High-quality, short-term Maryland municipal bonds generated modest positive returns in the third quarter. Short-term and high-quality bonds generally underperformed long-term and lower-quality bonds, respectively, over the past three months. The T. Rowe Price economics team believes that the Federal Reserve will wind down its asset purchase program in October, and short-term interest rate increases are likely to begin in mid- to late 2015. However, in recent months, short-term Treasury rates have moved modestly higher, while short-term municipal yields were little changed. This has made short-term munis relatively expensive versus taxable alternatives.
The Maryland Short-Term Tax-Free Bond Fund returned 0.15% in the quarter compared with 0.21% for the Lipper Short Municipal Debt Funds Average. For the 12 months ended September 30, 2014, the fund returned 1.01% versus 1.29% for the Lipper Short Municipal Debt Funds Average. The fund's average annual total returns were 1.01%, 0.94%, and 1.91% for the 1-, 5-, and 10-year periods, respectively, as of September 30, 2014. The fund's expense ratio was 0.53% as of its fiscal year ended February 28, 2014.
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Current performance may be lower or higher than the quoted past performance, which cannot guarantee future results.
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Because of the nature of the short-term Maryland bond market, we hold a significant allocation in general obligation debt with a focus on bonds issued by state and local authorities. We favor and have a large absolute weight, and relative overweight, to revenue-backed debt. We intend to keep a slightly longer maturity and duration position than our benchmark. (Duration measures a fund's sensitivity to changes in interest rates.) We have increased our allocation to health care holdings and bonds rated A and lower to boost current income.
Looking forward, we believe the market will start to price in some increase in the federal funds rate next summer. While Fed tightening will be the subject of many headlines, we are less concerned about it than in previous cycles because the economy is growing at a slow pace and inflation remains below the Fed's 2% target. As a result, we think there is a reasonable probability that the Fed will not raise rates as high or as quickly as is widely forecast. We believe that the Maryland Short-Term Tax-Free Fund is attractive for investors with a long-term focus who want more tax-free income than a money fund and are willing to accept modest interest rate risk. As always, we are on the lookout for attractively valued issues with good fundamentals, an investment strategy that has served our investors well in the past.