Municipal bond investors are typically a conservative lot, but it would have paid to take on more risk during the favorable market environment of the past four years. From 2009 through 2012, high yield municipal bonds trounced their investment-grade counterparts. The Market Vectors High Yield Municipal Index ETF (HYD) produced an average annual return of 12.63% from its inception on February 5, 2009 through year-end 2012, compared with 5.87% for the investment-grade iShares National AMT-Free Muni Bond ETF (MUB). The return gap was especially prominent last year, during which HYD gained 15.95% and more than tripled the 4.95% gain for MUB.
This year, however, it has been a different story. Year-to-date in 2013, HYD has returned -6.50% and lagged the -4.74% return of MUB, with much of this gap occurring in the past three months amid the instability in higher-risk segments of the bond market. High yield munis continue to offer a substantial yield-advantage: the SEC yield on HYD stood at 5.58% on July 31, more than double the 2.64% yield available on MUB - a gap that becomes even greater on an absolute basis once the tax advantages are taken into account. In addition, the muni market as a whole is generally seen as offering an attractive value after its recent underperformance. Nevertheless, yield-hungry investors should exercise caution with funds such as HYD as long as broader bond market performance remains shaky and muni-specific headline risk such as Detroit's bankruptcy remain in play.