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Are High-Yield Municipal Bonds “High Yield” or “Junk”?

Key Points
  • High-yield municipal bonds typically offer higher yields than investment-grade munis, but carry additional risk.

  • A small allocation to high-yield munis can make sense for more aggressive muni investors—but today’s yields are low relative to alternatives.

  • If you choose to venture into this part of the market, we suggest you do so via an exchange-traded fund (ETF), mutual fund, or separately managed account, to help with diversification and ongoing credit monitoring.

There’s an old joke in the bond market: “What’s the difference between a high-yield bond and a junk bond?” “It’s high yield when you buy it, but junk when you sell it!” Since high-yield munis—those that are rated below Baa3/BBB-, or not rated at all—were one of the best-performing bond sectors in 2018, should investors consider them more “junk” or more “high-yield” today?

High-yield munis were among the best-performing fixed income asset classes in 2018

In 2018, the total return for high-yield muni bonds was 4.9%. That compares with 1.49% for investment-grade munis, 0.92% for Treasury bonds, negative 1.99% for high-yield corporate bonds and negative 2.43% for investment-grade corporate bonds.

Source: Bloomberg, total returns from 12/29/2017 to 12/31/2018. See disclosures for list of indexes used. Past performance is no guarantee of future results.

We think the answer falls somewhere in the middle, but we are more cautious on high-yield munis today then we have been in the past. A small allocation to high-yield munis can make sense for more aggressive muni investors today, but if you already have a position we would caution against adding to it.

High-yield munis generally pay higher yields, but yields today are low

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 high-yield muni benchmark was just over 5%, compared with 2.7% for investment-grade munis.1

While a tax-advantaged yield above 5% 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 is well below historical averages. In other words, investors today aren’t getting as much compensation for taking on the additional risks that high-yield munis exhibit as they have in the past.

Yields for high-yield munis relative to investment-grade munis are low by historical standards

The difference in yield between high-yield municipal bonds and investment-grade municipal bonds was 2.3% as of January 10, 2019. That is below the 3.6% average since December 31, 2009.

Source: Bloomberg Barclays Indexes, as of 1/10/2019. See disclosures for list of indexes used. Past performance is no guarantee of future results.

Comparing high-yield munis to high-yield corporate bonds, the same story holds—investors aren’t getting compensated to the same extent as in the past. In fact, a muni investor would have to be in one of the top tax brackets to receive a higher after-tax yield on high-yield muni investments compared with high-yield corporate bonds. (Interest payments for municipal bonds, including high-yield munis, are generally exempt from federal income taxes, and may also be exempt from state income taxes if the issuer is domiciled in your home state.

High-yield munis yield more than high-yield corporate bonds only for investors in the top tax brackets

HY muni yields were 5.01% on 1/10/2019. By contrast, a taxable HY corporate bond would yield, after taxes: 6% for investors in the 12% bracket, 5.28% in the 22%, 5.13% in the 24%, 4.28% in the 32%, 4.06% in the 35%, and 3.56% in 37% brackets.

Source: Bloomberg, as of 1/10/2019. Note that high-yield corporate bonds assume an additional 5% state income tax and 3.8% tax on net investment income for the 32%-and-above tax brackets. See disclosures for list of indexes used.

It’s also important to note that the high-yield muni index has a longer duration—meaning it’s more sensitive to changes in interest rates—than the high-yield corporate bond index. For investments like some ETFs or passively managed mutual funds that simply track the index, high-yield muni investors are taking on greater interest rate risk combined with the other unique risks of high-yield munis, but yields are historically low compared with high-yield corporate bonds.

High-yield munis exhibit greater risks than investment-grade munis

In general, the high-yield muni market is made up of issuers that function with a greater degree of operational risk compared to the investment-grade muni market. For example, over half of the Bloomberg Barclays Municipal High Yield index is made up bonds backed by payments on tobacco products, real estate development projects, or nursing homes and medical facilities. 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. As illustrated in the chart below, over a five-year period 12.8% of munis rated B by Moody’s defaulted. That increased to 21.1% moving into the lower Caa-C rung of the high-yield market.

High-yield munis are more likely to default than investment-grade munis

During the five-year period ended July 31, 2018, the default rate was zero for Aaa-, Aa- and A-rated muni bonds; 0.5% for Baa; 2.1% for Ba; 12.8% for B; and 21.1% for Caa-C rated munis.

Source: Moody’s Investors Services, as of 07/31/2018. Chart shows the five-year cumulative average default rate. Past performance is no guarantee of future results.

We don’t think the low historical default rate should lull investors into a false sense of security. It’s important to note that the default statistics cited above only covers Moody’s-rated bonds, and therefore exclude bonds that aren’t rated by Moody’s or have no rating at all. Looking at it in another way, only 10 issuers rated by Moody’s defaulted in 2017, but if you include both bonds not rated by Moody’s and unrated bonds, 47 issuers defaulted in 2017.2 This matters for investors in high-yield muni ETFs or funds that track and index because nearly half of the most common high-yield muni index is composed of munis that aren’t rated by Moody’s, S&P, or Fitch.3

High-yield munis have historically offered returns similar to high-yield corporate bonds, but with less volatility

For the portion of your bond portfolio designed for stability, we don’t generally suggest high-yield municipal or corporate bonds. However, for investors with higher risk tolerance and in higher tax brackets, high-yield municipal bonds may make sense for a small portion of your portfolio. But keep in mind that spreads today are historically low, so it’s not an opportune time to add to existing positions.

As illustrated in the chart below, historically, returns for high-yield munis have been high relative to other riskier parts of the fixed income markets given their volatility (or standard deviation). Note that future returns for high-yield munis could be lower, due to lower yields today compared with historical averages.

Historically, the risk-return of high-yield munis has been attractive relative to other riskier sectors

Source: Bloomberg, monthly data from 12/31/1998 to 12/31/2018. See disclosures for list of indexes used. Past performance is no guarantee of future results.

High-yield munis don’t provide the same level of diversification benefits as investment-grade munis

Returns for high-yield muni bonds historically have been more correlated with equities than returns for investment-grade munis have been. Correlation is a measure of how closely returns for two investments move together. A correlation closer to 1 means that returns for the two assets move closely together and do not provide greater diversification benefits, 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,4 while the S&P 500® was down 37%, high-yield municipal bonds were down 27% and investment-grade municipal bonds were down just 2.5%.

High-yield munis are more highly correlated to the S&P 500 than investment-grade munis

High-yield municipal bonds historically have had a 0.23 correlation with the S&P 500 index, while investment-grade municipal bonds have had a negative 0.04 correlation.

Source: Bloomberg, monthly data from 12/31/1998 to 12/31/2018. See disclosures for list of indexes used.

High-yield munis are generally less liquid than investment-grade munis

In the bond market, the size of the market matters. 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

The total market value of the high-yield municipal bond market is $101.1 billion, compared with $1.2 trillion for high-yield corporate bonds, $1.5 trillion for investment-grade munis and $5 trillion for investment-grade corporate bonds.

Source: Bloomberg Barclays Indexes, as of 1/10/2019.


What to do now

If you do choose to invest in high-yield munis, keep in mind that yields are historically low relative to other alternatives, and high-yield munis have greater risks relative to investment-grade munis. We also strongly suggest you do so 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. For help selecting the right investments, Schwab clients should consider using our fixed income resources and tools, including Schwab BondSource®, or getting help from a Schwab Fixed Income Specialist.

 

¹ Source: Bloomberg Barclays Muni High Yield Index and the Bloomberg Barclays Municipal Bond Index, as of 1/9/2019.

² Source: Municipal Market Advisors, as of 12/28/2018.

³ Source: Bloomberg, as represented by the Bloomberg Barclays Municipal High Yield Index, as of 1/10/2019.

4 Source: Bloomberg, total return from 12/31/2007 to 12/31/2008.

What You Can Do Next

  • Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch or find a consultant.
  • Explore Schwab’s views on additional fixed income topics in Bond Insights.
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Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

Tax-exempt bonds are not necessarily suitable for all investors. Information related to a security's tax-exempt status (federal and in-state) is obtained from third parties, and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the alternative minimum tax. Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

Treasury Inflation Protected Securities (TIPS) are inflation-linked securities issued by the US Government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the dividend amount payable is also impacted by variations in the inflation rate, as it is based upon the principal value of the bond. It may fluctuate up or down. Repayment at maturity is guaranteed by the US Government and may be adjusted for inflation to become the greater of the original face amount at issuance or that face amount plus an adjustment for inflation.

Preferred securities: (1) Generally have lower credit ratings than the firm's individual bonds (2) They generally have a lower claim to assets than the firm's individual bonds (3) Often have higher yields than the firm's individual bonds due to these risk characteristics. (4) Are often callable, meaning the issuing company may redeem the securities at a certain price after a certain date.

Schwab does not provide tax advice. Clients should consult a professional tax advisor for their tax advice needs.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

Standard deviation is a measure that is used to quantify the amount of variation or dispersion of a set of data values.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

Indexes used:

High-yield Municipal Bonds: The Bloomberg Barclays Municipal Bond: High Yield (“High-Yield Municipal Bonds”) is composed of non-investment-grade U.S. municipal securities with a remaining maturity of one year or more.

Investment-Grade Municipal Bonds: The Bloomberg Barclays U.S. Municipal Bond Index (“Investment-Grade Municipal Bonds”) is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed tax exempt bond market. The index includes state and local general obligation, revenue, insured and pre-refunded bonds. The Bloomberg Barclays U.S. Corporate Index measures the investment-grade, fixed-rate, taxable corporate bond market. It includes U.S. dollar-denominated securities publicly issued by U.S. and non-U.S. industrial, utility and financial issuers.

Securitized Bonds: The Bloomberg Barclays Securitized Bond Total Return Index (“Securitized Bonds”) represents the securitized section of the Barclays US Aggregate.

Treasury Bonds: The Bloomberg Barclays U.S. Treasury Index (“Treasury Bonds”) includes public obligations of the U.S. Treasury excluding Treasury Bills and U.S. Treasury TIPS. The index rolls up to the U.S. Aggregate. Securities have $250 million minimum par amount outstanding and at least one year until final maturity.

Core Bonds: The Bloomberg Barclays U.S. Aggregate Index (“Core Bonds”) represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. The following indexes are a component of the Bloomberg Barclays U.S. Aggregate Index: Bloomberg Barclays U.S. Aggregate 1-3 Years Bond Total Return Index, Bloomberg Barclays U.S. Aggregate 5-7 Years Bond Total Return Index, Bloomberg Barclays U.S. Aggregate 10+ Years Bond Total Return Index.

Bank Loans: The S&P/LSTA U.S. Leveraged Loan 100 Index (“Bank Loans”) is a market value-weighted index designed to measure the performance of the largest 100 issues in the U.S. leveraged loan market.

TIPS: The Bloomberg Barclays U.S. Treasury Inflation Protected Securities (TIPS) Index (“TIPs”) is a market value-weighted index that tracks inflation-protected securities issued by the U.S. Treasury. To prevent the erosion of purchasing power, TIPS are indexed to the non-seasonally adjusted Consumer Price Index for All Urban Consumers, or the CPI-U (CPI).

International Bonds: The Bloomberg Barclays International Developed Bond Total Return Index (“International developed”) provides a broad-based measure of the global investment-grade fixed-rate debt markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. Bloomberg Barclays International Developed Bond Total Return Index ex US excludes the U.S. Aggregate component.

High-Yield Corporate Bonds: The Bloomberg Barclays U.S. Corporate High-Yield Bond Index (“High-Yield Corporate Bonds”) covers the USD-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.

Investment-Grade Corporate Bonds: The Bloomberg Barclays U.S. Corporate Bond Index (“IG Corporates”) covers the U.S. dollar (USD)-denominated investment-grade, fixed-rate, taxable corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P and Fitch ratings services. This index is part of the Bloomberg Barclays U.S. Aggregate Bond Index (Agg).

Emerging-Market Bonds: The Bloomberg Barclays Emerging Markets USD Aggregate Bond Index  (“Emerging Market Bonds”) includes USD-denominated debt from emerging markets in the following regions: Americas, Europe, Middle East, Africa, and Asia.

Preferred Securities: The ICE BofA Merrill Lynch Fixed Rate Preferred Securities Index (“Preferred Securities”) tracks the performance of fixed-rate USD-denominated preferred securities issued in the U.S. domestic market.

The S&P 500 Index is a market-capitalization weighted index that consists of 500 widely traded stocks chosen for market size, liquidity, and industry group representation.

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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