Short-duration, high yield municipal bonds may be an attractive option for investors  considering “moving off the sidelines.” We have noted three reasons why:

– First, short-dated, high yield munis have offered attractive yields versus other taxable and tax-free, fixed-income investments, but with much lower interest-rate risk.

– Second, the municipal-bond market continues to exhibit strong fundamentals, as indicated by data on credit-rating changes and default rates.

– Finally, credit spreads on short-maturity, high yield municipals have been consistently wider than those of the broader high yield muni market, suggesting that short, high yield muni valuations remain attractive.

Following last year’s historic bond market sell-off, concerns about the direction of interest rates and inflation continue to reverberate in 2023 after data on consumer and producer prices have shown that inflation remains sticky, potentially keeping the U.S. Federal Reserve (Fed) on its policy-tightening path. In addition, investors are also contending with worries about economic growth following some recent high-profile bank failures and speculation on the potential for new financial-market stress fueled by the Fed’s historic tightening cycle. This series of events may explain the historic levels of cash on the sidelines and the hesitance of investors to take on investment risk in the current market environment.

With ongoing uncertainties regarding interest rates and economic growth, short-duration, high yield municipal bonds may be an attractive option for investors seeking adequate compensation for reentering the market, while minimizing interest-rate risk. Here are a few reasons to consider short-duration, high yield municipals today:

1.  Bond Math: Shorter-maturity bonds can potentially mitigate the negative effects of rising interest rates and tend to have lower volatility than longer-maturity bonds. In today’s market, staying shorter does not necessarily mean sacrificing significant yield. According to Bloomberg index data, short-dated, high yield municipal bonds¹ offered a yield of 5.08% as of March 31—just 60 basis points under the 5.68% average yield on the Bloomberg High Yield Municipal Bond Index, and with a meaningfully shorter duration (2.14 years versus 7.74). Put another way, short-duration, high yield munis offer 90% of the yield of their longer-dated counterparts with only 28% of the duration.

The math is also compelling when comparing the asset class to the broader fixed-income universe. Figure 2 shows that short-duration, high yield munis offered the highest yield per unit of duration of the bond categories surveyed. Remember that the yield shown for short, high yield munis is on a pretax basis; it would become significantly more attractive once you adjust for the investor’s tax bracket.

2. Resilient Credit Fundamentals: Should the U.S. economy fall into a recession, high yield municipals may fare better than their taxable counterparts. Over the long term, municipal bonds historically have experienced a fraction of the default rates of similarly rated corporate bonds. (Note that the data in this study of defaults over the period 1970-2020 represent cumulative default rates over rolling ten-year periods.)

Focusing specifically on recessionary periods, municipal fundamentals have historically outperformed corporates: during the past five economic contractions in the United States, municipal bonds’ credit ratings have been much more stable (see Figure 4), and default rates have been much lower (see Figure 5) relative to corporate bonds.

While the jury is still out on whether the Fed will achieve a “soft landing” for the U.S. economy, municipal credit fundamentals are entering this period in a position of strength. Corporate bonds experienced a modest increase in default rates in the last calendar year, albeit coming off historic lows. But municipal bonds closed out 2022 with defaults down 30% compared to 2021 and at the lowest levels in recent history. Similarly, municipal bond credit-rating upgrades outpaced downgrades by over two times in the same period. As shown in Figure 6, this magnitude of upgrade/downgrade ratios is not uncommon in the municipal market.

3. Attractive Relative Spreads: One might expect that investors in longer-maturity bonds would receive a higher credit spread for the increasing uncertainty associated with a longer investment horizon. It seems intuitive that the fundamental credit picture for an issuer is clearer over shorter time horizons. However, despite this incremental uncertainty associated with longer-dated bonds, credit spreads on short-maturity, high yield municipals have been consistently wider than those of the broader high yield muni market. (See Figure 7.) Put another way, investors are being paid more for credit risk at the short end of the curve. This anomaly is partially explained by the investment preference of the municipal buyer base. 

There are few managers focused on the short-duration, high yield municipal segment: according to Morningstar, only around 9% of the strategies in the High Yield Municipal Bond Category are dedicated short-duration, high yield mandates. Most high yield managers are focused on longer-maturity bonds, as they are seeking to outperform the full-duration, high yield municipal bond index. Meanwhile, most short-duration municipal managers are focused on high-grade mandates. At a high level, with the typical muni investor being more risk-averse, a strong majority of flows are directed into higher-quality mandates. This lack of natural buyers in the short-duration, high yield muni space can lead to inefficiencies, creating value in this somewhat-neglected part of the market and allowing for attractive compensation for those willing to invest where the masses do not.

With record amounts of capital in short-term cash equivalents, some of which may not be needed by investors in the next few years for liquidity purposes, we think it makes sense to rethink asset allocations. If investors choose to redeploy cash sitting on the sidelines, short-duration, high yield municipal bonds may be an attractive option, due to their higher yields per unit of rate risk, resilient fundamentals, attractive compensation for credit risk, and the opportunity for active managers to take advantage of inefficiencies in this often-overlooked segment of the market. With the meaningful move higher in rates over the past year, the starting yields available on short, high yield municipals make a particularly compelling case for the asset class today.