High-yield municipal bonds offer higher income than investment-grade muni bonds. But they also feature higher risks. For those with higher risk tolerance and longer-term time frame, high-yield munis may be worth the risk. On the other hand, they may not be right for those who use a more conservative approach.
Learn more about high-yield muni bonds and how they work.
What Are High-Yield Municipal Bonds?
High yield munis are bonds issued by state or local governments. They are unrated by the major rating agencies; or, they have credit ratings that are below investment grade.
Investors own high-yield munis for the obvious reason: they offer higher income than their investment-grade counterparts—usually by a margin of about three percentage points—and they are tax-free on the federal level. They may also be tax-free on the state and local levels as well. However, with this higher yield also come some important differences compared with the investment-grade market. Those differences include:
- Liquidity: The high-yield muni market is much smaller than the investment-grade market. It is much less “liquid." This means that trading volumes are lower. For investors in mutual funds or exchange-traded funds (ETFs), this isn’t an issue; it only comes into play for investors in individual securities. But it also means that high-yield munis can have a greater downside when bond prices weaken.
- A different set of risks: Investment-grade municipal bonds are more affected by interest rate risk and less affected by credit risk. But the opposite is usually true for high yield. In other words, performance is driven more by the financial strength of the underlying issuers rather than movements in interest rates. It means that high-yield munis are more sensitive to fluctuations in the economy than investment grade issues. High-yield munis can, therefore, offer a measure of diversification to a portfolio that is heavily weighted in higher-quality bonds.
- Higher default risk: In the period from 1970—2011, only 0.8% of municipal bonds rated investment grade defaulted (i.e., failed to make interest or principal payments) within 10 years after issuance. In contrast, 7.94% of below-investment-grade muni bonds defaulted during this time. It indicates that default risk, while not particularly high on an absolute basis, is much higher for below-investment-grade munis. This is a potential issue when a weaker economy pressures the finances of state and local governments.
- More volatility: As is always the case, a higher yield means higher risk. As a result, price fluctuations can be much larger in the high-yield muni segment compared to investment-grade issues. High-yield bonds are at risk for a greater loss than investment-grade bonds when the market turns south.
- Long-Term Returns: Higher risk may translate to higher yields. But this doesn't always mean higher total returns in a given period. In June 2020, for instance, the average five-year total return of funds in Morningstar’s High Yield Municipal Bond Funds category was 3.93%. This was in line with the 3.11% return for the Municipal National Intermediate Funds category. Those who are considering high-yield municipal bonds need to weigh these factors. Be sure to consider whether the extra yield compensates for the additional risks. High-yield munis are most appropriate for aggressive investors. They also may work well for those with longer-term time horizons that enable them to absorb some short-term volatility.
Determine Goodness of Fit
Before deciding the proportion of your portfolio to invest in high-yield vs. investment-grade, you should figure out whether you should, in fact, be in tax-exempt issues. In most cases, those in higher tax brackets benefit most from munis’ tax benefits.
How to Invest
The rate of default among individual securities is relatively high in this market segment. That means only the most experienced, high-net-worth investors should attempt to construct their own high-yield municipal bond portfolios.
Fortunately, there are an abundance of options available in both mutual funds and ETFs. The full list of high-yield municipal bond mutual funds, together with one-, three, and five-year returns, is available from Morningstar.
There are also two ETFs that focus on the asset class: SPDR Nuveen Bloomberg Barclays High Yield Municipal Bond ETF (ticker: HYMB) and VanEck Vectors High Yield Muni ETF (ticker: HYD). These can be purchased with a brokerage account.
High-yield munis’ yield advantage can certainly add up over time, but make sure you fully understand the risks before you invest.