Investors seeking more income from their bond portfolios often look to the “high-yield” end of the spectrum, where returns can be higher but credit ratings are below investment grade. And although their first choice might be a high-yield corporate bond, high-yield municipal bonds or bond funds might also appeal, especially to investors who want to lower their tax bills.
After all, the interest on most municipal bonds, or “munis,” is exempt from federal taxes, as well as state and local taxes for bonds bought in an investor’s home state. (Some types of munis are not tax-exempt, and some investors may be subject to the Alternative Minimum Tax for interest paid on certain types of munis.)
Of course, higher yields usually mean more risk, and munis are no exception. Bond ratings are an opinion about an issuer’s ability to repay its debt, based on its history of borrowing, repayment and other factors. Issuers rated below investment grade—anything rated below Baa3 by Moody’s or BBB–by Standard & Poor’s—are considered the highest-risk, most speculative bonds available. The higher rates of interest these issuers pay on their bonds are intended to compensate for that risk. Just because munis are issued by public enterprises—which tend to have low default rates—doesn’t mean things can’t go wrong.
Since 2004, average annual returns from high-yield munis have been 1.3 percentage points higher than those from their investment-grade counterparts. But that doesn’t tell the whole story. While it’s tempting to focus on returns in a low-yield environment, investors should weigh the added risks and think about how they fit with their goals. We see three risks yield-hungry investors should consider before investing in high-yield munis.
1) More prone to wild rides
Since 2004, high-yield munis have been twice as volatile as their investment-grade counterparts, as you can see in the chart below.
High-yield munis, like high-yield corporate bonds, are generally more sensitive to market-wide credit conditions. In a credit crisis or when the economy is weak, investors tend to dump riskier, lower-rated bonds. This pushes down prices, as we saw during the credit crisis in 2008 when the total return for high-yield munis was –27% compared to –2.5% for investment-grade munis.1
At the same time, the cost of borrowing tends to rise during crises and times of weak economic growth. Financially strapped municipalities may find they have to offer higher rates to entice more risk-averse buyers. Such pressure can lead to a rise in defaults.
2) Higher sensitivity to rising rates
Rising interest rates cause bond prices to fall, and with rates likely to rise in the foreseeable future high-yield muni bonds could be in for some price volatility.
Most municipal issuers are organizations designed to function in perpetuity, and they often spread the cost of borrowing to build public projects over time. That tends to mean they issue longer-term bonds, which are usually more sensitive to interest rate changes than shorter-term ones.
Investors can look at a bond’s duration—a measure of future cash flows that can signal a bond’s interest rate sensitivity—to understand how it might react to rising rates. Typically, a bond’s price will fall 1% per year of duration for each percentage point increase in interest rates.
As of the end of July, the duration of the Barclays Municipal Bond High Yield Index was nearly 50% higher than that of the Barclays Municipal Bond Index.2 That means the average high-yield municipal bond or bond index fund may be more sensitive to rising rates than the average muni bond or fund.
For investors holding individual high-yield munis, the price volatility that can come from rising rates may not be much of an issue if they’re holding the bonds to maturity. Barring default, they’ll receive the principal back at maturity. It could be more worrisome for investors with high-yield muni bond funds.
Shares of bond funds are based on the value of the underlying bonds and have no maturity date, so there’s no return of principal. If you decide to sell fund shares after interest rates rise, they may fetch a lower price than when you initially bought them.
Of course, returns from bond funds come from two sources: interest payments (paid out as fund distributions) and changes in price. Higher rates can boost interest payments and help buffer negative price returns over time.
3) Less liquidity
The high-yield municipal bond market is less than one-tenth the size of the high-yield corporate bond market.3 Why might this be a problem? Unlike stocks or ETFs, bonds do not have a single exchange where investors can count on a steady market. Instead, they trade investor-to-investor, or “over the counter.”
If there are few buyers and sellers, that means it’s much more difficult to execute a trade when you want or at the price you want. This could be a real problem for investors if volatility picks up and the market turns turbulent: They may find it impossible to sell their potentially risky bond.
It could also affect bond funds and ETFs because if it’s difficult to trade the underlying investment, it will be difficult to trade the fund. As a result, funds holding less liquid bonds could see their prices drop when markets are volatile.
If you’re considering high-yield muni bonds, you should recognize and be comfortable with the risk you’re adding to your portfolio.
If you are willing to accept this risk in return for the potentially higher yields, we suggest that you consider doing so through an actively managed mutual fund. Again, rising interest rates could lead to some volatility, but those higher rates could help make up for losses over time. In addition, this approach will give you exposure to a diversified group of bonds, as well as access to a fund manager or team of managers who specialize in analyzing and selecting securities.
Finally, because of the risks involved, we suggest limiting these investments to a supporting role in the taxable allocation of your fixed income portfolio.
1Source: Barclays. Investment-grade munis are represented by the Barclays Municipal Bond Index and high-yield munis are represented by the Barclays Municipal Bond High Yield Index. Data from 1/1/2008 to 12/31/2008.
2Source: Barclays. The modified adjusted duration of the Barclays Municipal Bond High Yield Index was 9.83, while that of the Barclays Municipal Bond Index was 6.60. Data as of 7/31/ 2015.
3Source: Barclays. As represented by the Barclays U.S. Corporate High-Yield Index and the Barclays Municipal Bond High Yield Index. Data as of 7/31/2015.
The Puerto Rico factor
The debt crisis in Puerto Rico, one of the largest issuers in the high-yield muni market, may have some investors wondering about the broader muni market—especially after the U.S. territory defaulted on securities sold by one of its agencies in early August.
In our view, the situation in Puerto Rico isn’t likely to affect the investment-grade municipal bond market. Puerto Rico faces a combination of issues that no other state or territory faces. Credit conditions for most state and local governments have been improving lately. Also, Puerto Rico’s problems have been widely discussed in the marketplace, which has given investors time to react and adjust their investments.