Price Investment Services, Inc., Distributor. All rights reserved.