High yield municipal bonds, like high yield corporate bonds, offer investors higher income than investment grade muni bonds, but they also come with higher risks.
High yield munis are bonds are issued by state or local governments that are unrated by the major ratings agencies or that have credit ratings 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 comes 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.
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 true for high yield. (Learn the difference between the two types of risk here). Performance is therefore driven more by the financial strength of the underlying issuers rather than movements in interest rates. This 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. This indicates that default risk, while not particularly high on an absolute basis, is much higher for below-investment grade munis.
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.
Higher Long-Term Returns: In terms of their total return, high yield munis have finished slightly ahead of investment grade over the past ten years, with the yield differential providing the bulk of the outperformance. As of September 30, 2012, the average annual total return of funds in Morningstar’s High Yield Municipal Bond Funds category was 4.64%, versus 4.08% for the Municipal National Intermediate Funds category. However, the underperformance during the crisis period has affected the five-year numbers: in this interval, the 3.90% average for the high yield category trails the 5.17% for the intermediate funds category.
Those who are considering high yield municipal bonds need 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 Munis 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 here. 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 through a broker.
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.