In any given year, municipal bonds tend to deliver returns that are similar in direction to those of the broader investment-grade bond market, although not necessarily in magnitude. Munis have delivered positive total returns in 19 of the past 23 calendar years.
The performance of municipal bonds is driven by three key factors:
• Interest rate risk: This is the risk that broader bond-market fluctuations will impact performance in the municipal bond market. When yields on U.S. Treasuries are falling, as they did in the 2009-2012 interval, it helps create a positive backdrop for munis. (Keep in mind, prices and yields move in opposite directions). At the same time, periods of rising Treasury yields – such as 2013, create headwinds for municipal bonds.
• Credit risk: Credit risk is the way the shifting risk for the potential default by an issuer can affect its bonds' performance. For instance, a municipality that is seeing stronger tax revenues should see a positive impact on its price, while one that appears to be in increasing financial peril will be affected negatively.
Credit risk also incorporates the impact that broader economic conditions can have on the general creditworthiness of municipal bond issuers. For instance, when the economy and housing market are strong, investors typically gain more confidence with regard to the underlying financial strength of municipal issuers. Conversely, a recession reduces confidence and causes investors to demand higher yields (and lower prices). This is visible in municipal bonds -2.48% return of 2008. Even though Treasury yields fell and investment-grade bonds returned nearly 5.5%, municipal bonds lost ground due to concerns about the broader impact of that year’s financial crisis.
• Headline risk: Municipal bonds are also affected by headline risk, or the risk that news items will cause investors to lose confidence. Examples include not just the financial crisis of 2008, but also the Orange County bankruptcy of 1994. Typically, however, sell-offs related to headline risk have proven to be compelling buying opportunities.