Don't Get Caught Searching for the Perfect Wave

By Joe Gotelli - May 9, 2019

All surfers dream of the perfect wave but the best ones in the world are keenly aware of the currents, swells, and risks of a wave peaking early. They choose the best option and paddle toward shore. Many investors are aware of opportunities and risks associated with the current fixed income market but might be hesitant to make choices to improve overall portfolio performance.

Investors in the tax-exempt municipal bond market are typically familiar with the benefits of the asset class: those include including tax-free income, generally low default rates, and low correlation to other asset classes. Many investors consider municipal bonds to be a relatively conservative investment, given the high credit quality of most state and local issuers.

However, investors willing to move beyond the highest quality areas of the asset class may find new opportunities with an allocation to high-yield municipal bonds. To be fair, high-yield municipal bonds do pose more risks such as greater default potential. Investors considering them should have a higher risk tolerance.

Considering High-Yield Municipal Bonds

Similar to high-yield corporate bonds, high-yield municipal bonds are securities that are rated below investment-grade. Whereas investment-grade (high-quality) securities have credit ratings between AAA and BBB (as designated by S&P, Moody's, or Fitch), below-investment-grade (high-yield) securities have credit ratings lower than BBB, or no rating at all. Given the increased level of credit risk, high-yield municipal securities generally compensate investors with higher coupons and yields than investment-grade securities.

Finding the Right Wave—Types of High-Yield Munis

Unlike higher-quality general obligation or essential service bonds,¹ the high-yield municipal market tends to be more economically sensitive and/or project-specific. Based on market weights, the high-yield municipal market is dominated by tobacco settlement revenue bonds—secured by payments from tobacco companies to states—and various Puerto Rico credits.

However, away from these market heavyweights, there are many different projects and issuers to pick from in this very diverse part of the municipal market. Credits in industries such as hospitals, continuing care retirement communities (CCRCs), development districts, and private activity (subject to the alternative minimum tax, or AMT) all can add incremental yield and help diversify a portfolio.

Understanding the Risks

Investing in the high-yield municipal market requires an institutional level of research and surveillance to keep an eye on risks and take advantage of inefficiencies.

Although high-yield municipal securities may show a higher degree of volatility at times, they may also help lessen other risks. When included in a diversified portfolio, the additional yield compensation of high-yield municipals may help mitigate some of the interest rate sensitivity of the investment-grade allocation. Income is an important contributor to the total returns of long-term investors' portfolio. Therefore, we believe complementing an investment-grade portfolio with a high-yield allocation may help improve returns over longer timeframes.

¹ Essential service revenue bonds are typically issued to fund projects for that provide critical services to maintain public health and safety. Examples are for water and electricity. These bonds are typically issued by utilities or transportation agencies. The main sources of revenue for these bonds are connection fees and user consumption costs.