Tax-free municipal bonds outperformed taxable bonds in the fourth quarter. Intermediate- and long-term Treasury interest rates increased as the economy continued expanding and as Congress agreed late in the year on a two-year budget deal that could add slightly to 2014 economic growth. The Federal Reserve announced in mid-December that it will begin to curtail its $85 billion of monthly asset purchases in January. The 10-year Treasury note yield rose to 3.03% by the end of 2013, the highest level in about two and a half years. In the municipal market, long-term interest rates rose, but not as much as Treasury yields, while shorter-term yields declined or were flat. BBB rated municipals in the investment-grade universe fared worse than higher-quality tiers.
The Tax-Free High Yield Fund returned 0.67% in the quarter compared with 0.05% for the Barclays 65% High-Grade/35% High-Yield Index and 0.20% for the Lipper High Yield Municipal Debt Funds Average. For the 12 months ended December 31, 2013, the fund returned −4.51% versus −3.58% for the Barclays 65% High-Grade/35% High-Yield Index and −6.14% for the Lipper High Yield Municipal Debt Funds Average. The fund's average annual total returns were −4.51%, 10.46%, and 4.45% for the 1-, 5-, and 10-year periods, respectively, as of December 31, 2013. The fund's expense ratio was 0.67% as of its fiscal year ended February 28, 2013.
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Current performance may be lower or higher than the quoted past performance, which cannot guarantee future results.
Share price, principal value, and return will vary and you may have a gain or loss when you sell your shares.
The Tax-Free High Yield Fund charges a 2%
redemption fee on shares held 90 days or less.
The performance information shown does not reflect the deduction of the redemption fee;
if it did, the performance would be lower.
Our credit selection and sector allocations drove the fund's performance during the quarter. We were effectively positioned in the industrial revenue and transportation sectors, which fared well. Our health care holdings were strong performers, and we had relatively low exposure to water and sewer bonds, which were weak. The call structure of the bonds we owned was also beneficial in an environment in which intermediate- and long-term rates moved higher. On a negative note, the portfolio's duration, which measures a bond fund's sensitivity to interest rate volatility, trimmed results. We maintained a modest long-duration posture, which hurt as longer-term rates increased during the period.
The decline in municipal bond prices in 2013 has rattled some investors, but it does not represent a fundamental change in the nature, quality, or risk characteristics of the market. We continue to believe that it is a high-quality market, with good investment opportunities for those with a long-term focus, particularly for those in the highest tax brackets. The poor performance of long-term munis in 2013 makes their nominal and taxable-equivalent yields more attractive, but if market outflows persist and rates resume rising, further price declines are likely. Given the potential for rates to rise further, we will remain careful with any investment shift that might materially increase our portfolio's interest rate sensitivity. We do believe, however, that future rate increases will be more modest than those experienced in 2013.