June 20, 2014

Hugh McGuirk Hugh McGuirk, head of municipal bond investing at T. Rowe Price.

Despite market headwinds last year, munis continue to provide significant advantages to fixed income investors.

Municipal bonds issued by state and local governments provide investors with tax-free income and the benefits of diversification—important aspects of a long-term investor's portfolio. The fluctuations were due, in part, to fiscal problems facing certain municipal governments—especially Detroit, which filed for bankruptcy protection in July 2013, and Puerto Rico, whose deteriorating financial situation and credit rating downgrades received significant media attention. Moreover, investor concerns about a reduction in the Federal Reserve's asset purchase program triggered a sharp increase in long-term bond yields.

There are signs that the market is stabilizing, however. Long-term muni yields have retreated from recent highs. Also, investment dollars began to flow back into muni funds in 2014 following persistent outflows in the second half of 2013. One reason for munis' staying power: Despite the headlines, it is rare for a municipality to default or miss an interest or principal payment to bondholders.

What's more, municipal bonds' tax and diversification benefits provide investors with longer-term advantages. "The tax advantages and regular income mean that investors in every tax bracket should consider whether munis might be a good fit for the fixed income portion of their portfolios," says Hugh McGuirk, head of municipal bond investing at T. Rowe Price.

How Munis Work

Municipal bonds are tax-exempt debt obligations issued by cities, counties, states, and other governmental entities. They are used to fund infrastructure projects, essential services, and other projects that serve the public interest. There are two main types of munis. General obligation bonds are backed by the issuer's ability to raise money through taxes and include projects such as schools and roads. Revenue bonds are issued by a government-related entity to fund a particular project, such as a stadium or a hospital wing. Interest and principal payments to investors in revenue bonds are funded by the revenues generated by that project.

The Benefits of Munis

Municipal bonds offer a potential income stream that is exempt from federal income taxes. Income from munis issued in an investor's home state is also typically exempt from state income taxes. The value of this tax benefit depends on your tax situation and is highest for investors in higher tax brackets or those who live in high-tax jurisdictions. Furthermore, these tax advantages are most useful when munis are held in taxable accounts. The reason: Muni yields are typically lower than the pretax yields on taxable bonds with comparable maturities. Investors can choose from a diverse array of muni issues, which vary in purpose, maturity, and yield. Consider investing in a municipal bond mutual fund rather than targeting individual securities to achieve greater diversification. The muni market's rough patch in 2013 underscores the value of investing in a fund that offers active management. Such funds enable investors to benefit from the expertise of professional managers and analysts who perform essential credit research and navigate a changing market effectively. For example, a special team of T. Rowe Price analysts identified Puerto Rico's municipal bond risks a year before the country's financial problems were widely publicized and long before the bonds were downgraded.

Drawdown December 1979 - November 2013.

Understanding the Risks

Municipal bonds, like other investments, carry certain risks. For instance, there is a risk that interest rates will rise at some point in the future, causing bond prices to drop. When long-term rates rose in May 2013 in response to concerns that the Federal Reserve would start tapering its bond-buying efforts, bond prices fell. That said, many of today's muni investors are focused on credit risk, especially in light of the Detroit and Puerto Rico headlines. Credit risk represents the potential that a bond issuer will fail to make timely interest and principal payments to its bondholders, thereby resulting in a default. Generally speaking, general obligation bonds are considered to be at lower risk of default than revenue bonds because the former are backed by the issuer's power to raise taxes. While the default rate has risen over the past few years, defaults themselves remain very rare, however.1 Regardless of market conditions, municipal bonds continue to play an important role in a well-designed fixed income portfolio. "The tax-free income generated by munis can benefit investors in all tax brackets," McGuirk says. "Munis can also provide valuable diversification benefits in an investment portfolio." Of course, diversification cannot assure a profit or protect against loss in a declining market.

1 S&P Dow Jones Indices, January 3, 2014.