Municipal bonds have traditionally appealed to wealthier, risk-averse investors due to their tax-exempt status and historically low default risk. Given the limited size of the municipal bond market and heavy influence of this retail client base, the risk-averse mentality dominates the municipal market return dynamics. With a preference for shorter-to-intermediate duration and higher quality tilt, the lower-rated structures and high yield (HY) sectors typically are left for larger HY mutual funds or savvy individuals seeking higher returns.
In the first half of 2024, investment-grade, risk-averse investors have missed out on solid outperformance from the HY Muni market. To illustrate, the iShares Municipal Bond ETF (MUB), which is primarily investment grade is down -0.25%. Whereas the iShares High Yield Muni ETF (HYD) is up +2.74% YTD, outperforming by almost 300 basis points.
Index Yield-to-Worst Comparison:
As shown in the chart above, the yield on investment grade Munis (S&P Dow Jones Investment Grade Muni Index) has risen by 49 bps., while high yield Munis (S&P Dow Jones High Yield Muni Index) have declined by 21 bps. As a result, the spread has tightened by a total of 70 bps and is now hovering around 2.0%.
The Risk of owning HY Munis:
HY Munis are speculative investments that demand careful consideration within a portfolio’s risk management strategy. For private investors that are interested in improving the yield profile on their bond portfolio but are still hesitant in owning non-rated or HY credits, consider dipping into lower rated structures like ‘A’ or ‘BBB’ rated credits. The 10yr cumulative default rate for BBB-rated Munis has averaged 1.05% (1970-2022). This compares to a 3.64% for BBB-rated corporate bonds. High yield or speculative grade default rates are harder to measure, but Moody’s estimates that 6.8% have defaulted within 10 years of being issued over the past 50 years. Again, this compares favorably to speculative corporate credit which has had a cumulative default rate of closer to 29.0%. Furthermore, defaults in Munis have typically been idiosyncratic, meaning that they originate from credit-specific risks. Obviously, an economic shock or recessionary environment would have negative consequences for any ‘risk-on’ asset, including High Yield Munis. This is why we believe that adding diligent fundamental credit analysis and study of the liquidity profile of high yield bonds is essential.
If you are interested in learning more about the opportunities we are seeing in the Colorado Muni landscape or would like to learn more about how we manage individual bond portfolios, please give us a call.
Sources:
iShares National Muni Bond ETF (Ticker: MUB); iShares, 2024.
VanEck High Yield Muni ETF (Ticker: HYD); VanEck, 2024.
S&P Municipal Bond Investment Grade Index; S&P Dow Jones Indices, 2024.
S&P Municipal Bond High Yield Index; S&P Dow Jones Indices, 2024.
US Public Finance: US Municipal Bond Defaults and Recoveries, 1970-2022; Moody’s Investors Service, 2023.
Disclosures:
This content has been prepared for informational purposes only and should not be considered as investment, tax, or legal advice. Opinions and forward-looking statements expressed are subject to change without notice. We recommend all investors to consult with a financial and/or tax advisor regarding their individual circumstances before taking investment decisions.
Investing in bonds exposes the investor to the risk of loss of principal. Lower and non-rated securities are more volatile and less liquid than investment grade bonds. Liquidity risk relates to the timing of converting a security into cash without affecting the market price.
Please visit our website for a complete list of disclosures and risks: www.maustininvestments.com.
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