Munis Mount a Comeback

Beth Foos: Despite general expectations for another rough road for municipal bonds, overall muni-bond funds had a very solid fourth quarter and year in 2014, both in terms of fund flows and returns.

Many muni funds struggled dearly in 2013's challenging fixed-income markets, which brought worries about rising interest rates, tapering of the Federal Reserve's QE program, and the credit quality of local and state governments after all the negative headlines around Detroit's bankruptcy and budget strain in Puerto Rico.

All of this contributed to significant outflows for many muni funds, and all of our national muni categories averaged losses for the year. But instead of more of the same in 2014, that story changed pretty dramatically for most. Both interest rates and muni default rates remain low. Overall credit quality throughout the U.S. muni sector improved, supported by cost-cutting and better revenue collections from a growing, albeit slow, domestic economy.

Also, new issuance was down, which kept the supply of municipal bonds low at the same time demand was building. Returns for muni funds varied by category, with funds that took on more credit and interest-rate risk garnering the highest rewards. Investors continued their reach for yield, pushing high-yield muni bonds into the spotlight. At the same time, muni yields fell throughout the year, which rewarded longer-maturity bonds and funds with longer durations.

Overall, Morningstar's high-yield muni category and muni-national long category outperformed their shorter-duration and higher-quality counterparts, and we've seen similar trends throughout the first month of 2015.