High Yield Municipal Bonds: Explained

Volatility in the market can be a rush for some investors. It can be hard to take for others.  It’s the real deal!
 
It remains a threat as we continue to march through 2022. Inflation continues to elevate prices on the shelves, and geopolitical events are unpredictable.
 
So let’s take  some time to  discuss high-yield municipal bonds as well as municipal bonds in general.  and let you decide if they’re a good fit for your investment portfolio.

What Are Municipal Bonds?

Municipal bonds are defined as securities issued by local governments. This includes cities, states, and counties. Their purpose within those municipalities is to fund day-to-day operations and capital projects.
 
These securities have a nickname, too: they are known as “muni” bonds for short.
 
The results from muni bonds stand before our very eyes, and you may not even realize it! Take the Golden Gate Bridge, for example. It’s living proof that muni bonds are beneficial to the community.
 
Other municipal bond-backed government projects that you’ll be familiar with are  your local roads and the New York City subway system.
 
Let’s dive deeper into the roots of what makes a muni bond work.

Basic Structure of a Municipal Bond

Interest is the key to growth for investors when it comes to a municipal bond. Not only does growth benefit you as the investor, but it also benefits the local government that issued it.
 
Put the government hat on for a moment as we walk through an example. You’ve been tasked with a public project: to build a school. Where will you get the money to implement the vision?
 
One outlet, of course, is municipal bonds. Consider it a loan from investors to bring your plans to life. In return, the investors earn interest.
 
Typically, the interest earned on a muni bond is not taxable by the federal government, so it will not impact federal income taxes. (Two notable exceptions are capital gains taxes and “private activity” municipal bonds, which are subject to an alternative minimum tax.)
 
Interest is most often paid on a semi-annual basis to investors, and, depending on its location, it may also be exempt from state and local taxes.

The Benefits of Municipal Bonds

Okay, time to cut to the chase and talk about why else municipal bonds are attractive.
 
Municipal bonds offer:

• Typically Low risk. Attractive, right? Focus on the default risk when selecting a muni bond.
• Possible Tax advantages. If you are in a higher tax bracket now or anticipate you will be in the future, municipal bonds offer tax-exempt benefits. They offer fewer benefits to people with lower income levels.
• A Potential Source of Steady income. Most have a fixed interest rate, allowing you to calculate your return on investment. They are also paid regularly up until the date of maturity.

The Cons of Municipal Bonds

With every pro in life comes a con. It’s best to be thorough when evaluating whether or not a municipal bond is right for you.
 
Here are some things to consider:

• Interest rates. At the time of purchase, the interest rate is locked in. It may turn out to be favorable or unfavorable as time progresses.  Interest rates are a principal risk for bond investors
• Credit risk.  The municipality may fall under hard times, with a corresponding drop in their bond’s credit rating’s (like your credit score).  This is not only bad for the locals, but it also makes it harder for existing bondholders to sell their bonds at competitive prices. 
• Yield. Interest rates vary and will fluctuate with inflation. Inflation may erode the purchasing power of those fixed coupon payments.  What are your investment objectives? If you are looking for high returns, stocks, stock mutual funds, and equity -focused exchange-traded funds may be more appealing to your portfolio than muni bonds.  Keep in mind these may be higher risk too.
• Opportunity cost. What tax bracket do you currently fall in? If you are on the lower end, you may not reap all of the intended benefits of muni bonds. Instead, consider investing in other high-yield securities first.
• Your age. How old are you? If you have numerous years before retirement, it may not make the most sense to tie up your hard-earned cash in municipal bonds. If you are on the brink of retirement, though, a shift in your investment allocation to muni bonds and other fixed-income investments like inflation-protected securities is beneficial. This strategy helps to preserve your capital while you earn additional interest.
• Liquidity. This will differ depending on the type of bond; however, it’s possible your money could be tied up when you need it most. Active buyers could be hard to find, which prevents the sale of a bond.

Types of Municipal Bonds

There are two common types of municipal bonds, general obligation bonds, and revenue bonds.
 
Does it matter which type of bond you invest in? The short answer is yes.
 
The type of muni bond selected determines the level of risk that will be associated with it. Some have a higher risk of default than others, which can result in an unexpected loss.

General Obligation Bond

The general obligation bond (GO) makes up about a quarter of the investment-grade muni bond market. It is secured by the pledge from a government entity and is labeled as either a limited or unlimited general obligation bond.
 
Generally speaking, GO bonds are not backed by collateral like the revenues of a project. Instead, they are backed by the credit of the issuer. However, some general obligation bonds are backed by property taxes, other taxes, and general revenues.
 
Be cautious and take the time to read the official statement issued, which describes the general obligation bond, before committing to investing.

Revenue Bond

Revenue bonds make up the remaining 75% of investment-grade municipal bonds on the market. But, even though they comprise a larger bucket, they do not receive as much attention.
 
Revenue bonds are backed by the net or gross revenue of a specified source behind the project — for example, income received from a toll road or a higher education system.
 
Revenue bonds hold additional risks, but they may yield a higher return. Think of it this way: the higher the business risk, the higher the potential interest payment.
 
Here are some examples of revenue bonds that you can choose from the market:

• Education revenue bonds
• Transportation revenue bonds
• Utility bonds
• Hospital and healthcare revenue bonds

What Are High-Yield Municipal Bonds?

Simply put, a high-yield municipal bond is a municipal bond with greater risk and potentially greater returns. They are a favorable choice for investors who do not walk the conservative path, but they are not always recommended.

Highlights of High-Yield Municipal Bonds

The obvious reason to own high-yield municipal bonds versus investment-grade ones is the chance of a higher return. Who doesn’t want to earn larger returns when possible?
 
But is it truly worth the risk?
 
Only the investor can answer that question. However, there are a few key factors to keep in mind when considering a high-yield muni bond:

• Liquidity. Don’t expect to liquidate a high-yield muni bond as you can an investment-grade muni bond. The market is smaller; thus, the demand follows suit.
• Risk appetite. With gain may come loss. How much are you willing to risk by investing in high- yielding bonds? 
• Default risk. This is the rate assessed for the number of municipal bonds that are unable to make interest or principal payments within ten years after issuance, resulting in a defaulted loan. You’ll want to consider the default risk of your individual muni bond. Bonds are scored on a scale, much like grades in school: The best bonds are AAA, while the worst (not really called worst, but “below investment grade” or sometimes “junk”) are graded Ba1/BB+ and lower
• Long-term returns. There’s a difference between the length of return and the total return. Consider this factor carefully before moving in on a high-yield municipal bond. This strategy can work out well for investors, assuming any short-term volatility can be tolerated.

 
High-yield municipal bonds are not trending favorably in the market today. The economy continues to suffer from an excessive demand versus supply, ultimately affecting its performance.
 
In addition, current inflation does not aid the situation. As interest rates rise, the price of municipal bonds falls — along with the demand.

Investing in Municipal Bonds: Where To Begin

Okay, so you’ve made your investment decisions and are ready to get started with adding municipal bonds to your portfolio. What’s next?
 
If you’re not using a portfolio manager, you’ll need to research bonds that meet your investment goals in terms of risk, maturity date, investment return, and tax status. Your research tools will include pricing information that is required to be disclosed by the Municipal Securities Rulemaking Board (MSRB), as well as information from a summary prospectus.
 
Also, keep in mind that some investment management companies offer state-specific funds so you can choose municipal bonds that are local to your area. California, for instance, taxes only interest from non-California bonds, meaning that residents can gain state and local tax exemptions from choosing California bonds.

Adding Muni Bonds to Your Portfolio

High-yield municipal bond funds are one option for adding muni bonds to your investments. However, investing in this kind of mutual fund involves a fair amount of credit risk. Some people, therefore, choose to invest in muni bond exchange-traded fund (ETF), which offers diversification in the fund’s portfolio.
 
High-yield municipal bond funds can also be complicated to choose from. Municipal bond funds each have a net asset value (NAV), also known as the share price. This is the USD dollar value of one share of the fund, and it usually fluctuates daily.
 
High-yield municipal bond funds also include annual fees that are usually calculated as a percentage of your investment. This can involve a high expense ratio — a.k.a. the percentage of your investment that goes toward fund fees — and is therefore not recommended.
 

Are Credit Ratings Important?

The short answer is yes. It’s always a good idea to check a bond rating company like Moody’s,  S&P Global, or Fitch to determine credit quality before you invest in a particular bond.
These ratings come in the form of letter grades, with AAA or triple-A being the highest-quality bonds, BBB or triple B rating being medium-grade quality bonds with medium financial protection, and below triple B or junk bonds being speculative, high-risk securities.
 
However, you don’t want to rely solely on credit ratings when choosing municipal bonds to invest in. Each ranking agency has its own policies, methodology, and standards, and none will give you exactly the same information.
 
Assessing the credit rating on a muni bond is similar to when a lender runs your credit for a loan application. The downfall? The credit ranges on a scale, and, much like your personal credit, it moves over time.
 
Use the credit rating at your discretion. They can be a useful way to gauge past performance, but it’s also okay if you don’t base your decision on them. They do not serve as a guarantee of future results, just a benchmark.

The Bottom Line

Just like the average person may inquire about a loan for personal financing needs or to make a large purchase, government entities do, too. It is one way they can successfully serve the needs of the community.
 
Roads, schools, hospitals, general operations, and more are examples of how local and state government entities use municipal bonds for the greater good. And in return, investors earn a steady income with tax advantages.
 
LifeGoal Investments is here to help you understand the importance of investing. We’re ready to help you build a successful, strategic financial portfolio so that you can focus on today and be prepared for the future.