Five Things to Know About High-Yield Municipal Bonds Now

Will the tailwinds that drove strong municipal bond performance in 2019 continue through 2020? Last year, we saw the U.S. Federal Reserve (Fed) shift to a more dovish stance. Muni-specific factors also supported the market, including strong technicals, improving credit fundamentals and demand for tax exemption. As investors consider ways to gain exposure to the muni bond market, we believe the high yield space offers an attractive opportunity in the current environment. Here are five things we believe investors should know about high-yield munis in 2020.

1. High-yield municipal bonds have historically outperformed investment grade munis. 

Credit spreads for high-yield munis have been stable, and higher coupons and longer duration have boosted performance. The Bloomberg Barclays Municipal High-Yield Index returned 12.65% in 2019.¹ Rich valuations will make it difficult to repeat a year of double-digit gains in 2020, but spread narrowing may support positive returns. The benchmark is up 2.98% so far this year as of February 19, 2020.

2. Defaults remain low.

The total par value of first-time non-payments of interest or principal due was $3.6 billion in 2019.²This is just 0.09% of the $3.82 trillion market. Recent defaults have been generally from smaller healthcare sub-sectors such as nursing homes and continuing care retirement communities (CCRCs). These alone represented nearly three quarters of last year’s total.

3. Demand for munis continues, regardless of U.S. presidential election.

While it is too early to forecast the results of the election, a change in the White House may lead to changes in federal tax policy and impact the municipal market. The leading Democratic candidates support higher and/or new income taxes on high-income earners. Higher taxes historically support demand for tax-exempts, and even the possibility of higher taxes could contribute to positive fund flows. If Trump wins reelection, federal tax policies are likely to remain unchanged. No matter the outcome, we expect continued demand for municipal bonds.

4. The Fed is likely to hold interest rates steady.

In 2019, the Fed reversed its tightening stance and cut rates three times. Absent a significant economic shift, the Fed appears set to leave rates unchanged for the time being. As investors search for yield, we believe high-yield munis offer an opportunity to add extra income to their portfolios.

5. Supply and demand imbalance appears likely to remain.

The total issuance of municipal bonds expanded by 21.9% in 2019.³ However, this was not nearly enough to meet the reinvestment demand generated by calls, coupon payments and maturing bonds, let alone the demand from mutual fund and ETF fund inflows, which totaled $93.6 billion last year.⁴ We expect a similar dynamic to play out in 2020. According to the SIFMA Municipal Issuance Survey, we may see a slight uptick in issuance this year, but demand has remained exceptionally strong, with funds reporting $9.7 billion of inflows as of January 22.

Constructive View for High-Yield Municipal Bonds

We remain constructive on high-yield municipal bonds in 2020 given the factors outlined above. Additionally, this asset class has a long history of low volatility, non-correlations, low default experience, attractive income and positive performance. While past performance is not reflective of future returns, we believe it is interesting to point out that over the past 20 years the Bloomberg Barclays High-Yield Municipal Bond Index has only been in the red in three years—all of which were headline driven rather than based on fundamentals.

Source: Bloomberg. Data as of12/31/2019. Past performance is no guarantee of future results. Indexes are unmanaged and are not securities in which an investment can be made. See index descriptions at the end of this presentation.

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