Bond market activity has been fairly volatile, as the market tries to anticipate when – and by how much – the Federal Reserve (Fed) might cut interest rates. Essentially, there is much less certainty about the timing and direction of the Fed’s next move as economic data and inflation have been more buoyant than expected.
We believe this presents an opportunity concerning high yield bonds given that yields are at elevated levels while a strong economy has kept rising default rates at bay.
The continued strength of fundamentals has led high yield bonds to outperform with respect to both US Corporate and Municipal sectors, outearning their investment-grade counterparts by 99 bps each, year to date from a total return perspective.1,2
What is a municipal high yield bond?
A municipal high yield bond is a tax-exempt obligation issued by a governmental entity that is rated below BBB- or not rated by an agency rating. The municipal high yield market offers not only the benefits of tax exemption for a large part of the market but also diversification from the greater global corporate high yield market. Top issuers in the global high yield asset class are typically in consumer cyclical, communications, and energy sectors.
Conversely, top issuers in the municipal high yield market are in the sectors of senior living, education (both higher education and charter school), hospitals, and housing. These sectors more closely align with essential services versus corporate high yield issuers and may in part explain the historically lower default rates in the space.
All in yields look attractive
In the wake of aggressive Fed interest rate hikes to combat inflation in 2023, yields on municipal bonds (munis) have climbed significantly. This includes high yield munis, which, with a higher yield, offer a more attractive income potential. On a taxable equivalent basis, the Bloomberg High Yield Index offers a 8.67% versus 7.73% in the Corporate High Yield Index.1,2 A spread of 93 bps (versus an average of 53 bps over the last three years), which represents a historically attractive opportunity for investors to benefit by locking in income at this point in the cycle (Chart 1).
Chart 1. Municipal high yield index tax-equivalent yield vs. Corporate high yield index tax-equivalent yield
Source: Bloomberg, March 2024.
Good total return story
Historically, following periods of rising yields, municipal bonds have often shown attractive relative total return. This is true even in the high yield sector of the market, as high yield municipals have outperformed high yield corporates in two of the last three cutting cycles. High yield munis currently lead the pack with a return of 1.25% versus negative returns in most other asset classes outside of the muni investment-grade index (Chart 2).
Chart 2. Municipal bond high yield total return index YTD vs. other asset classes
Source: Bloomberg, March 2024.
We believe high yield munis offer a two-pronged approach to total return:
Current income
The higher coupon payments provide a consistent and attractive income stream, which can be especially beneficial for investors seeking regular payouts or building their retirement nest egg.
Capital appreciation
As interest rates stabilize and potentially decline in the future, the price of high yield munis is likely to rise. In addition, as many of these securities have become heavily discounted in this high interest rate environment as the securities amortize up to par, investors are likely to benefit as the security gets closer to maturity. This price appreciation, coupled with the ongoing income stream, contributes to a strong total return potential.
Strong fundamentals, expectation for continued outperformance near term
The outlook for munis remains relatively positive. Several factors contribute to this strength:
Tax revenues
State and local governments have generally experienced healthy tax revenue collections and relatively robust rainy day funds. This bolsters their ability to service their debt obligations and maintain their creditworthiness.
Federal infrastructure push
The Infrastructure Investment and Jobs Act is pumping billions of dollars into state and local projects. This influx of funding should further strengthen municipal finances.
Historically low default rates
Municipal default 10-year cumulative default rates portray a picture of relative stability versus its corporate counterparts. According to Moody's 10-year cumulative default rates in the high yield municipals are 3.97% versus 32.53% in high yield corporates.3 The difference becomes even more stark when comparing investment-grade rates of 0.04% in investment-grade municipalities versus 1.85% in corporates. These solid fundamentals create an environment where high yield munis have the potential to outperform in the near term. While no investment is without risk, the risk/reward ratio for high yield munis may be favorable for investors seeking both income and potential for capital appreciation.
Final thoughts
For investors willing to accept a bit more risk for the chance at higher returns, we believe the current environment offers a compelling case for high yield munis. With attractive yields, a potential total return story, and solid fundamentals, they could be a worthwhile addition to a diversified portfolio.
1 Bloomberg US Corporate High Yield to Bloomberg US Aggregate comparison as of March 11, 2024. The Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. The Bloomberg US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market.
2 Bloomberg Municipal Bond: High Yield to Bloomberg U.S. Municipal Index comparison, as of March 11, 2024. The Bloomberg Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market. HY Muni represents the High Yield Municipal portion of the Bloomberg Municipal Bond Index.
3 Moody's Default Trends and Rating Transitions, March 2024.
Important information
Indexes are unmanaged and have been provided for illustrative purposes only. No fees or expenses are reflected. You cannot invest directly in an index.
High yield securities may face additional risks, including economic growth; inflation; liquidity; supply; and externally generated shocks.
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