There’s no denying it—municipal bond yields are low.
With interest rates still very low, it may be tempting to invest in munis from less-creditworthy issuers that offer higher yields. These bonds are known as high-yield municipal bonds. They offer higher yields, but come with higher risks. We don’t believe they’re attractive relative to the investment-grade muni market. However, a small allocation to high-yield munis relative to high yield corporate bonds may be appropriate for investors with a higher risk tolerance.
A primer on high-yield munis
High-yield municipal bonds have credit ratings that are below investment-grade, or have no credit rating at all. Lower credit ratings mean high-yield bond issuers are considered more vulnerable to missing interest payments or even failing to repay principal. In exchange for the increased risks, yields for high-yield munis are usually greater than yields for investment-grade munis. For example, the recent yield for a broad high-yield muni benchmark was 3.3%, compared with 1.3% for investment-grade munis.1
While a tax-advantaged yield near 3.3% may seem attractive, we don’t think it is relative to historical averages. As shown in the chart below, the difference in yields between high-yield and investment-grade munis with similar durations has been declining since the onset of the COVID-19 crisis and is below historical averages. In other words, investors today aren’t getting as much compensation now as they have in the past for taking on the additional risks that high-yield munis exhibit. Below are a few points to keep in mind when considering high-yield municipal bonds.
Yields for high-yield munis relative to investment-grade munis are low by historical standards
Source: Bloomberg Barclays High-Yield 5-year (4-6) and Bloomberg Barclays Municipal Bond 5 Year (4-6) indices, as of 3/3/2021. Past performance is no guarantee of future results.
1. High-yield muni risks are elevated
In general, the high-yield muni market is made up of issuers that function with a greater degree of operational risk compared to issuers in the investment-grade muni market. For example, nearly 20% of the Bloomberg Barclays Municipal High-Yield index is made up bonds issued by nursing homes and medical facilities. These were among the hardest-hit sectors due to the COVID-19 crises.
Although muni defaults historically are rare, when they happen they’ve most often been in the high-yield portion of the muni market, partly due to their greater operational risks. Of all the munis that are currently in default, over 80% were unrated; unrated bonds are considered part of the high-yield universe. The bottom line is that when compared to investment-grade munis, yields aren’t attractive now and the risks are elevated.
2. High-yield munis are not a replacement for investment-grade munis
Historically, high-yield munis have not provided the same diversification benefits that investment-grade municipal bonds have. As illustrated in the chart below, high-yield munis tend to have a higher correlation to equities than investment-grade munis do. Correlation is a measure of how closely returns move with one another. A correlation closer to 1 means that returns for the two assets move closely together and do not provide the diversification benefits when added to a portfolio, whereas the opposite is true for a correlation of negative 1.
In other words, investors looking for stability are likely to be disappointed with high-yield munis when riskier investments, like stocks, are falling. For example, during the 2008 credit crisis,2 while the S&P 500® was down over 55%, high-yield municipal bonds were down nearly 24% and investment-grade municipal bonds were up 2.4%.
High-yield munis have been more correlated to the S&P 500 than investment-grade munis
Source: Bloomberg, monthly data from 12/31/2009 to 2/26/2021. Bloomberg Barclays US Treasury, Bloomberg Barclays US Aggregate, Bloomberg Barclays Municipal Bond, Bloomberg Barclays US Treasury Inflation Notes, Bloomberg Barclays Muni High Yield, Bloomberg Barclays US Corporate, Bloomberg Barclays Global Aggregate ex-USD, ICE BofA Fixed Rate Preferred Securities, Bloomberg Barclays Emerging Market USD, Bloomberg Barclays US Corporate High Yield Indices. Correlation is a statistical measure of how two investments have historically moved in relation to each other, and ranges from -1 to +1. A correlation of 1 indicates a perfect positive correlation, while a correlation of -1 indicates a perfect negative correlation. A correlation of zero means the assets are not correlated. Past performance is no guarantee of future results.
3. High-yield munis can make sense relative to high-yield corporate bonds
Comparing high-yield munis to high-yield corporate bonds, a slightly different story holds. Spreads for high-yield munis relative to high-yield corporate bonds have also declined since the onset of the COVID-19 crisis, but they’re very close to their longer-term averages. In other words, high-yield munis are not overly attractive at these levels, but also not overly unattractive.
Spreads for high-yield munis relative to high-yield corporates are near their longer-term averages
Source: Bloomberg, as of 3/3/2021. Bloomberg Barclays High-Yield 5-year (4-6) Total Return Index for high-yield municipal bonds and the Bloomberg Barclays Intermediate US High-Yield index for high-yield corporate bonds. Past performance is no guarantee of future results.
After considering taxes, high-yield munis look more attractive. Investors may achieve higher yields with high-yield munis compared to high-yield corporate bonds as shown in the chart below. For investors in all tax brackets other than the 12% bracket, high-yield munis yield more than high-yield corporate bonds after taxes.
High-yield munis may yield more after taxes for some investors
Source: Bloomberg, as of 3/3/2021. Note that high-yield corporate bonds assume an additional 5% state income tax and 3.8% tax for the 32% and above tax brackets. Using the Bloomberg Barclays High-Yield 5-year (4-6) Total Return Index for high-yield municipal bonds and the Bloomberg Barclays Intermediate US High-Yield index for high-yield corporate bonds. The 3.8% tax is on “net investment income” that was originally enacted as part of the Affordable Care Act (ACA).
In addition to potentially higher after-tax yields relative to high-yield corporate bonds, high-yield muni issuers historically have made timely interest and principal payments more frequently than have issuers of high-yield corporate bonds with similar credit ratings. Over a five-year period, 12.2% of munis rated B by Moody’s defaulted, compared with 20.3% of corporates rated B by Moody’s. It’s important to note that these figures likely understate the amount of defaults because the study only includes bonds rated by Moody’s. That’s important because roughly half of the bonds in the Bloomberg Barclays Municipal Bond Index, which some exchange-traded funds (ETFs) and mutual funds track, contain bonds that are not rated by Moody’s.
High-yield munis have tended to default less often than high-yield corporate bonds
Source: Moody’s Investors Service, as of 7/15/2020. Chart shows the five-year cumulative average default rate. Past performance is no guarantee of future results.
4. High-yield munis are generally less liquid than high-yield corporates
Although high-yield munis can offer higher after-tax yields and have historically defaulted less frequently than high-yield corporate bonds, they do carry additional risks. One such risk is the size of the high-yield muni market. In the bond market, the size of the market matters because unlike stocks or ETFs, bonds don’t trade on an exchange. This can pose a challenge for investors in parts of the bond market because nobody is required to execute a trade when you want or at a price you may reasonably expect.
Lower liquidity can affect bond funds and ETFs that hold high-yield munis. If it’s difficult to trade the underlying investment, the fund may have to revalue the bond at a lower price. As a result, the funds that hold less-liquid bonds could see their net asset value drop more precipitously in a down market.
The high-yield muni market is a fraction of the size of other fixed income markets
Source: Bloomberg Barclays Indexes, as of 3/3/2021.
What to consider now
If you do choose to invest in high-yield munis, keep in mind that yields are historically low and risks are elevated. We strongly suggest you consider investing with a professionally managed solution, such as a mutual fund, ETF, or separately managed account. Due to the combination of unique risks that high-yield munis exhibit, a professional manager can help with diversification and ongoing credit monitoring.
1 Source: Bloomberg Barclays Municipal Bond Index and Bloomberg Barclays High Yield Municipal Bond Index, as of 3/1/2021.
2 We use the term “2008 credit crisis” to refer to a time period between 10/9/2007 and 3/9/2009.
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