Municipal Bonds and Historical Calendar Year Returns
Municipal Bonds Total Returns, 1991-2013
The individual calendar year returns for municipal bonds are shown in the Barclays Municipal Bond Index table below. The returns of the Barclays Aggregate Index, a measure of U.S. investment-grade bond market performance, are also shown to provide a sense of how municipal bonds performed in relation to the broader fixed-income market. Municipal bonds outperformed in 11 of the 23 calendar years, while underperforming in 12.
|Year||Municipal Bonds||Barclays Agg.|
Municipal Bond Interest-Rate Risk
With respect to interest-rate risk, it’s evident that municipals generally track the performance of the broader market. In the three calendar years in which rates rose and the Barclays Aggregate Index lost ground (1994, 1999, and 2013), municipals also finished with a negative return.
On the other side of the ledger, munis delivered a positive return in 19 of the 20 years in which the bond market finished the year in positive territory.
Municipal Bond Credit Risk
Credit risk also plays a role in the returns of municipal bonds. Credit risk is the risk that a bond will default (fail to make interest or principal payments), and it incorporates broader factors that cause the outlook for defaults to shift.
For instance, an economic downturn raises the risk of defaults, weighing on bonds whose performance incorporates an aspect of credit risk. Since municipal bonds are offered by such a wide range of issuers – from states and large cities to small towns and specific entities (such as airports and sewer districts) – credit risk can also impact performance.
This is visible in the results posted in 2008, when rates fell and the bond market gained over 5% but municipal bonds lost ground. This reflects a year characterized not just by recession and heightened investor risk aversion, but also the housing market collapse. In turn, this led to a sharp decline in tax revenues for municipal entities, fueling concerns about the potential increase in the default rate.
Similarly municipals underperformed in years characterized by headline risk: 1994 (the Orange Country bankruptcy), 2010 (Meredith Whitney’s prediction of a “wave of defaults”) and 2013 (Detroit’s bankruptcy, Puerto Rico’s financial troubles). The impact of these events also help underscore the fact that there’s more to municipal bonds’ performance than simply the direction of interest rates.
Over the longer-term, however, the returns of municipal bonds have been fairly close to those of the investment-grade market.
As of December 31, 2013, the 10-year average annual total return of the Barclays Municipal Bond Index was 4.29%, close to the 4.55% return of the Barclays Aggregate. Keep in mind, however, that this isn't an apples-to-apples comparison since the interest on municipal bonds is tax-free. As a result, the after-tax total return of municipals is actually closer to that of investment-grade bonds than it appears at first glance.
A Final Thought
It's often stated that bonds provide the lower-risk returns appropriate for conservative investors and those nearing or already in retirement. But the table above, with its 20 point difference between the best year's returns and the worst, also shows that bonds are by no means risk-free. They are less volatile than stocks (perhaps), but they are still volatile.
And, as with stocks, it matters a great deal when you begin investing. Bond returns in the early 1980s were extraordinarily high and due to the fac that compounding gave bond investors a head start that investors investing later were unlikely ever to match. Similarly, bond investors who began investing in the post-financial-meltdown area that began in 2007 have suffered nearly a decade of extremely low returns. Even the eventual return to high interest rates are unlikely to make up for this discouraging start.