Municipal bonds have been on a hot streak this year, generating higher returns than many investors are earning in stocks.

The question for 2015 is whether to stick with shorter-term muni issues – investors’ clear favorites this year – or take the risk of tilting portfolios more toward longer-term bonds to pick up higher yields.

Munis have long been a favored asset for high-net-worth investors, particularly in California. The bonds' tax-free interest has been a key source of income for people in moderate to high tax brackets. Further, the low-volatility of munis remains attractive in a world of uncertainty.

As with other fixed-income investments, muni yields have tumbled since the 2008 financial crisis as risk-averse investors have snapped up bonds and as inflation has waned. The annualized yield on the benchmark Bond Buyer 20 muni index was 5.2% at the beginning of 2009. Today the index yield is about 3.9%.

But munis’ tax exemption means low nominal yields still equate to attractive returns. Case in point: The State of California sold new 10-year bonds yielding 2.48% in September. For a California investor in the 43% combined federal and state tax bracket, that tax-free 2.48% yield is the same as earning 4.35% on a fully taxable bond.

This year, muni bonds have provided investors with capital appreciation on top of interest earnings. As market yields have fallen again, prices of previously issued bonds have risen. That has lifted the value of muni bond portfolios. And the riskiest bonds have rallied the most.

Muni funds that own high-quality bonds also have produced hefty returns. The average fund that owns a nationwide mix of long-term investment-grade muni issues has generated a total return of 9.7% this year, according to Morningstar Inc., not including sales costs.

That beats the year-to-date returns on most other categories of bond and stock funds, Morningstar data show.

Part of munis' rally this year, however, has just recouped what was lost last year. Muni bond prices sank in 2013, and yields rose, as the market was hit by a double-whammy: expectations that the Federal Reserve would begin raising short-term interest rates, and the widely publicized financial woes of muni bond issuers including Puerto Rico, Detroit and Stockton.

The average long-term muni bond fund lost 4.6%, last year, according to Morningstar.

The scare suffered by the muni market in 2013 was a reminder that the sector can take sudden swings. Worried investors pulled a net $58 billion from muni bond mutual funds last year, or about 10% of total fund assets. But that proved to be a buying opportunity for other investors.

This year muni funds have had a net inflow of about $24 billion through October, according to Morningstar. Most of that has gone into funds that own short- or intermediate-term bonds. Many investors continue to avoid longer-term bonds.

That may reflect continuing concerns that the Fed finally will boost short-term interest rates in 2015. Investors are conditioned to assume that higher market rates would depress the value of longer-term bonds more than the value of shorter-term bonds.

But that would depend on how much long-term interest rates would rise once the Fed lifts short-term rates. Greg Kaplan, managing director at City National Rochdale and head of the unit's tax-exempt bond team, notes that long-term rates largely cue off investors’ inflation expectations. If investors believe that any rise in short-term rates could slow the economy and keep inflation subdued, long-term rates might not rise much, or could rise and then quickly reverse.

"A  lot of money has flowed into the short end of the muni market, almost to a fault," Kaplan says. "But we see value in the longer end of the market, where yields are higher.” His favored strategy is a “barbell” approach: concentrating holdings in shorter-term and longer-term issues, with less in intermediate-term bonds.

A few other market pointers from Kaplan:’

  • Despite periodic scares caused by high-profile municipal bankruptcies such as Detroit's, muni bond defaults remain rare. “Most investors correctly see them as isolated incidents," Kaplan says.
  • Though yields on shorter-term munis (such as three- to five-year bonds) remain low compared to money markets, the short end is still “attractive" for investors looking for a relatively safe place for cash.
  • The muni market could face "headline risk" volatility in 2015 stemming from the Republican majority in both the House and Senate. The reason: GOP senators and representatives who favor abolishing or limiting the tax-free status of muni bond interest could join with sympathetic Democrats to push for legislation toward that end. But Kaplan believes that "there are a lot of governors and interested parties who would push back against that."


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