A hidden gem: high yield municipals

Key takeaways

1. 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.
2. High yield muni bonds have historically had less credit risk than corporate high yield bonds, proven by lower default and higher recovery rates.
3. The complex and fragmented nature of the high yield muni market gives actively managed strategies the opportunity to identify and capitalize on inefficiencies.
4. 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 yields¹, and lower default rates than high yield corporates.² 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).

What are high yield munis

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.

High yield munis have equal or better TEY than high yield corporates

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.

HIMU outyields corporates across tax brackets

Performance data represents past performance and does not guarantee future results. Investment return and principal value will fluctuate with market conditions and may be lower or higher when you sell your shares. Current performance may differ from the performance shown. For most recent month-end performance see www.iShares.com. For standardized performance, click here.

A longer-term investment

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.³ 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.

High yield munis have historically had lower credit risk than high yield corporates

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:

1. Limited tax-revenue pledge: Commitment by the issuer to use specific revenue streams to repay the bond holder.
2. Incremental tax pledge: Commitment by the issuer to use new tax revenues from a project to make debt payments.
3. 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.⁴ 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 2024.⁵

Average default rates, HY corps vs HY munis 2020-2024

Fragmented market: a need for active management

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.

To put it in perspective: there are approximately 5,500 high yield muni issuers versus about 2,000 high yield corporate issuers.⁶ And despite having twice as many issuers, the high yield muni market is roughly a tenth of the size of the high yield corporate market: $150B versus $1.3T.⁷

Additionally, unlike the high yield corporate market, where bonds typically have a rating of BB, B, or CCC, most high yield munis do not seek a credit rating, requiring a manager to perform their own research to determine if its yield is warranted given its risks. In fact, 70% of the bonds in the high yield muni index are unrated, versus virtually none in the high yield corporate index.⁸

There are several specific reasons why high yield munis may not be rated by an agency:

1. Too expensive: Small issuers may forgo a rating because it is too expensive or because the expected benefits don’t justify the expense.
2. Limited public information: Some high yield issuers don’t have enough public information available to allow them to be rated.
3. Private placements / limited offerings: Certain high yield muni bonds will be sold directly to a small group of institutional investors, bypassing the credit rating process of an agency.

Unrated bonds require additional resources to determine relative value, but the rewards for investors can be well worth the effort. Also considering the variety of types of issues – from retirement communities to hospitals to charter schools – delivering a portfolio of high yield muni bonds is particularly suited to managers with deep credit research capabilities and experienced portfolio managers. The iShares High Yield Muni Active ETF (HIMU) can offer both advantages.

Armed with Aladdin risk management technology and sophisticated credit research tools, HIMU’s team of credit research analysts can identify attractive relative value opportunities amidst the thousands of small-issue high yield bonds – delivering them to clients through the accessible and efficient ETF wrapper.

Portfolio implementation

Whether a financial advisor should recommend a high yield muni bond portfolio can depend upon the client’s individual tax profile and their state of residence. But for clients already holding both investment grade muni bonds or any high-yielding taxable fixed income bonds, it’s worth assessing if a high yield muni bond portfolio could deliver equal or better tax-equivalent income with less credit risk.

To learn more about the iShares High Yield Muni Active ETF (HIMU), click here ->

HIMU Product Page

Explore more ways to access the high yield municipal market

For investors seeking to manage duration while maintaining high yield exposure, explore the iShares Short Duration High Yield Muni Active ETF (SHYM) ->

SHYM Product Page

For investors interested in an interval fund structure, explore the BlackRock Municipal Credit Alpha Portfolio (MUNEX). MUNEX is an unlisted, continuously-offered closed-end fund that conducts periodic repurchases of its shares pursuant to Rule 23c-3 under the Investment Company Active of 1940->

MUNEX Product Page