High-Yield Municipal Bonds: A Tax-Efficient Investment Opportunity
Municipal bonds have long been a favorite investment for income-seeking investors due to their tax-exempt status. These bonds are issued by states, cities, and other local governments to finance various projects, such as building schools, roads, and bridges. High-yield municipal bonds, also known as “junk bonds,” offer higher yields than their investment-grade counterparts, making them an attractive option for income-focused investors.
Investment-Grade vs. High-Yield Municipal Bonds
Traditionally, investment-grade municipal bonds have been considered a safe and stable investment. However, the economic downturn caused by the COVID-19 pandemic has led to an increase in credit risk for some municipalities, causing their bond ratings to weaken. High-yield municipal bonds, which were once considered risky, have become more attractive due to their higher yields.
Benefits of High-Yield Municipal Bonds
One of the primary benefits of high-yield municipal bonds is their dividend yields, which are typically in the range of 4.0% to 5.0%. These yields provide higher after-tax income for investors in high-tax-rate states or for those with taxable accounts. For example, an investor in California, where state income taxes can reach as high as 13.3%, would see a significant increase in after-tax income from a high-yield municipal bond compared to a taxable corporate bond with a similar yield.
Four High-Yielding Muni ETFs
Here is a quick look at four high-yield municipal ETFs that investors might consider:
- iShares National Muni Bond ETF (MUB): This ETF tracks the investment results of the iShares National AMT-Free Municipal Bond Index, which is composed of tax-exempt, investment-grade municipal bonds with an effective duration between five and ten years.
- PIMCO Municipal Income Fund II ETF (MUNH): This actively managed ETF invests in a diversified portfolio of municipal bonds with varying maturities and credit quality. The fund seeks to provide current income exempt from federal income tax, and it has a yield of approximately 4.3%.
- SPDR Nuveen S&P High Yield Municipal Bond ETF (HYD): This ETF tracks the performance of the S&P High Yield Municipal Bond Index, which is composed of high-yield, tax-exempt municipal bonds. The fund has a yield of approximately 4.9% and seeks to provide a high level of current income exempt from federal income tax.
- BlackRock iShares Short-Term High Yield Muni Bond ETF (SHYM): This ETF tracks the performance of the iShares Short-Term High Yield Municipal Bond Index, which is composed of short-term, high-yield municipal bonds. The fund has a yield of approximately 3.2% and is designed to provide current income exempt from federal income tax with a lower duration than traditional high-yield municipal bond ETFs.
Impact on Individual Investors
For individual investors, high-yield municipal bonds and ETFs can provide an attractive source of tax-exempt income. However, it is important to remember that these investments come with additional risk compared to investment-grade municipal bonds. As such, investors should carefully consider their investment goals, risk tolerance, and tax situation before investing in high-yield municipal bonds or ETFs.
Impact on the World
The shift towards high-yield municipal bonds and ETFs could have a significant impact on the municipal bond market as a whole. As more investors seek out these higher-yielding investments, demand for investment-grade municipal bonds may decrease, causing their yields to fall further. This could make it more difficult for states and cities to finance their projects through the bond market, potentially leading to higher borrowing costs or fewer projects being financed.
Conclusion
High-yield municipal bonds and ETFs offer an attractive source of tax-exempt income for income-seeking investors. However, these investments come with additional risk compared to investment-grade municipal bonds. As such, investors should carefully consider their investment goals, risk tolerance, and tax situation before investing in high-yield municipal bonds or ETFs. Additionally, the shift towards high-yield municipal bonds could have significant implications for the municipal bond market as a whole, potentially leading to higher borrowing costs for states and cities.
