A Fresh Look at High Yield Municipal Bonds

In Brief

While the broad high yield municipal bond market performed well in 2023, spreads closed the year little changed from the end of 2022. The potential for spreads to compress may present an opportunity for investors in 2024.
Meanwhile, yields remain near multi-year highs, suggesting attractive long-term performance potential.
Fundamentals should remain positive in 2024, as default rates are expected to stay very low. Based on financial reserves, various high yield issuers appear well prepared for any prospective softening of U.S. growth.

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High yield municipal bonds staged a strong rebound in 2023, outperforming investment-grade munis by over 300 basis points. Much of this excess return can be attributed to the lower-quality segment’s longer duration and greater carry. Although there was some spread volatility over the last 12 months, high yield municipal credit spreads have not changed on a year-over-year basis, while most taxable credit sector spreads have compressed to the tightest levels since early 2022. (See Figure 1.) We believe this presents a relative value opportunity for investors looking to allocate to credit.

Figure 1. Spreads of High Yield Munis Remain Little Changed, While Comparably Rated Corporate Bond Spreads Have Tightened

Spreads for indicated indexes (in basis points), December 15, 2022–December 15, 2023

Source: Bloomberg Index Services Limited and MMD Refinitive. Data as of December 15, 2023.
BBG Muni HY/AAA Spread represented by the Bloomberg High Yield Municipal Bond Index YTW (yield-to-worst) minus the MMD AAA 20-year YTW. ICE BofA US High Yield Constrained OAS represents the option-adjusted spread on the ICE BofA US High Yield Constrained Index.
For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Past performance is not a reliable indicator or guarantee of future results.

We expect high yield municipal bonds to continue to outperform in 2024, driven by credit spread compression, as mutual fund investors recognize the relative value in this sector. High yield municipal bond yields are still near historically high levels, even after the rally at the end of 2023. On a tax-equivalent basis, the Bloomberg High Yield Municipal Bond Index’s yield is approaching the high single digits, indicating long-term performance potential that is comparable to equities, with much lower volatility. Historically, this has represented an attractive entry point for investors.

In terms of high yield credit, we expect defaults to remain immaterial to the broader context of the market and isolated in particular segments of non-investment grade. We anticipate revenues will remain at healthy levels but continue to moderate from the record-setting levels of the past few years, particularly as economic growth slows. Should the U.S. economy enter a recession, which still seems to be a low probability, many municipal issuers are much better prepared in terms of reserves, given the strong collections since the pandemic, above-trend growth, and significant fiscal aid.

We are constructive on specific parts of the healthcare sector, such as hospitals, where we believe selling has been overdone. We are also optimistic about select corporate-backed bonds in the industrial development sector, particularly those tied to commodities, as well as tobacco bonds, many of which receive payments that are adjusted for inflation. We are finding opportunity in transportation bonds, particularly airlines and airports, which have experienced a strong recovery in volumes. Beyond the strong fundamentals, we believe all of these segments may outperform amid a recovery in mutual fund inflows and lower-than-average supply. Security selection will remain important as issuers adjust to the lower growth, but there will remain many attractive investment opportunities in the high yield municipal bond market.

HYMAX

Class A

High Income Municipal Bond Fund

The Lord Abbett High Income Municipal Bond Fund seeks to deliver income exempt from federal income tax by investing in lower-rated municipal bonds.

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About the Contributors

Daniel S. Solender, CFA

Partner, Director of Tax Free Fixed Income

Nicholas Bragdon

Product Specialist

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Glossary & Index Definitions

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

A basis point is one one-hundredth of a percentage point.

Carry is the difference between the yield on a longer-maturity bond and the cost of borrowing.

Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. A bond spread is often expressed as a difference in percentage points or basis points (which equal one-one hundredth of a percentage point). The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Typically, an analyst uses the Treasury securities yield for the risk-free rate.

Yield is the income returned on an investment, such as the interest received from holding a security. The yield is usually expressed as an annual percentage rate based on the investment's cost, current market value, or face value. Yield-to-maturity (YTM) represents the expected return (expressed as an annualized rate) from the bond’s future cash flows, including coupon payments over the life of the bond and the bond’s principal value received at maturity. Yield-to-worst refers to the lesser of a bond’s (a) yield-to-maturity or (b) the lowest yield-to-call calculated on each scheduled call date.

The tax-equivalent yield is the pretax yield that a taxable bond needs to possess for its yield to be equal to that of the tax-exempt yield on a municipal bond. This calculation can be used to fairly compare the yield of a tax-free bond to that of a taxable bond to see which bond has a higher applicable yield.

The Bloomberg Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market. The index is a broad measure of the municipal bond market with maturities of at least one year. Bonds must have an outstanding par value of at least $7 million and be issued as part of a transaction of at least $75 million.

The Bloomberg High Yield Municipal Bond Index is an unmanaged index consisting of noninvestment-grade, unrated or below Ba1 bonds.

Bloomberg Index Information: Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Indices. Bloomberg does not approve or endorse this material, or guarantee 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.

The ICE BofAML U.S. High Yield Constrained Index is a capitalization-weighted index of all US dollar denominated below investment grade corporate debt publicly issued in the US domestic market.

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The Municipal Market Data (MMD) AAA Curve is a proprietary yield curve that provides the offer-side of “AAA” rated state general obligation bonds, as determined by the MMD analyst team. The “AAA” scale (MMD Scale), is published by Municipal Market Data every day at 3:00 p.m. Eastern standard time, with earlier indications of market movement provided throughout the trading day. The MMD AAA curve represents the MMD analyst team’s opinion of AAA valuation, based on institutional block size ($2 million+) market activity in both the primary and secondary municipal bond market. In the interest of transparency, MMD publishes extensive yield-curve assumptions relating to various structural criteria, which are used in filtering market information for the purpose of benchmark yield-curve creation.

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