Among the many changes to the municipal bond market wrought by the financial crisis, one may be the factors that drive muni mutual fund returns.

Josh Gonze, a portfolio manager at Thornburg Investment Management, said in the past returns on municipal funds have been driven mainly by changes in interest rates or shifts in the yield curve.

Funds beat or lagged their benchmarks mainly because they took too much interest rate risk, or not enough, or were positioned at better or worse segments of the yield curve, Gonze said during a presentation at the National Federation of Municipal Analysts annual conference in Santa Ana Pueblo, N.M .

Spreads widening or tightening had been a more substantial factor in the corporate bond market because appetite for risk often waxed and waned. In the municipal market, though, spreads relative to Treasuries were pegged so reliably within a fairly narrow band that changes rarely outweighed the effects of duration or the slope of the yield curve.

From the beginning of 2000 to the end of 2007, the 10-year triple-A municipal bond yield ranged from 78% to 98% of the 10-year Treasury yield. The average was 85% and the standard deviation was only four percentage points —implying very little fluctuation. Shaving a few basis points off the muni yield relative to the Treasury yield rarely affected the value of a municipal portfolio more so than the complexion of interest rates.

That changed in 2008. The 10-year triple-A yield that year ranged from 88% of the 10-year Treasury yield to 186%. The mean was 106%, and the standard deviation from that mean was a wild 21 percentage points.

Losses that year were driven by spread-widening, Gonze said, an unfamiliar plight for muni fund managers.

Last year, the ratio averaged 94%, with a standard deviation of 15%.

Spread-tightening in the second half of the year propelled returns for many municipal funds — again an unfamiliar feeling.

Thus, the widening and tightening of spreads became the dominant force in fund returns over the last two years, supplanting the traditional differentiations of duration and the yield curve.

Will that continue? Gonze said it’s possible defaults in the municipal space could take on greater prominence in the coming years, possibly ensuring that variations in credit spreads continue to overwhelm duration and the yield curve and the overriding factor driving returns to municipal funds.

Thornburg manages $5 billion in tax-exempt bonds, about 80% of which is in mutual funds and the remainder of which is in separately managed accounts.

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