Tax-free municipal bonds produced positive returns and outperformed taxable bonds in the second quarter of 2016. With solid fundamentals and relatively attractive yields, munis generated strong demand as global growth expectations slowed, interest rates on many high-quality government bonds in developed markets were minimal or negative, and volatility escalated after the British vote to leave the European Union. Yields decreased across the municipal yield curve, with long-term rates reaching record lows. In the municipal market, longer-maturity bonds outperformed shorter-maturity issues, and lower-quality securities outperformed higher-quality bonds as investors continued to search for yield. High yield tobacco bonds performed particularly well, outpacing the broad municipal market by a wide margin.
The Tax-Free High Yield Fund returned 3.85% in the quarter compared with 3.48% for the Barclays 65% High-Grade/35% High-Yield Index and 3.79% for the Lipper High Yield Municipal Debt Funds Average. For the 12 months ended June 30, 2016, the fund returned 9.66% versus 9.20% for the Barclays 65% High-Grade/35% High-Yield Index and 10.04% for the Lipper High Yield Municipal Debt Funds Average. The fund's average annual total returns were 9.66%, 7.85%, and 5.40% for the 1-, 5-, and 10-year periods, respectively, as of June 30, 2016. The fund's expense ratio was 0.69% as of its fiscal year ended February 29, 2016.
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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.
In general, we prefer revenue bonds to general obligation (GO) debt because they offer the relative security of specific claims on revenues versus the generic pledges of taxing power associated with GOs. Within the revenue bond sector, our security selection in the health care, transportation, and education subsectors boosted relative performance, while bond selection in the industrial revenue subsector detracted. The fund's overweight to longer maturities helped performance as that segment of the yield curve rallied. The portfolio's duration, which measures sensitivity to interest rate changes, was longer than the duration of the benchmark.
We believe that the municipal bond market remains a high-quality market that offers good opportunities for long-term investors seeking tax-free income. Fundamentals are sound overall, and technical support should persist as global economic uncertainties further increase demand for the relatively high-quality municipal bond asset class. If signs of economic recovery prompt the Fed to continue raising short-term interest rates, muni bond yields are likely to rise along with Treasury yields-although probably not to the same extent. We expect any potential Fed rate increases to be gradual and modest. 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.