Editor’s Note
For tax-sensitive investors, high-yield municipal bonds can offer compelling advantages over corporate bonds, including potentially higher after-tax returns and historically stronger credit profiles. This article explores why active management may be key to navigating this specialized market.
For investors in certain tax brackets, high yield municipal bonds, or munis for short, may generate a higher tax-equivalent yield (TEY) than other high yielding sectors, such as high yield corporate bonds.
High yield muni bonds have historically had less credit risk than corporate high yield bonds, proven by lower default and higher recovery rates.
The complex and fragmented nature of the high yield muni market gives actively managed strategies the opportunity to identify and capitalize on inefficiencies.
The iShares High Yield Muni Active ETF (HIMU) seeks to uncover attractive opportunities in the high yield muni bond market, delivering them through the accessible and efficient ETF wrapper.
The high yield muni market is a long-existing, yet often overlooked, segment of fixed income markets. It is typically made up of small issuers, fragmented across industries, is often only mentioned when something goes wrong (e.g., Puerto Rico), and ultimately can be difficult for investors to build portfolios on their own. The reality, though, is investors have often missed out on what has proven to be a market with higher after-tax yields, and lower default rates than high yield corporates.
Notably, investors can now implement a thoughtfully constructed portfolio, managed by an experienced team who is well versed in the nuances of this market, all through the efficiency of the ETF wrapper, using the iShares High Yield Muni Active ETF (HIMU).
The high yield muni bond market is primarily comprised of ‘project bonds’, typically funding new developments – such as retirement communities, charter schools, and land development – with tax-exempt status. Unlike general obligation (GO) muni bonds, most high yield muni bonds are not backed by the taxing power of a municipality. Rather, the source of repayment is often a revenue stream associated with the project, resulting in additional credit risk relative to investment grade issuers. Much like high yield corporate bonds, investors in high yield munis are rewarded for this additional credit risk with potentially higher yields.
However, there are several key differences between the high yield muni market and the high yield corporate market that are worth diving into – such as their higher after-tax yields, longer durations, lower historical default rates, and nuanced credit ratings (or lack thereof) – all of which can offer investors an attractive outcome when approached correctly.
Despite lower default rates and higher recovery rates, high yield muni bonds offer investors in the highest tax bracket an additional 310bps in after-tax return – a significant yield advantage.
High yield corporates have typically had shorter maturities, as they have generally funded riskier companies whose outlook and risks are near-term. High yield munis, on the other hand, have typically been issued to fund longer-term projects and, as a result, have historically had longer maturities – more in line with investment grade corporates. The effective duration of the Bloomberg High Yield Corporate Bond Index is 3.01 years, while the Bloomberg High Yield Municipal Bond Index is 7.3 years.
Because high yield municipals often fund long-term projects, investors are exposed to both credit risk and interest rate risk – meaning they need to understand how changes in both credit spreads and yield curves impact performance.
An underlying characteristic of most high yield muni bonds may contribute to a lower default rate: security covenants. These covenants provide additional protection to high yield muni investors that high yield corporates may not offer. Common covenants include:
Limited tax-revenue pledge: Commitment by the issuer to use specific revenue streams to repay the bond holder.
Incremental tax pledge: Commitment by the issuer to use new tax revenues from a project to make debt payments.
First mortgage lien: A provision that gives bondholders priority on the property’s assets if the issuer defaults.
These additional protections may contribute to the lower average default rates, as was the case from 2020 to 2024: 0.9% for high yield munis, versus 2.4% for high yield corporates.
The difference is even more pronounced when looking at the iShares High Yield Muni Active ETF (HIMU), which had a default rate of just 0.1% from 2020 to 2024.
As discussed above, high yield muni bonds have historically delivered higher tax-equivalent yields and lower default rates than their corporate counterparts. However, reaping the benefits of the high yield muni market could require active management due to its fragmented nature and the sheer volume of small issuances.
