How Municipal Bond Investors Have Avoided the Recession

In the last 12 months, nearly every asset class has gone down in value. The Dow Jones Industrial Average is sitting 5000 points lower than where it was last June. Commodity prices have dropped, real estate prices have dropped, and interest rates on money market accounts have dropped to near zero. Despite devaluation in just about every part of the market, there’s been one set of investments that have actually performed well in the last year–municipal bond funds.

A municipal bond is essentially a loan to a municipality or state to fund a public works project. Typically they’re used for things like the swimming pools, schools, convention center, and other public buildings. The major advantage of investing in municipal bonds (as opposed to corporate bonds) is that the interest and growth from them are typically not taxable. There are some exclusions for those that fall under the alternative minimum tax.

Why have municipal bonds faired so well in this down market? It turns out that municipal bonds typically gain value after interest rates fall. For example, if you invested in a municipal bond that had bonds out at 7%, then the prevailing interest rate that was offered dropped down to 5%, your set of bonds would be more valuable than another fund that only had loans out at 5%. Additionally, municipal bonds are considered very safe investments. When the market took a nose dive, investors searched for safer investments. Since there was more of a demand for municipal-bonds from investors, the value of the shares naturally increased.

Bond prices did fall initially when the major problems of the financial sector first were announced in September of 2008, however they recovered all of that value by the end of the year. Vanguard’s Limited-Term Tax-Exempt Bond Fund has earned a rate of return of 3.36% between April of 2008 and April of 2009. The Short-Term Exempt Bond Fund that Vanguard has earned 3.42% between April of 2008 and April of 2009. Their Massachusetts Tax-Exempt fund has already grown 4.08% this year.

It’s important to remember that just because municipal bonds have done well in the last year does not mean that they will continue to see the same appreciation in the coming months. If the Federal Reserve starts to raise interest rates as the economy recovers, it’s possible that municipal bonds will lose some of the growth that they have had in the last year.