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High-Yield Munis: Approach With Caution

Municipal bond investors who are looking for extra income may be tempted by the high-yield portion of the market. As with high-yield corporate bonds, this category can offer higher yields—but also higher risks. After all, the term applies to issues with sub-investment grade credit ratings (below BBB-/Baa3).

We think investors who are considering high-yield municipal bonds should be aware of the following:

  • High-yield munis are more volatile than their investment grade counterparts.
  • The market for high-yield munis is small and relatively illiquid.
  • High-yield munis have a much higher likelihood of defaulting.
  • The yield advantage they offer today is very low.
     

High-yield munis are generally more volatile than investment grade rated munis

Returns from high-yield munis, like those from high-yield corporates, are often more like returns from stocks. That means they tend to be more volatile than investment-grade munis. Investors who buy bonds because they want stability may be disappointed with high-yield munis when riskier investments, like stocks, are falling.

During the credit crisis in 2008, high-yield munis lost 27.0% of their value, while investment-grade munis lost just 2.5%.1 By way of comparison, the S&P 500® Index dropped 37.0%, while high-yield corporate bonds fell 26.2%. The investment-grade muni market quickly recovered and returned 3.4% in 2009, while high-yield munis were down again by 2.3%.

High returns come with high volatility

Historically, the higher returns offered by high-yield munis have tended to come with increased volatility.

Source: Bloomberg Barclays indexes using monthly data from 1/30/09 to 12/29/2017. Returns are shown before taxes and would be lower, after taxes, for non-municipal sectors including high-yield corporate bonds.

The high-yield muni market is small

In the bond market, the size of the market matters because unlike with stocks or exchange-traded funds (ETFs), bonds don’t have a single exchange where investors can count on a steady market. Instead, they trade investor-to-investor, or “over the counter.”

This can pose challenges for investors in the high-yield muni market because the small number of buyers and sellers can make it difficult to execute a trade when you want or at the price you want. This can make it very difficult to sell a high-yield bond during periods of market stress.

Lower liquidity can also affect bond funds and ETFs that hold high-yield munis because 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 less than a tenth the size of the high-yield corporate market 

The high-yield muni market, at about $102 billion, is a fraction of the size of the high-yield corporate bond market.

Source: Bloomberg Barclays Municipal Bond Index, Bloomberg Barclays High Yield Municipal Bond Index, and Bloomberg Barclays High Yield Corporate Bond Index, as of 1/24/18.

Municipal defaults are concentrated in the high-yield part of the market

Muni defaults are exceedingly rare. Since 2007, the five-year default rate for the municipal bonds rated by Moody’s—both investment grade and high yield—was just 0.15%. 2 In comparison, 6.92% of the corporate bonds rated by Moody’s defaulted over the same period.

When defaults have happened, they’ve generally been in the high-yield portion of the muni market. Research by Moody’s found that since 1970, 90% of the defaults for the munis they rated were rated below investment grade at the time of default. 

Although municipal defaults are generally rare, we don’t think that should lull investors into a false sense of security when choosing lower-rated or unrated issues. 

Lower rated bonds have defaulted more often

The five-year default rate of both the corporate and municipal bonds rated by Moody’s shoots sharply higher below investment grade.

Source: Moody’s, as of 6/27/2017.

It’s also important to keep in mind that the Moody’s data covers only Moody’s-rated bonds and therefore excludes munis that aren’t rated by Moody’s or have no rating at all. To put this in perspective, according to Moody’s there were only four defaults totaling $22.6 billion in 2017. But using data from Municipal Market Advisors that looks at the entire muni market, the number of defaults rises to 44.

That said, 2017 was also an anomaly, notching up the highest value of defaults since 1970 because of the problems in Puerto Rico. Excluding Puerto Rico, defaults actually declined from 2016 to 2017, according to Municipal Market Advisors.

We don’t think that other municipal issuers have the same debt and demographic problems as Puerto Rico, and that defaults for investment-grade-rated municipal bonds will continue to be rare.

The additional yield on offer from high-yield munis is the lowest it has been in nearly 10 years

To weigh the relative attractiveness of high-yield munis, start with the additional yield they offer compared to investment-grade-rated municipal bonds. The spread today is well below its average in recent years.

Going back to 2007, the Bloomberg Barclays High Yield Municipal Bond Index has yielded on average 3.6% more than the broad Bloomberg Barclays Municipal Bond Index. Today, the yield-to-worst of the high-yield market is only 2.7% higher. The smaller the spread, the less attractive high-yield munis are relative to investment-grade rated munis, all things being equal. That means you’re just not getting as much income from a bond bought today.

Yields for high-yield munis aren’t as attractive as they’ve been in the past

At 2.7%, the spread between the Bloomberg Barclays High Yield Municipal Bond Index and Bloomberg Barclays Municipal Bond Index is well below its recent average.

Source: Bloomberg Barclays Municipal Bond Index and Bloomberg Barclays High Yield Municipal Bond Index, as of 1/24/18.

What to do now

For the portion of your bond portfolio designed for stability, we don’t generally recommend 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 their portfolio. As with investment-grade munis, high-yield munis pay income that is generally exempt from federal taxes, as well as state taxes for munis bought in your home state.

If you are considering entering this part of the market, be aware of the additional risks associated with high-yield munis and remember that spreads are narrower than usual now. Finally, if you choose to invest in high-yield munis, we believe you should do so through a professionally managed investment like a mutual fund, which can help with both diversification and ongoing credit monitoring.

Source: As represented by the Bloomberg Barclays Municipal Bond Index, the Bloomberg Barclays High Yield Municipal Bond Index, and the Bloomberg High Yield Corporate Bond Index. Returns for 2008 are from 12/31/2007 to 12/31/2008 and returns for 2009 are from 12/31/2008 to 12/31/2009.

Moody’s Investor Services, “US Municipal Bond Defaults and Recoveries, 1970-2016,” 6/27/17.

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. Supporting documentation for any claims or statistical information is available upon request.

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

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.

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

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.

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..

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

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

Bloomberg Barclays U.S. Aggregate Bond Index (“US Aggregate”)  is a market-value-weighted index of taxable investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgage backed securities, with maturities of one year or more.

The Barclays U.S. Treasury Index (“Treasuries”) measures U.S. dollar-denominated, fixed-rate, nominal debt issued by the U.S. Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index. STRIPS are excluded from the index because their inclusion would result in double-counting.

The Barclays U.S. Municipal Bond Index (“Investment grade munis”) 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 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.

The Bloomberg Barclays U.S. Corporate Bond Index (“Investment grade 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).

The Bloomberg Barclays U.S. Corporate High-Yield Bond Index (“High-yield corporates”) 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.

Bloomberg Barclays Emerging Markets Local Currency Government Index (“Emerging market bonds”) is designed to provide a broad measure of the performance of local currency emerging markets debt. Classification as an emerging market is rules-based and reviewed on an annual basis using World Bank income group and International Monetary Fund country classifications.

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).

Barclays Global Aggregate ex USD Index (“International bonds”) provides a broad-based measure of the global investment-grade fixed-rate debt markets. The two major components of this index are the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices.

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.

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