A pronounced setback in the stock market also could spook some investors into munis. Even if the muni market has an off year in 2014, any losses would pale in comparison with the damage that could be suffered in stocks.
The poor performance of muni funds last year is a turnaround from their steady gains over much of the last decade, when their returns were goosed by principal gains stemming from falling interest rates.
The average California muni fund surged 10.8% in 2011 and 9.1% in 2012, according to Morningstar. The sector tumbled 9.6% in 2008 during the global financial crisis but rebounded with a 16% gain the following year.
The performance measures total return, which is the change in a fund's share price plus interest income. A negative return means the decline in the value of the portfolio more than offset whatever interest was earned.
Munis have overcome concerns in recent years amid the financial problems of Detroit and a handful of other cities, including Stockton and San Bernardino. Even though Detroit defaulted on some of its general-obligation bonds, municipal defaults are at low levels as the improving national economy boosts tax revenue for cities.
The biggest threat to munis is an expected climb in interest rates.
Rising interest rates cause older bonds paying lower yields to fall in value. Even though a fund earns slightly higher yields on new bonds it buys, the market value of all its older securities declines.
The entire bond market got walloped last summer when the Fed hinted at an end to its economic stimulus program, which had kept a lid on bond yields. The S&P muni bond index slumped 7% in four months.
The central bank in December announced a so-called tapering of its monthly purchases of Treasury and mortgage bonds to $75 billion from $85 billion. It may eliminate all its bond buying by the end of 2014.
The fixed-income market reacted far more calmly, but interest rates have continued to inch up. The yield on the benchmark 10-year Treasury note eclipsed 3% in late December, its highest level in 21/2 years.
Some experts think that munis could be especially susceptible to pain. Yield-hungry investors crowded into them in recent years, causing the market to become overvalued.
“While all fixed-income markets are sensitive to changes in interest rates, munis have developed an outsized vulnerability,” Michael Zezas, Morgan Stanley's chief municipal strategist, wrote in a report last month.
“In recent years, muni performance binged on lower rates moves, an improving credit story, and investor thirst for yield,” he wrote. “This resulted in valuations that amplified munis' vulnerability to higher rates.”
For investors in California munis, the state's chronic fiscal woes improved considerably in 2013.
The state's improving economy, especially in Silicon Valley, and the booming stock market have boosted income tax revenue. So did the temporary tax hikes approved by voters in the November 2012 passage of Proposition 30.
California still has significant long-term financial challenges, including billions owed for public-employee pensions and healthcare. But the state is expected to notch multibillion-dollar budget surpluses over the next few years.
A November report by the state Legislature's nonpartisan budget analyst declared that California's “budgetary condition is stronger than at any point in the past decade.”
Standard & Poor's and Fitch each raised California's credit rating, once tied for the worst in the nation, last year. That's a bit of a double-edged sword for investors.
California's improved financial outlook has allowed the state to issue bonds more cheaply. Translation: lower yields for investors.
The yield premium on California 10-year triple-A-rated bonds compared with munis from other states is 0.49%, down from 0.92% in March 2012, according to Thomson Reuters Municipal Market Data.
“It's safer, and when it's safer you always get less yield,” said Cohen of Envision Capital Management. “This trade-off is well worth it for a state that was in such despicable financial shape.”
Of the 50 funds specializing in California muni bonds, only one — the City National Rochdale California Tax Exempt bond fund — had a positive return in 2013, according to Morningstar. The fund (ticker symbol: CNTIX) eked out a 0.09% gain, according to preliminary Morningstar data.
Experts recommend that investors interested in munis stick to short- and intermediate-term debt — 10 years or less — which is less vulnerable to rising rates than longer-term issues.
Among larger intermediate funds, the Vanguard California Intermediate-Term Tax-Exempt fund (ticker: VCAIX) was off 0.83% in 2013, according to Morningstar.
The American Century California Intermediate-Term Tax-Free bond fund (BCITX) fell 1.31% and the Franklin California Intermediate-Term Tax-Free Income fund (FKCIX) declined 1.69%.
“The big risk is you just cannot be out there blindly chasing yield,” said Genter of RNC Genter Capital Management. “That's the biggest problem we're seeing for investors.”