A COMPARATIVE RISK RETURN ANALYSIS AND PERFORMANCE EVALUATION OF TAX-FREE MUNICIPAL BOND FUNDS

Little research has been done on performance evaluation and risk return analysis of municipal bonds, despite the importance of municipal bonds both to the financial professional and to the individual investor. By comparing the returns of municipal bonds to other types of bonds, an interesting and dynamic underlying process that drives the returns, is revealed. This paper undertakes such evaluation and analysis.; Using mutual funds, the first part evaluates comparatively the performance of municipal bond funds to other bond and equity funds. The funds' returns were adjusted for federal taxes and reflect the impact of individual marginal tax rates at different levels of income, The findings suggest that municipal bond fund returns are superior to other bond funds for the middle and high income investors when the tax benefit is considered.; In the second part, asset pricing models are used to analyze the risk return relationship of the different funds to the market and to interest rates. The analysis indicates that the municipal bonds are highly correlated with the market, as indicated by a relatively high beta; the correlation seems to be higher during periods of economic growth. The test of risk sensitivity to market and interest rates indicates that municipal bonds have a higher sensitivity to market and economic changes than to interest rates and as such their performance behavior is similar to low grade corporate bonds and to equities.; These findings are consistent with the Miller corporate equilibrium model except that here the municipals and equities are pooled together, versus the debt (corporate and government), and the corporation will issue debt according to market forces, resulting in a Miller clientele equilibrium where the equity investors are also the municipal bond investors. This assertion gets support also from the results of risk return evaluation against a municipal bond index that produces a high correlation for the municipal bonds, but no significant correlation to corporate high yield and equities.; I find that municipal bonds are good investments because of their superior returns for higher marginal tax bracket investors and their relative superior performance during economic growth.