August 12, 2014

 Jim Murphy Jim Murphy, manager of the T. Rowe Price Tax-Free High Yield Fund and the new T. Rowe Price Intermediate Tax-Free High Yield Fund.

The municipal bond market has rebounded this year after suffering a modest loss in 2013 amid concerns about credit crises in Detroit and Puerto Rico and Federal Reserve policy.

With an average return of 6% in the first half of the year, tax-free municipals outperformed taxable bonds. Defying expectations, interest rates have fallen this year even as the Federal Reserve has begun tapering its purchases of Treasury and mortgage-backed securities. The average yield in the muni market declined from 3.15% at the end of last year to 2.35% as of June 30, 2014.

Jim Murphy, manager of the T. Rowe Price Tax-Free High Yield Fund and the new T. Rowe Price Intermediate Tax-Free High Yield Fund, says that the market has been supported this year by favorable supply/demand trends for muni debt as there has been less issuance of new bonds and investor demand has stabilized.

Although long-term muni bond yields fell more than long-term Treasury yields in the first half, Mr. Murphy says that muni bond yields remain attractive relative to taxable securities, particularly for those in higher tax brackets, but not quite as attractive as at the start of the year.

"Munis have come a long way, and the market has righted itself to more traditional levels. But we still think they offer value, and if you are in a high tax bracket, the tax exemption is still a great benefit," says Mr. Murphy.

He notes, for example, that the 3.28% yield offered by a 30-year tax-free bond rated AAA at midyear was about 98% of the 3.36% pretax yield on a 30-year Treasury bond. Because the interest on the municipal bond is free of federal income taxes, an investor would have to earn 4.56% on a taxable bond to realize the same after-tax income.

"We think rates are going to be lower than normal for an extended period," Mr. Murphy says. "Even if the Fed is getting out of the tapering business, and they should be done [with asset purchases] by the end of this year, the economy is still pretty sluggish, and inflation is not a problem." He expects rates to gradually rise "a little bit" just because the Fed is exiting the Treasury market.

He says that the firm recently launched the Intermediate Tax-Free High Yield Fund for investors who are concerned about the potential for higher rates, which could result in principal declines.

Investors can obtain higher tax-free yields but would have to accept more credit risk. Mr. Murphy says about 20% of the Tax-Free High Yield Fund is invested in corporate-backed, tax-exempt securities because the firm is able to take advantage of the higher yield due to its strong credit research.

With the fiscal problems in Puerto Rico deteriorating in recent months, Mr. Murphy says that credit concerns remain a key focus for investors but that he does not expect the Puerto Rico situation to roil the market as it did last year.

Puerto Rico has about $50 billion of municipal debt outstanding and over $70 billion of general indebtedness for the commonwealth and its various governmental agencies. Moreover, the commonwealth's legislature recently approved a bill that would allow the territory's public corporations, such as the Puerto Rico Electric Power Authority, to restructure its debts, leading to sweeping credit rating downgrades this summer.

T. Rowe Price had minimal exposure to Puerto Rico, as the firm's credit analysts warned about its shaky financial position well before the problems surfaced.

Aside from Puerto Rico, Mr. Murphy says investors are worried that Detroit's Chapter 9 bankruptcy could establish adverse legal precedents for bond investors.

While credit concerns persist, Mr. Murphy says, "We still believe the municipal bond market remains a high-quality market that historically has had very low default rates. Fundamentally, the credit environment for municipalities is sound and should improve with the economy.

"Some states, like Illinois and New Jersey, are still struggling financially, but others, like California, are getting better," Mr. Murphy says. "Generally, most states are improving with a combination of higher tax revenue and very strong fiscal restraint over the past five years. Taking a longer view, we remain concerned about state and local government liabilities, such as pension benefits and retiree health care costs."

With the rally in the first half of the year behind us, and rates at historically low levels, Mr. Murphy says investors should expect to earn the coupon on muni bond funds with little prospect for capital appreciation.

"I expect a low volatility, kind of boring environment over the rest of the year," he says. "It's a period of quiescence and a little concern about complacency. But if we basically earn the portfolio yield between now and the end of the year, that would be a nice end to the good run we had earlier in the year."

Diversification cannot assure a profit or protect against loss in a declining market. 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. In addition to their sensitivity to interest rates, high-yield bonds carry a significant level of credit risk.

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action. The views contained herein are as of July 2014 and may have changed since that time. Past performance cannot guarantee future results.