Are High Yield Municipal Bonds Right for You?

Higher Risks, Higher Returns

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High yield municipal bonds offer investors higher income than investment grade muni bonds, but they also feature higher risks. Miguel Navarro / Getty Images

High yield municipal bonds offer investors higher income than investment grade muni bonds, but they also feature higher risks. For those with a higher risk tolerance and longer-term time frame, high yield munis may be worth the risk. Conversely, they may not be appropriate for more conservative investors.

High Yield Municipal Bonds 101

High yield munis are bonds are issued by state or local governments that are unrated by the major rating agencies or that 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, and sometimes on the state and local levels as well. However, with this higher yield also come some important differences compared with the investment grade market:

Liquidity: The high yield muni market is much smaller than the investment grade market, so it is much less “liquid” – meaning that trading volumes are lower. For investors in mutual funds or exchange-traded funds, this isn’t an issue; it only comes into play for investors in individual securities. However, it also means that high yield munis can have a greater downside when bond prices weaken.

A Different Set of Risks: While investment grade municipal bonds are more affected by interest rate risk and less affected by credit risk, 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 ten 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 - a potential issue when a weaker economy pressures the finances of state and local governments.

More Volatility: As is always the case, 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.

Here’s an extreme example: during the height of the financial crisis in late 2008, most high yield municipal bonds lost about 20-25% in the three-month period from September through November. In contrast, investment-grade funds shed approximately 10-13%. This was a unique time period, but it serves to illustrate that high yield bonds are at risk for a greater loss than investment grade bonds when the market turns south.

Long-Term Returns: While higher risk may translate to higher yields, it doesn't always mean higher total returns in a given period.

As of January 31, 2014, for instance, the average annual total return of funds in Morningstar’s High Yield Municipal Bond Funds category was 3.67%, in line with the 3.50% return for the Municipal National Intermediate Funds category.

Those who are considering high yield municipal bonds need to weigh these factors when considering whether the extra yield compensates them for the additional risks. High yield munis are most appropriate for aggressive investors or those with longer-term time horizons that enable them to absorb some short-term volatility.

Should You Be in Municipal Bonds in the First Place?

Before deciding the proportion of your portfolio to invest in high yield versus investment grade, it’s first necessary to determine whether you should, in fact, be in tax-exempt, rather than taxable, issues.

Typically, investors in lower tax brackets are better off in the latter, while those in higher tax brackets benefit from munis’ tax benefits. To find out whether you should consider taxable or tax-free bonds, click here.

How to Invest in High Yield Municipal Bonds

Since the rate of default among individual securities is relatively high in this market segment, only the most sophisticated, 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 exchange-traded funds (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 S&P High Yield Municipal Bond ETF (ticker: HYMB) and Market Vectors High-Yield Municipal Bond Index ETF (HYD), which can be purchased with a brokerage account.

The Bottom Line

High yield munis’ yield advantage can certainly add up over time, but make sure you fully understand the risks before you invest.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Always consult an investment advisor and tax professional before you invest.