Last year was a good one for municipal bond mutual funds, approaching the robust overall returns seen in 2011.

Muni bond funds with long maturities and those that focused on high yield performed best in 2012. A few high yield bonds’ total returns surpassed 20%, Morningstar numbers showed.

As a whole, the market for muni bond mutual funds saw 6.89% returns for the year, compared with 9.36% overall in 2011. In general, fund investors in 2012 searched for yield farther out the yield curve and further down the credit scale and reacted to credit spreads tightening, muni fund watchers said.

“If you look at the best performing funds, they tended to be a little bit longer in maturity, a spread of different credit qualities, because credit spreads did narrow this past year,” said Cynthia Clemson, co-director of municipal bond investments at Eaton Vance. “High yield did very well, and any funds that had any type of below-AA exposure in them did very well.”

Muni bond fund returns last year, though falling short of those of 2011, actually outperformed the industry benchmark Barclays Municipal Total Return index, a longer-duration index for the muni national long category. The Barclays index returned 6.78% in 2012, after an impressive 10.7% in 2011, Morningstar reported.

For the year, 277 of 559 muni bond funds beat the benchmark, and the total returns for 85 funds topped 10%. In 2011, 168 of 548 muni bond funds beat the benchmark, while 254 funds had total returns of more than 10%.

Several factors dominated the muni bond fund market last year. Demand from retail fund investors was particularly strong in the face of little, and sometimes negative, net new supply, said Miriam Sjoblom, a bond fund analyst at Morningstar, Inc.

In addition, most state governments saw improved revenues, Clemson said. Subsequently, investors perceived revenue bonds and bond funds as being a little stronger than they had been in recent years.

Also, many of the credit worries of the past few years diminished.

The market failed to see predicted spikes in muni defaults while actual credits stabilized or improved. Consequently, more investors grew increasingly comfortable both extending maturity and venturing down the credit spectrum, Clemson said.

In terms of absolute total return, longer duration muni funds performed the best. Rising muni bond prices stood as the primary reason for their success, said Dan Loughran, who heads the Oppenheimer Rochester municipal investment team as a senior vice president and senior portfolio manager of OppenheimerFunds Inc.

“Obviously, the longer your bond or bond fund, the greater the price change there was on the upside,” he said. “To give you a feel for that, 10 years and in, rates didn’t change that much. But for 30-year munis, interest rates fell about 70 basis points for all of 2012.”

OppenheimerFunds muni funds had a strong 2012. It boasted three of the top six performing funds for the year, and 11 in the top 50. Loughran traced the firm’s muni fund success to the fact that its funds generally are heavy in yield: a good starting point for outperformance.

In addition, the firm’s funds generated strong price performance from two important sectors.

“Muni tobacco bonds were the best performing sector in the muni market, and we had an overweight versus our peers,” he said. “And muni airline bonds probably were the second-best performing sector. We’re also overweight.”

The Eaton Vance AMT-Free Municipal Income I fund returned 13.57% in 2012, generating excess returns over the Barclays benchmark to the tune of 6.79%. The fund is a longer maturity fund.

“It has some lower-rated … that are mostly BBB-and-above-type credits in it,” Clemson said. “It’s definitely benefitted from credit spreads tightening and from the longer maturities doing well.”

Nuveen High Yield Municipal Bond A topped all funds in 2012 total return at 20.91%.

Subscribe Now

Independent and authoritative analysis and perspective for the bond buying industry.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.