Municipal high yield bonds: Why they’re more relevant than ever for your portfolio

September 13, 2018 Categories: Portfolio Corner, Tax Talk
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Municipal high yield bonds: why they’re more relevant than ever for your portfolio

The road leading to the recent tax policy change had many investors expecting that large reductions in U.S. personal income tax rates would make tax-exempt municipal bonds virtually obsolete.  The reality proved to be far from the case, as income tax rates were only modestly lowered—while at the same time municipal bond supply took a hit, as the disallowance of advanced refunding municipal bonds is expected to decrease overall supply by 10-15% annually.1 Thus, with retail demand expected to hold while supply is decreasing, it behooves investors to continue searching for their optimal tax efficient portfolio, which would include municipal high yield bonds.

What are municipal high yield bonds? A brief look under the hood

Most think of municipal debt as only high quality and, when you consider the entire muni universe, that’s broadly true, with high yield only 3% of the approximate $3.9 trillion muni market.2 This small market size of $100 billion as of March 1, 2018, means that most high yield municipal bond funds blend in 40-60% investment grade tax-exempt debt, as a high yield-only muni fund would be too illiquid and lack appropriate diversification.

Key sectors in high yield municipal debt are tobacco settlement (where states have securitized future settlement payment from tobacco companies), general obligation (supported by broad tax authority of local authorities), and industrial development bonds (supported by revenue generated from specific economic activities like waste disposal or manufacturing).

Looking for income? Municipals may out-yield corporate bonds on a taxable-equivalent basis

One area that continues to draw investors’ attention is the ability of their investments to generate income, especially in this low yield environment. As we’ve noted in the past, municipal high yield bonds may provide an attractive option for investors. The average yield-to-maturity (YTM)  as of August 31, 2018, across Morningstar’s list of covered municipal high yield mutual funds  is 4.8%3—the taxable equivalent of which (assuming the new 40.8% highest tax bracket) is 8.1%.4  This compares quite favorably to U.S. high yield corporate bonds, the market of which has a YTM of 6.5%.5  This difference is even starker when you factor in that all of the corporate bonds in this example are sub-investment grade, while the municipal high yields funds tend to include some amount of investment grade positions.

Credit quality: Municipals have the advantage

We believe defaults in corporate bond space are expected and are a matter of course. Corporate issuers may willingly stretch themselves financially, knowing that they can default, restructure and re-enter the capital market to again issue debt. However, this is not generally the case for tax exempt bonds. Municipal issuers are very reliant on the bond market.  This (plus attendant political issues) makes them very reluctant to miss payments and risk cutting themselves off from lenders. It is for these reasons that defaults rates for municipals—for a given level of credit quality/rating—are much lower versus corporates.

Default rates by investment grade and sub investment grade bonds

Bottom line: Municipal high yield bonds shouldn’t be overlooked in your allocation decision  

Many investors are searching far and wide for attractive returns in the current low rate environment, often stretching for yield and taking risks that may go uncompensated. Tax-managed investors searching for attractive risk-adjusted returns might consider municipal high yield as part of their overall portfolio solution. The power of tax-exemption has resulted in historically competitive risk-adjusted returns for tax-sensitive investors. Coupled with valuations (relative to corporate bonds) that are appealing in the current market cycle, favorable historical default rates, and tax-equivalent yields that would require taking on much more risk to achieve in the corporate high yield market, we believe municipal high yield is worthy of consideration as a strategic allocation in your portfolio.

Disclosures:
1 Source: Goldman Sachs Assets Management

2 Sources: Municipal Securities Rulemaking Board (MSRB); Bloomberg (Bloomberg Barclays Indices).

3 Source: Morningstar Direct data through 8/31/2018 (for the average of the municipal high yield universe Morningstar covers).

Source: Morningstar Direct data through 8/31/2018 (for the tax equivalent yield of the aforementioned Morningstar universe average).

5  Source: Morningstar Direct data through 8/31/2018 (for the average of the U.S. high yield Corporate universe Morningstar covers).

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.

This material is not an offer, solicitation or recommendation to purchase any security.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment. The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

Bond investors should carefully consider risks such as interest rate, credit, default and duration risks. Greater risk, such as increased volatility, limited liquidity, prepayment, non-payment and increased default risk, is inherent in portfolios that invest in high yield (“junk”) bonds or mortgage-backed securities, especially mortgage-backed securities with exposure to sub-prime mortgages. Generally, when interest rates rise, prices of fixed income securities fall.  Investment in non-U.S. and emerging market securities is subject to the risk of currency fluctuations and to economic and political risks associated with such foreign countries.

Morningstar universe for High Yield Muni: A fund that invest at least 50 percent of assets in high-income municipal securities that are not rated or that are rated by a major rating agency at the level of BBB (considered speculative in the municipal industry) or below.

Morningstar universe for Corporate Bond: Corporate Bond portfolios concentrate on bonds issued by corporations. These tend to have more credit risk than government or agency-backed bonds. These portfolios hold more than 65% of their assets in corporate bonds, hold less than 40% of their assets in foreign bonds, less than 35% in high yield bonds, and have an effective duration of more than 75% of the Morningstar Core Bond Index.

The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity.

Russell Investments’ ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments’ management.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the “FTSE RUSSELL” brand.

The Russell logo is a trademark and service mark of Russell Investments.

Copyright © Russell Investments Group, LLC 2018. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty.

Russell Investments Financial Services, LLC, member FINRA (www.finra.org), part of Russell Investments.

RIFIS: 20465

 

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