The current state of the bond market is confusing to say the least. But for fixed income investors willing to do a little digging, there could be plenty of opportunities. In fact, some may even produce higher yields with less risk than other segments of the bond market, which doesn’t happen very often in history. And when it does, investors should pounce.
Right now, that opportunity could exist in high-yield municipal bonds.
High-yield munis offer very strong credit profiles despite their ‘high-yield’ moniker. And right now, they offer investors a better after-tax yield than lower-rated and relatively more risky investment-grade corporate bonds. This is an opportunity that investors don’t want to miss.
When ‘Junk’ Doesn’t Equal Junk
Municipal bonds are issued by state and local governments as well as their entities. As such, when investors tend to think about municipal bonds they think about so-called general obligation (GO) bonds. The ability to repay these bonds is directly tied to the State of Texas’s or City of Sacramento’s ability to tax its citizens and businesses.
However, the muni market is a two-sided coin. And here, the other side is a larger share of the pie. Revenue-backed bonds are those tied to specific projects. These bonds are issued to fund essential services that are financially independent of the city, county, or state they serve. They are repaid by the revenues generated from the project. Some examples include hospitals, mass transit, utilities and even sports stadiums/concert venues.
Because of their revenue-backed nature, many investors look for more yield from these bonds than GOs. With that, revenue bonds are often considered high-yield munis. Some- such as those used to fund Tribal gaming facilities or stadiums- can even be called “junk” by pundits.
The thing is, they aren’t junky at all. Despite the name, they offer strong credit profiles and even include many riders in their issuance. This includes first liens on the property or assets, revenue pledges, and even limited tax pledges- where property taxes and even sales taxes from the project area are pledged to support the bond’s repayment.
As a result, high yield munis offer low default rates versus high yield corporate bonds and other junk debt. Looking at the 10-year cumulative default, rating agency Moody’s shows that only 3.97% of high yield munis defaulted versus 32.53% for high yield corporate bonds. The data gets even more interesting when you break it out into subsections. Most of the defaults have come from vanity projects and senior living sectors rather than water systems or light-rail projects. 1
Today’s Market-Beating High Yield
With high-yield munis, investors have an opportunity to score top-notch credit profiles and a great after-tax yield.
According to investment manager abrdn, high-yield munis are now paying more than corporate junk bonds on an after-tax basis. Remember munis offer tax advantages in that Uncle Sam will let investors skirt all or a portion of their interest from these bonds on their federal taxes. And thanks to changes in the AMT tax requirements, the vast bulk of investors are able to benefit.
Right now, the Bloomberg High Yield Muni Index offers a very compelling 8.67% after-tax yield, compared to a 7.73% yield for the Bloomberg Corporate High Yield Index. This is a spread difference of around 93 basis points, and is nearly double the historical average. The below chart from abrdn shows the yield advantage in munis.
Source: abrdn
Investors have an opportunity to own a higher yield with less risk by choosing high-yield munis over high-yield corporate debt.
According to abrdn, the big spread difference has long signaled a wonderful buying point for total returns as well.
Looking at historical data and the last three rate-cutting cycles, high-yield munis have managed to beat junk corporate bonds on price appreciation and income two out of three times. In fact, high-yield munis have even managed to outperform investment-grade corporate bonds during these periods as well by an average of nearly 1 full basis point per year.
Buying Some High-Yield Munis
So, right now investors have an opportunity to score some of the highest yields in the fixed income space, save on taxes, and have a lower default rate/higher credit quality than other risky bonds. That’s a win-win-win for portfolios.
The choice to add high-yield munis is an easy one. Buying them is easy as well.
Individually, buying munis of any kind is generally a hard proposition. But thanks to the world of ETFs, homing in on the sector is as easy as clicking a mouse in your brokerage account. This makes it easy to add the bonds to a portfolio and gain their added yields. Furthermore, active management might generate higher returns than passive alternatives due to the fund manager’s capability to perform thorough credit research.
High-Yield Municipal Bond ETFs
These funds were selected based on their exposure to the high-yield municipal bond market. They are sorted by their YTD total return, which ranges from 2.8% to 7.8%. They have assets under management between $82M and $2.92B and expenses between 0.32% and 1.82%. They are currently yielding between 1.8% and 4.9%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| XMPT | VanEck CEF Muni Income ETF | $239M | 7.8% | 5.7% | 1.82% | ETF | No |
| HYMU | BlackRock High Yield Muni Income Bond ETF | $82M | 5.1% | 4.3% | 0.35% | ETF | No |
| HYMB | SPDR® Nuveen Bloomberg High Yield Municipal Bond ETF | $2.59B | 4.3% | 4.2% | 0.35% | ETF | No |
| FMHI | First Trust Municipal High Income ETF | $573M | 4.3% | 4% | 0.70% | ETF | Yes |
| JMHI | JPMorgan High Yield Municipal ETF | $175M | 3.8% | 4.9% | 0.49% | ETF | Yes |
| HYD | VanEck High Yield Muni ETF | $2.92B | 3.6% | 4.3% | 0.32% | ETF | No |
| SHYD | VanEck Short High Yield Muni ETF | $329M | 2.8% | 3.3% | 0.35% | ETF | No |
Overall, high-yield munis are offering a compelling asset class to score high yields and strong credit quality — and that’s an opportunity that shouldn’t be ignored. In the end, high-yield munis are a big-time buy.
Bottom Line
It’s very rare for investors to have an opportunity to score higher-than-average yields and strong credit quality. Such an opportunity exists within the high-yield muni market. Right now, investors can get market-beating yields and very strong credit profiles in these bonds. And that’s an opportunity for high total returns.
1 abrdn (May 2023).
