High-yield municipal bonds offer higher income than investment-grade muni bonds, but they also feature higher risks. For experienced investors with higher risk tolerance, longer-term time frame, and enough financial cushion to absorb potential losses, high-yield munis may be worth the risk.
Learn more about high-yield muni bonds and how they work.
Key Takeaways
- High-yield municipal bonds (known as "munis") are issued by state or local governments.
- While the income they return can be higher than that from investment bonds, the market for sale is smaller.
- Mutual funds and ETFs are ways to create a municipal bond portfolio.
- It is risky for an inexperienced investor to invest in high-yield munis on their own.
What Are High-Yield Municipal Bonds?
High yield munis are municipal 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. That means they're rated below Baa (by Moody's) or BBB (by S&P and Fitch).
Investors own high-yield munis for the obvious reason: They offer higher income than their investment-grade counterparts and they are tax-free on the federal level. They may be tax-free on the state and local levels as well.
However, with the higher yield also comesome important differences compared with the investment-grade market. Those differences are detailed below.
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), that isn’t an issue; liquidity only comes into play for investors in individual securities. But the lack of liquidity 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 bonds. In other words, performance is 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
From 1970 to 2021, only 0.9% of municipal bonds that were rated investment grade defaulted (i.e., failed to make interest or principal payments) within 10 years after issuance. In contrast, 6.94% of below-investment-grade muni bonds defaulted during this time.
This 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
High-yield securities generally have more price volatility, meaning their prices fluctuate more and are harder to predict than investment-grade bonds. That volatility is another form of risk.
Long-Term Returns
Higher risk may translate to higher yields, but that 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%, which was not that far above the 3.11% return for the Municipal National Intermediate Funds category.
Determine the Fit
Investors 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.
Before deciding the proportion of your portfolio to invest in high-yield vs. investment-grade bonds, you should first figure out whether you should be in tax-exempt issues. Tax advantages are typically offset by lower yields, so you should compare the yields of taxable investment-grade corporate and government bonds using the tax-equivalent yield of the municipal bond you're considering. In most cases, investors in higher tax brackets benefit most from munis’ tax benefits.
How To Invest
The rate of default among individual securities is relatively high in the high-yield muni segment. It's best suited for experienced investors who have enough wealth to absorb potential losses.
Tip
High-yield munis’ yield advantage can certainly add up over time, but make sure you fully understand the risks before you invest.
Fortunately, there is an abundance of options available in both mutual funds and ETFs. A list of high-yield municipal bond mutual funds, together with one-, three-, and five-year returns, is available from Morningstar. The company also has a list of ETFs that focus on the asset class. In both cases, you'll need to look for the term "High Yield" in the Morningstar Category column. These funds can be purchased with a brokerage account.
Frequently Asked Questions (FAQs)
What is the downside of municipal bonds?
One disadvantage of municipal bonds is that, like all other bonds, they are exposed to inflation risk. When inflation is high, interest payments lose purchasing power and that erosion of value can outweigh the interest payments. However, in 2022, a time of high inflation, muni bond yields rose as U.S. Treasury rates rose.
How can I avoid taxes with a municipal bond?
Municipal bond gains are all exempt from federal taxes. If you buy munis from the state and city where you live, you are usually exempt from state and local taxes as well. These are known as "double-exempt" and "triple-exempt" bonds.
