fixed income  |  january 11, 2021

Understanding the Current Opportunity in High Yield Munis

Strong credit analysis is key in mid- and low-quality municipals.

 

Key Insights

  • High yield municipal bonds have historically provided an attractive return profile with above-market yields.

  • Municipal bonds with high yield credit ratings are a small part of the overall asset class but can be a strong component of a tax-exempt debt portfolio.

  • We believe idiosyncratic opportunities exist in mid-quality parts of the muni market in sectors such as transportation and health care.

Jim Murphy, CFA

Portfolio Manager for Tax-Free High Yield Fund

Dawn Mueller, CFA

Portfolio Specialist

High yield municipal bonds have historically been a strong component of a tax-exempt debt portfolio, providing an attractive return profile with above-market yields1 as well as considerably less default risk than similarly rated corporate bonds. We believe our flexible approach to managing funds based on the foundation of strong credit research should be a sound long-term strategy for investors looking to access the municipal high yield market.

In an increasingly “yield-less” fixed income world, the taxable-equivalent yield2 of a blend of high yield and investment-grade municipals looks attractive. While higher-quality muni yields have retraced to their pre-pandemic levels, we believe that yields on mid- to low-quality munis now provide meaningfully more compensation for credit risk, especially compared with their recent historical levels. Furthermore, we believe idiosyncratic opportunities still exist in mid-quality parts of the market in sectors that we historically have favored, such as transportation and health care.

As a result of the unprecedented stimulus to combat the economic fallout of the pandemic, the U.S. government is running a deficit of more than USD 3 trillion in fiscal 2020. This could pave the way for future tax increases, regardless of the political balance of power. Taking a broader view, the overall attractiveness of municipal debt depends on tax policy, with higher tax rates making munis more attractive with all else equal.

Bulk of High Yield Index in Five Sectors

(Fig. 1) Percentage of index1 market value

This bar chart shows the percentage of index market value when looking at five sectors: Puerto Rico (about 13%), Tobacco (about 12.5%), Life Care (about 12%), Chicago Board of Ed (about 6%), and Airlines (about 5%).

As of November 30, 2020.
1Bloomberg Barclays High Yield Municipal Bond Index.
Source: Bloomberg Index Services Ltd. (see Additional Disclosures).

High Yield Munis: Opportunities in a Small Corner of the Market

Municipal bonds with below investment-grade credit ratings are a small component of the overall asset class, accounting for about 5% of the total market. The broad municipal market is generally higher quality, with roughly two-thirds of issuers rated AA or better. As such, the additional yield offered to investors in mid- to lower-quality bonds should create a return advantage in most market environments.

The high yield municipal market is concentrated in a handful of lower-quality sectors (see Figure 1 above), spread across smaller, sometimes illiquid issuers whose bond prices can fluctuate dramatically during periods of market stress. T. Rowe Price’s municipal high yield strategies manage against a benchmark of 65% investment-grade and 35% high yield municipal debt. This method can help mitigate some of the inherent risks present in the high yield muni market, while also giving our experienced research team the flexibility to try to take advantage of relative value opportunities as they emerge. We believe that this research-driven approach is especially crucial in the current market environment, where yields remain elevated on lower-quality municipal credits.

Two sectors dominate the high yield municipal universe: Puerto Rico-related debt and tobacco bonds. We have been cautious investing in Puerto Rico bonds, as our analysts feel the territory’s long-term credit outlook is tenuous. However, the commonwealth’s ongoing emergence from bankruptcy has presented opportunities for careful investment at attractive risk-adjusted yields.

Tobacco securitization bonds, which are backed by the proceeds from legal settlements between states and tobacco companies, are the second-largest segment of the high yield muni market. While we have selectively invested in tobacco bonds, our funds are structurally underweight this sector as we feel traditional cigarette usage will continue to decline in the face of health concerns and the availability of alternatives like e-cigarettes.

Opportunities in the Life Care Sector

We prefer to maintain overweight positions in segments of the high yield muni market where we believe that the skill of our credit analysts can help uncover attractive relative value. For example, we favor the life care sector, which accounts for roughly 10% of the below investment-grade municipal market.

Specifically, we have found opportunities in bonds issued by nonprofit continuing care retirement communities (CCRCs), which have a higher percentage of independent living units in a less dense layout than traditional nursing homes. While the pandemic has pressured the prices of CCRCs, we rely on the work of our credit analysts who cover the sector to find bonds issued by CCRCs with established operations and strong, capable management teams that we believe can maintain their financial strength during the pandemic and benefit from longer-term positive demographic trends. We also aim to keep position sizes relatively small and diversify our holdings across states and projects.

Attractive Taxable‑Equivalent Yields in Mid- to Lower-Quality Munis

In an increasingly “yield-less” fixed income world, the taxable-equivalent yield of a blend of high yield and investment-grade municipals looks attractive. As of November 30, the taxable-equivalent yield (using a 40.8% total tax rate consisting of the 37.0% highest marginal rate plus the 3.8% net investment income tax) on the blended investment-grade/high yield muni index3 was 3.77%. The tax-equivalent yield for BBB rated munis was 3.99%, compared with 2.09% for corporates with the same rating.

Attractive Tax-Adjusted Yields

(Fig. 2) Mid-quality muni, corporate bond yields over time

This line chart shows the yield to worst (%) per certain time periods (December 2017 to November 2020) in looking at muni BBB (about 3% in November 2020), tax adjusted muni BBB (just under 5% in November 2020), and corp BBB (about 3% in November 2020).

Past performance is not a reliable indicator of future results. Yields are subject to change.
As of September 30, 2020.
1Yield to worst is the lowest possible yield on a bond that does not default, reflecting provisions that allow it to be redeemed before the final maturity date.
2Tax-adjusted yield reflects 40.8% tax rate.
Sources: T. Rowe Price analysis of Bloomberg Barclays index yields. Bloomberg Index Services Ltd. (see Additional Disclosures).

Historically Resilient Performance in Down Markets

Over the past 20 years, both the broad municipal index4 and the blended investment-grade/high yield muni index3 have only experienced two years with negative total returns. The average return of the broad muni market during the two down periods is -2.51%, which is a meaningfully lower decline than in taxable fixed income asset classes.5 The blended municipal index returned an average of -7.62% in the two down years, which is a bit more than taxable corporate bond markets. The more negative returns reflect an illiquidity penalty for high yield municipal debt relative to corporate bond markets, both investment grade and high yield.

While striving to limit losses in a down market is important, it is also vital to keep up in the subsequent recovery. We analyzed the performance of the blended muni index in the six- and 12-month periods following four recent significant downturns in municipal bond markets (the global financial crisis of late 2007 through early 2009, the sell-off in late 2010 to early 2011 triggered by a “60 Minutes” interview forecasting widespread municipal defaults that never transpired, the Fed taper tantrum from early 2013 to early 2014, and the Brexit and U.S. presidential votes in 2016). The blended index modestly lagged the pure muni high yield index, as expected, but outperformed the investment-grade municipal index.

Two Down Years in 20

(Fig. 3) Annual returns for blended muni index1

This bar chart shows the annual returns for blended muni index from 2000 to November 2020 where the average is 5.52%. 2000 started at 10% and ended just under 5% in November 30, 2020.

Past performance is not a reliable indicator of future performance.
As of November 30, 2020.
1Bloomberg Barclays 65% High Grade/35% High Yield Municipal Bond Index. Rebalanced monthly.
Source: Bloomberg Index Services Ltd. (see Additional Disclosures).
Index performance is for illustrative purposes only and is not indicative of an actual investment or portfolio.
It does not reflect fees or expenses associated with an actual investment. Investors cannot invest directly in an index.

Historically Lower Default Rates Than Corporate Bonds

Using the Sharpe ratio6 to compare historical risk-adjusted returns, the blended municipal index compares relatively well with its taxable high yield counterpart over longer time periods. For the 10- and 20-year periods ended November 30, the blended muni index produced Sharpe ratios of 0.99 and 0.79, respectively, versus 0.88 and 0.67 for the Bloomberg Barclays U.S. Corporate High Yield Index.

Importantly, the relatively high historical Sharpe ratios for municipal debt did not come at the expense of higher default rates. Historical municipal default rates are well below those in corporate bonds with similar credit ratings. From 1970 through 2019, the 10-year cumulative default rate for all rated munis was just 0.2%, compared with 10.2% for global corporates. In comparison, high yield municipal debt’s default rate over the same period was 7.3%, considerably lower than noninvestment-grade corporate bonds, which approached 30%.7

Rigorous Credit Research is Essential

The municipal bond market is a fragmented market consisting of debt from mostly small issuers, making rigorous fundamental credit research essential. There are more than 50,000 issuers in the overall muni market, spread across about 1 million securities.8 Experienced credit research is critical to helping navigate this unique market.

What We're Watching Next

Outside of what happens in Washington, the municipal market—especially the high yield market—is very technically driven, so flows into and out of the asset class can exacerbate performance trends. After seeing record-breaking outflows during the spring, flows into municipal bond funds have seen a significant rebound and were net positive for 2020 through November. However, flows into high yield muni bond funds, which represented the majority of the spring outflows, have lagged. As investment-grade muni yields continue to decline, flows back into high yield munis could be a tailwind for future performance.

Call 1-800-225-5132 to request a prospectus or summary prospectus; each includes investment objectives, risks, fees, expenses, and other information you should read and consider carefully before investing.

1Yields are subject to change.
2To calculate a municipal bond’s taxable-equivalent yield, which is the pre-tax yield of a tax-free bond if it were taxable, divide the yield by the quantity of 1.00 minus the federal tax rate expressed as a decimal.
3Bloomberg Barclays 65% High Grade/35% High Yield Municipal Bond Index.
4Bloomberg Barclays Municipal Bond Index.
5Based on annual returns from 1999 through 2019 for Bloomberg Barclays indexes tracking municipals, blended investment-grade/high yield municipals, investment-grade corporates, U.S. high yield bonds, global high yield bonds, U.S. Treasuries, the U.S. investment-grade aggregate, and the global investment-grade aggregate. Past performance is not a reliable indicator of future performance.
6Calculated as an asset’s return above the risk-free rate, divided by the standard deviation of the asset’s excess return. A higher Sharpe ratio indicates a higher return per unit of risk.
7Source: Moody’s Investors Service historical default rate study in July 2020 covering all municipal and global corporate issuers rated by Moody’s. (see Additional Disclosures).
8Source: Municipal Securities Rulemaking Board as of December 31, 2020.

Additional Disclosures

Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

© 2021, Moody’s Corporation, Moody’s Investors Service, Inc., Moody’s Analytics, Inc. and/or their licensors and affiliates (collectively, “Moody’s”). All rights reserved. Moody’s ratings and other information (“Moody’s Information”) are proprietary to Moody’s and/or its licensors and are protected by copyright and other intellectual property laws. Moody’s Information is licensed to Client by Moody’s. MOODY’S INFORMATION MAY NOT BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIOR WRITTEN CONSENT. Moody’s (R) is a registered trademark.

Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of January 2021 and are subject to change without notice; these views may differ from those of other T.  Rowe Price associates. Fixed-income securities are subject to credit risk, liquidity risk, call risk, and interest-rate risk. As interest rates rise, bond prices generally fall. Investments in high-yield bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. Some income from the Funds may be subject to state and local taxes and the federal alternative minimum tax.

This information is not intended to reflect a current or past recommendation concerning investments, investment strategies, or account types, advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Please consider your own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. Yields are subject to change and are not guaranteed. All charts and tables are shown for illustrative purposes only.

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