Article from Vanguard website (go to webssite to read full article)

October 17, 2008

Perspective on volatility in the muni markets
Recent market volatility has affected municipal bonds as well as other securities, including stocks and mortgage-backed securities. Municipal bond prices have fallen as a result of the overall credit crisis, and yields for tax-exempt bonds have risen well above those of U.S. Treasury bonds. For long-term investors, this has made municipal bonds—whose interest is generally exempt from federal income tax—especially attractive relative to Treasuries.

Causes of volatility in municipals
Unusual days in the muni bond market
Christopher Alwine, who oversees Vanguard's municipal bond fund operations, discussed volatility in the tax-exempt bond market in a podcast earlier this year.

Listen now »
According to Lipper data, the average general municipal bond fund returned –5.4% in September alone, capping what has been a volatile year to date. The roots of the turbulence go back several years, when institutions such as hedge funds and closed-end funds began borrowing massive sums through low-interest, short-term debt and using the cash to buy higher-yielding, longer-term bonds, including mortgage-backed securities and munis.

Last year, when problems arose with securities tied to subprime mortgage loans, many institutional investors sold those securities, depressing bond prices and ramping up their yields. To raise cash, institutional investors sold even their higher-quality bonds, including municipals, depressing their prices.

"All the factors that were in place earlier only accelerated in recent weeks," said Christopher Alwine, head of Vanguard's municipal bond fund operations. "We don't use leverage in our funds. And Vanguard's experienced team of analysts methodically reviews all holdings to assess their creditworthiness. But what happens in the broad market inevitably has an impact on the share price of our portfolios as well."