Corporate junk bonds may be out of vogue these days, but their tax-exempt counterparts have become a popular alternative. High-yield municipal bonds returned 2.9% in September, according to Bank of America Merrill Lynch, returning more than four times the broader muni market and posting their best month since August of 2014. By comparison, high-yield corporate bonds have lost around 2.7% last month as investors fled the market.
Investors have been buying up exposure to these high-yield muni bonds through mutual funds, with some $178 million in inflows during the latter weeks of September alone, according to Lipper US Fund Flows data. While Puerto Rico and Chicago may be struggling, the diversification provided by mutual funds has made the asset class quite popular among investors as a relative safe-haven amid uncertainty surrounding the global economy.
In this article, we’ll take a look at some high-yield muni funds to consider, as well as some key risks that investors should keep in mind before taking the leap.
Funds to Consider
There are a number of different high-yield muni bond funds that investors may want to consider when building exposure to the asset class.
The Nuveen High Yield Municipal Bond Fund (NHMAX) has grown to about $10.6 billion of assets under management, compared to just $6 billion before the financial crisis, as investors have fled to safety without sacrificing yields. As the sixth-largest muni bond fund in the U.S., according to Morningstar, it’s widely considered to be the most established play on high-yield muni bonds in the market, with a four-star rating from Morningstar.
The highest rated high-yield muni bond funds from U.S. News include the American High-Income Municipal Bond Fund (AMHIX) and the MFS Municipal High Income Fund (MMHYX), which offer two additional options for investors seeking exposure to the space. With assets of just over $3 billion, they are a bit smaller than the Nuveen fund, and they are rated three stars and four stars, respectively, on Morningstar.
Risks to Remember
High-yield municipal bonds can be risky business, as was seen during Puerto Rico’s debt crisis and during the financial crisis when some cities defaulted.
The strength in high-yield muni bonds right now may be due to Puerto Rico’s rebound since June, after Garcia Padilla’s administration revealed plans to ask investors to voluntarily exchange securities for new ones with lower interest rates or longer maturities. According to some experts, the territory may account for as much as 20% of high-yield indexes, and investors should remember that the pendulum swings both ways.
Investors should also remember the sector’s historical risks. In 2008, when the muni bond market fell just 2.5%, the high-yield muni bond subsector dropped 40%. As a result, investors may want to consider incorporating high-yield muni bond funds into a diversified income portfolio rather than relying on them exclusively to increase returns during a low interest–rate environment, especially given the economic uncertainty.
The Bottom Line
The fall of corporate junk bonds has led many income investors to consider high-yield muni bonds as a safer alternative given the economic uncertainty. While these funds offer attractive yields and have performed relatively well, investors should keep in mind that a lot of this performance may have been due to Puerto Rico’s recovery, while keeping in mind that the sector has seen some significant volatility in the past during economic uncertainty.
In general, income investors are best off incorporating high -yield muni bond funds – which provide a level of diversification – into their portfolios as only a piece of their income component in order to ensure proper diversification.
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