Tax-free municipal bonds edged lower in the second quarter of 2015 but held up better than taxable bonds. Munis fell with Treasuries in response to rising long-term interest rates, a strengthening economy, and concerns that the Federal Reserve, which kept short-term rates steady during the quarter, would begin raising them sometime in 2015. Light issuance and solid demand for tax-free income provided support for the municipal market. However, high yield municipal bonds underperformed the broad municipal market. Late in the quarter, bonds issued by Puerto Rico, a major component of many high yield municipal bond indexes, fell sharply following an acknowledgement by its governor that the commonwealth's debt was "not payable."
The Tax-Free High Yield Fund returned −1.24% in the quarter compared with −1.62% for the Barclays 65% High-Grade/35% High-Yield Index and −1.11% for the Lipper High Yield Municipal Debt Funds Average. For the 12 months ended June 30, 2015, the fund returned 5.11% versus 3.32% for the Barclays 65% High-Grade/35% High-Yield Index and 4.98% for the Lipper High Yield Municipal Debt Funds Average. The fund's average annual total returns were 5.11%, 6.53%, and 4.82% for the 1-, 5-, and 10-year periods, respectively, as of June 30, 2015. The fund's expense ratio was 0.69% as of its fiscal year ended February 28, 2015.
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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.
We are underweight in general obligation (GO) debt as a result of our concerns about the long-term liabilities many state and local borrowers face in both pension and health care obligations to retirees. We prefer revenue bonds in general because they offer the relative security of specific claims on revenues versus the generic pledges of taxing power associated with GOs. This positioning benefited our relative performance as GOs underperformed. Within revenue bonds, the portfolio is overweight in the health care segment, where issuers have bolstered their balance sheets, enhancing their creditworthiness. The fund's duration, which is a measure of sensitivity to interest rate changes, was longer than the benchmark's duration. This positioning detracted from relative returns as yields increased.
We believe that the municipal bond market remains a high-quality market that offers good opportunities for long-term investors seeking tax-free income. While fundamentals are sound overall and technical support should persist, there could be hurdles later in 2015. In particular, with the Fed preparing to tighten monetary policy, we are mindful that rising rates would likely weaken the appetite for bonds with higher interest rate risk. However, with the Fed likely to act cautiously, the transition to higher rates may not be as painful as some fear. Ultimately, we believe T. Rowe Price's independent credit research is our greatest strength and will remain an asset for our investors as we navigate the current market environment.