The Risks Of High Yield Municipal Bonds

2010 February 2
by Kyle Bumpus
from → Investing And Investments

It happens every time interest rates stay low for any sustained period of time:  people freak out and look for yield.  No longer satisfied with the returns of FDIC insured bank CD’s, many people who have no business doing so decide to take on more risk by reaching for yield.  Well, let me rephrase that.  Many of them reach for yield not knowing the risks involved.  And that’s a recipe for disaster.  And these are the same people who will lecture greedy bank CEO’s about taking on too much risk…

High Yield Municipal Bonds Are Riskier Than You Think

Many people consider municipal bonds, bonds issued by state and local governments to pay for public works projects, to be one step below U.S. Treasury Bonds in their safety.  And there may be some truth to this belief.  In a 2003 study on municipal bond default rates over the 1980-2002 period, Fitch Ratings found that municipal bonds issued before 1986 had a 1.5% default rate while municipal bonds issued after 1986 was 0.63%.  The decrease was attributed to the Tax Reform Act of 1986, which among other things restricted the issuance of poorly-performing tax-free industrial development bonds.

Still, a 1.5% default rate is significant.  High yield municipal bonds, being generally of lower quality than high-grade municipal bonds, have an even higher default rate, perhaps twice as high.  In fact in some segments the cumulative municipal bond default rate reached 17.02% (non-hospital health care bonds), 14.62% (Industrial revenue bonds), and 5.72% (multi-family housing bonds);  sectors high yield municipal bonds funds are more likely than average to own.

Some people cite the solid performance of Vanguard’s High Yield Tax Exempt bond fund (VWAHX) as evidence of the safety high yield municipal bonds can offer.  What they don’t seem to be aware of, though, is that the Vanguard fund keeps between 70-75% of its assets in high-grade municipal bonds, only dipping its toe in the higher-yielding but riskier lower credit tiers.  Though it has High Yield in the name, this fund is not really a high yield municipal bond fund.  It’s more of a low-investment-grade fund.

California’s Debt Downgraded, Outlook Negative

Barely 3 weeks ago, Standard & Poors downgraded California’s credit rating to A-, just barely a step above the lowest investment-grade rung, in light of a $20 billion budget deficit.  The company also said it had a negative outlook on California debt, meaning there’s a distinct possibility of further downgrades.  So yes, municipal bonds are backed by the taxing power of the issuing government and the best municipal bonds are probably more resilient than most corporate bonds.  Still, you can only raise taxes so much without choking off economic debt.

So while municipal bond default rates do tend to be lower than their corporate counterparts, defaults are also not unheard of.  If safety is your main criteria, you would do well to stick with an FDIC insured savings account like ING Direct or high yield CD.  Investors who reach for yield without considering the risk are often burned.  Don’t be one of those investors.

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3 Responses
  1. 2012 June 19
    J Mags permalink

    I very much disagree with this article. Given the fact that we are in one of the lowest interest rate environments in history, one should be looking at what is going to happen when rates eventually start to increase. In that light, one needs to examine the HY Muni market. Not simply for the yield, but to prepare for rising rates (while getting paid while you wait). HY Muni’s have actually been close to negatively correlated to treasuries over the last several years. The spreads between HY and High grade are way wider than historic norms. When rates eventually move higher, confidence will come back to these muni’s. The balance sheets of the municipalities will be getting stronger as well. Similar to how HY Corporates are traditionally one of the strongest fixed income asset classes in a rising interest rate environment, Muni’s will behave even better. HY Munis are still trading at large discounts where HY Corps are pretty much fully priced right now. Default rates are very low right now especially true for funds with exceptional research like Nuveen. A position like NHMAX will be your best fixed income position over the next 5 years+, especially if you start counting taxes into the equation.

  2. 2012 June 19
    J Mags permalink

    This article I see was written 2 years ago. See what the HY Muni space has done since then. This article has already been proven worn. AND RATES HAVE YET TO TURN, so the outperformance has yet to even begun to shine. It is not too late to get into the HY Muni space.

  3. 2012 June 19

    What do you mean you disagree with this article? It mostly consists of a list of undisputed facts. Do you disagree with the figures presented? I fail to see how the article has been proven wrong.

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