Yield-hungry investors are plowing record amounts of cash into high-yield munis.

Enthusiasm for these bonds reflects historically low yields on investment-grade munis and, as we pointed out recently, muni ratios to U.S. Treasuries dipped to their lowest levels in almost 20 years (“Muni Market Comes Full Circle”).

Following a strong end to 2020, which returned 6% for the year, high-yield bonds have produced more than 1.75% so far this year, compared with .25% for AA-rated bonds.

As a result of these disparities, high-yield muni funds have seen a dramatic surge of interest, including record inflows in late 2020 and earlier this year. Many analysts see positive conditions ahead.

“The low default rate and high performance of municipal high-yield paper in 2020 translates into potential value and opportunity ahead in 2021,” an asset manager told The Bond Buyer recently.

Can high-yield bonds be healthy for your portfolio

Risky but popular

When investing in municipal bonds, FMSbonds has always recommended individual investors look for quality first, then yield. It’s a simple strategy used by generations of investors: Earn a steady, reliable stream of tax-free income and sleep soundly at night.

High-yield bonds, on the other hand, are by definition lower-quality bonds.

They’re rated below investment grade or unrated by the major rating agencies and they become distressed more frequently than investment-grade munis. For example, Moody’s Investors Service studied the average cumulative default rates of bonds from 1970-2018. Within a decade of issuance, a scant 0.10% of investment-grade bonds failed vs. 7.47% of speculative-grade munis.

Despite these increased risks, many investors are jumping in. Consider, for example, $560 million in below-investment grade bonds issued by the Chicago Public Schools. Its 10-year bonds were priced at 1.94%, and its 20-year bonds were offered at 2.24%, barely a point above AAA muni bond benchmark yields, The Wall Street Journal noted.

The issue sold out.

Various risks with high-yield bonds

For investors looking to minimize risk and prefer their white-knuckle thrills at an amusement park, not on their monthly statements, high-yield bonds probably don’t make sense.

But for those willing and able to assume more risk, high-yield bonds can be quite rewarding.

First, though, hold on to the railings: Prices of high-yield bonds can fluctuate dramatically. Interest rates don’t drive their price as much as the financial strength of their underlying issuers. Changes in the economy can greatly affect the value of investors’ holdings.

Of course, it’s imperative that investors fully understand the fitness of the issuers and the particulars of the bonds. In addition, certain sectors of the high-yield market can have significantly better prospects than others. Timing can be important, too.

High-yield bonds can boost investors’ returns and help diversify their tax-free bond portfolio. But increased risk, and some restless nights, are possible.

Before investing in high-yield bonds, be certain they suit your investment objectives. Your FMSbonds bond specialist will assist you in explaining how these bonds are secured.

James A. Klotz is the President of FMSbonds, Inc. Email the Author02/18/2021