Investors face as challenging a dilemma as ever for building a portfolio. Cash-like alternatives have become very enticing amid rising rates, while bonds got battered. After a disappointing 2022, equities have been rebounding. To make matters more complicated, the path of the economy is as mysterious as ever: opinions range from impending recession to years of growth ahead. Amid all these questions, high-income munis may be a possible answer. Yet, some investors may not be very familiar with this asset class.

Don’t confuse high-income munis with high-yield corporate bonds

First, let’s cover terminology. There’s an important distinction between high-yield corporate bonds (corporates) and high-income municipal bonds (munis). “I think people hear the term ‘high yield’ and they immediately think ‘high risk.’ They might also imagine high-yield corporates, sometimes referred to as ‘junk bonds.’ However, high-income munis are a very different group of bonds, typically with lower credit/default risk profiles than their high-income corporate counterparts available in the taxable fixed income market,” says Chad Rach, fixed income portfolio manager for American High-Income Municipal Bond Fund.

“High yield” typically describes below-investment-grade (BB/Ba and below) bonds. The yields on lower rated bonds are generally higher than those offered on investment-grade (BBB/Baa and above) bonds. This is to help compensate investors for the riskier nature of the bonds, e.g., the greater possibility of default. "High income" can refer to investments that are higher yielding, lower quality munis, but can also include investments higher on the credit spectrum that offer attractive yields despite not carrying ‘junk-like’ credit risk. High income can also include unrated bonds. While large credit rating agencies, such as Moody’s Investors Service or Standard & Poor’s, assign ratings to many bonds, not every bond has a rating. But so-called “unrated bonds” should not automatically be assumed to have a low credit quality profile. These issuers simply do not request a rating by an agency.

In fact, muni bonds are often unrated. An issuer may be small and not want to endure the cost required to obtain a rating on its debt. At times, such an issuer may instead offer a premium in the form of an attractive yield on its bonds to entice investors to do their own research on its creditworthiness. Some of the largest high-income muni bond issuers, including those offering bonds secured by payments from tobacco producers, do not have ratings.

The possibility of default is on every bond investor’s mind. This is one of the strongest differentiators between high-yield corporates and high-income munis. Muni defaults do occur; a well-known example was Puerto Rico’s heavily publicized default in 2016. Yet they are relatively rare compared to high-yield corporates. Non-investment-grade global corporates were eight times as likely to default as non-investment-grade munis, on average over the past 10 years, according to a Moody’s Investors Service 2023 report. “We know defaults happen, but in general, they are an outlier, not an everyday occurrence in the muni market,” notes Rach.

Munis, in general, are attractive because the income is exempt from U.S. federal income taxes — and, depending on where the investor lives, state and local taxes. “Looking only at the yield of a muni bond isn’t presenting the full picture,” says Rach. “You need to consider the net or 'take-home' income due to the tax-exempt status compared to the after-tax income investors receive from a similar taxable bond. When you combine the tax-exempt nature of munis with the relatively low rate of defaults, it’s a compelling story for investors.”

High-income munis’ two secret ingredients: Research and diversification

Unlike the somewhat abundant market in the taxable debt world, higher income muni opportunities are harder for individuals to access. Many deals would even be tough to find on their own. However, approximately 50,000 U.S. municipalities issue debt. Over one million individual CUSIPs (a unique identification number for a security) exist. The muni debt market is approximately four trillion dollars. The American High-Income Municipal Bond Fund held 2,955 bonds as of September 30, 2023.

Our specialized analyst team’s deep research seeks to provide value to investors who can instead spend their time on other endeavors such as portfolio construction. Unrated bonds require significant research efforts, especially in the high-income space. Furthermore, some muni deals are very small, adding another layer of complexity. We have a large, dedicated team of experienced muni analysts who span all sectors and maintain close ongoing contact with governments and companies through on-site research visits. The average investor may not have access to those deals and could miss out on those opportunities.

For a case study into the kind of research we undertake, let’s dive into…dirt. Dirt deals, also referred to as “dirt bonds,” may sound like an unlikely treasure, but our muni analysts have found some compelling opportunities. “Dirt bonds represent raw land ripe for development,” says Ivan Mirabelli, muni analyst. “While the start of a dirt deal may seem risky, down the line it could be developed into, for example, a single-family home development. Suddenly, this dirt is transformed into something very appealing, with bonds paid for by property taxes from the homeowners, who are unlikely to stop paying,” notes Mirabelli. “Alternatively, the land can be developed for a school or multi-tenant office building. All these structures can support muni debt. The bond proceeds are used to develop the neighborhood’s infrastructure, such as sewer setup and service, roads, water or anything that can help develop the area.”

“We’re not going to purchase dirt bonds only in one area. We study areas and sub-markets to understand the implications and micro-trends in real estate. This includes studying area-specific economic data, such as potential job growth and competing projects. We also hop on a plane, then jump in a car to perform site visits to see what’s going on: what’s the activity? How many rooftops are appearing? Is construction actually taking place? One way to know is to see if porta potties are present and being used. All these factors help determine if we should make an investment,” says Mirabelli.

Vintage — the year a bond was created — is also a consideration. Owning varying vintages, such as purchasing bonds from not only 2016, but also from 2014, 2015, 2017 or 2018, helps to diversify a portfolio. Some of the older vintages benefit from areas that are built up. “While we have selectively purchased more recent vintage deals, our primary focus recently has been in secondary market purchases of older vintage projects that are farther along in development and have less risk while still potentially offering significant total return,” notes Mirabelli.

Putting it all together: Positioning for high-income munis

For a fund manager, doing the research needed for high-income investing takes a lot of effort, but for investors looking to outsource that work, getting exposure to the sector can be easy. Capital Group offers a distinctive take on high-income munis through American High-Income Municipal Bond Fund. Notably, the portfolio seeks to provide a broadly diversified source of high tax-exempt income, emphasizing higher yielding investment-grade and non-investment-grade municipal bonds. As of November 30, 2023, the fund contained approximately 36% investment-grade bonds, 38% unrated bonds (for which our analysts create internal ratings), 18% below-investment-grade bonds and 8% cash and equivalents.

Managers also have the flexibility to move in and out of bond positions, including shifting within the credit quality spectrum as our fundamental research and perceptions about relative valuations evolve. “Recently, we’ve been investing in a variety of opportunities in the multi-family housing space, from mid-quality up to AA investments. We’re obtaining yields that are very comparable to those assigned to much weaker credit risks. In particular, we’re reducing exposure to tobacco, which we believe is quite risky, and moving up in quality without giving up a lot of yield,” says Rach.

The portfolio is also constructed mindfully with duration, which is commonly described as the bond’s sensitivity to interest rates. Managers actively adjust duration exposure to manage risk and seek excess returns, which has been a particularly important driver of investor total returns as overall interest rates have moved significantly in various directions since the COVID pandemic.

American High-Income Municipal Bond Fund could be used as a part of a broader fixed income allocation for tax-aware investors. As it contains more risk than a traditional muni fund, it could be paired with our broad, diversified option, The Tax-Exempt Bond Fund of America®. In this example, relative to a taxable corporate blend, the muni combination would have provided more duration exposure, a lower historical correlation to equities and the potential to provide more yield, even if an investor is not in the highest tax bracket.

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Unlike higher risk corporate bonds, munis – including even some portfolios that contain non-investment-grade munis – can provide diversification from equities. “This is particularly meaningful to investors when the equity market is unpredictable, as it has been over the last couple of years,” says Rach. Diversification is often shown by how a bond fund of index returns correlate to equity market returns. The American High-Income Municipal Bond Fund had a 5-year correlation to the S&P 500® (a broad measure of the U.S. stock market) of 0.51 as of November 30, 2023. This provides some diversification from equities, in a comparable range as the broader taxable bond benchmark’s 5-year correlation of 0.44 (the Bloomberg U.S. Aggregate Index) as of November 30, 2023.

In today’s market, investors are finding income opportunity more easily than over the past few decades. But higher yielding options typically come with greater risk. Investors seeking elevated income levels, especially those in higher tax brackets, can consider moving to high-income munis, which may also provide some measure of diversification amid equity turmoil. “High-income munis can hold potential for investors,” says Rach. “Tax-exempt income and diversification through low relative correlation to equities could make the sector an intriguing one for investors to add to their portfolio in pursuing their broader goals.”