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  • August 1, 2012

    Despite a history of relatively few municipal bond defaults, some analysts have been sounding alarms about the credit quality. Meanwhile, the sector has continued to provide stellar returns in low interest rate environment. Hugh McGuirk, head of municipal bond investing at T. Rowe Price, acknowledges that state and local governments need to address long-term issues around pensions and health care benefits, but he is confident that the firm's in-depth credit research can continue to find good investment opportunities in a large market that offers the advantage of tax-free income.

    Municipal Bonds Have Done Well and Offer Attractive Yields Versus Treasuries
    • While absolute yields remain low, municipal bonds, as measured by the Barclays Municipal Bond Index, have returned just under 4% in the first half of 2012 and almost 10% for the one-year period ended June 30, 2012.
    • We expect municipal bond returns to be more moderate for the rest of 2012, but their tax advantage still makes them attractive to fixed income investors.
    • Over the long term, high-quality 10-year municipal bond yields have been about 90% of 10-year Treasury yields. As of June 30, 2012, 10-year munis rated AAA were yielding approximately 115% of 10-year Treasuries. This nominal yield advantage is prompting taxable bond portfolio managers to buy munis.
    Despite Overly Alarmist Predictions, the Municipal Bond Market Remains Strong
    • While some state and local governments need to address long-term challenges regarding pension fund obligations and health care benefits, warnings about a string of large, imminent defaults have proven to be overly alarmist.
    • The municipal bond market is a high-quality market with a history of few defaults. A Moody's study of municipal bonds showed only 71 defaults over a period of more than 40 years through 2011.
    • The year-to-date default rate in 2012 is lower than it was last year. While credit issues may periodically pop up, the broad municipal market is doing quite well.
    Revenue Bonds, Rather Than General Obligations, Dominate the Municipal Market
    • Revenue bonds, which represent approximately two-thirds of municipal issuance, are backed by revenue streams generated by projects such as sewer systems, hospitals, and airports.
    • In contrast, general obligation bonds are used to fund municipal government operations, including those that are linked to their pension fund obligations.
    • Using credit research in this large market, T. Rowe Price can analyze the revenue streams to figure out a bond's relative quality and determine if the revenues are sufficient to back it.
    The End of Municipal Bond Insurance Makes Credit Research Even More Important
    • In the 2005-2006 period, about half of all municipal bonds were insured, which made the muni market highly commoditized and limited the yield spreads (differences) between higher- and lower-quality bonds.
    • The demise of municipal insurers in 2008 not only led to wider yield spreads, but also made research and credit analysis of the underlying issuer—what T. Rowe Price always does before buying bonds—much more critical.
    • With a $3.7 trillion market containing 50,000 issuers, T. Rowe Price analysts see many municipal bond opportunities for investors seeking income and tax advantages.

    Yield and share price will vary with interest rate changes. 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. Some income from municipal bonds may be subject to state and local taxes and the federal alternative minimum tax. The views are as of July 19, 2012 and may have changed since that time. This information is provided for informational purposes only and is not intended to reflect a current or past recommendation, or investment advice of any kind. Opinions and commentary do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

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