Capital Ideas^™ 
Investment insights from Capital Group

High-yield corporate bonds have been on a tear. Total returns in January were 0.6%, building on a gain of nearly 8% in 2017 for the Bloomberg Barclays U.S. High Yield Index. For many investors seeking higher income and total returns, this fixed income asset class has been the place to be.

Following an extended rally, however, high-yield valuations have begun to look stretched. This is true for credit broadly, which would also include both U.S. investment-grade corporates and equities.

As Harry Phinney explained in January, the potential for significant additional yield spread tightening and price appreciation in the high-yield corporate bond market appears to be limited.

And while there have been few signs that a major turn for the worse is imminent, now seems like an appropriate time to consider alternatives to high yield.

High yield has had a good run, but is running out of track

Seasoned high-yield investors may sense that valuations feel rich. In order to target a similar level of income to that offered several years ago, investors have generally had to accept greater credit risk.

Given the current combination of valuations and fundamentals, caution seems appropriate. And for investors with equity-heavy portfolios, there's another potential pitfall: The asset class has tended to be highly correlated with equities.

In other words, if stocks sink, they’re likely to take high yield down with them.

Reasons to consider reallocating from taxables to municipals

Higher income municipal bonds offer comparable yields to their taxable counterparts — in excess of 5%. And when the potential tax advantage is factored in, the income opportunity in municipals becomes even harder to ignore.

In the post-tax reform world, the after-tax income potential of municipals still outshines comparable taxable bonds. To calculate the taxable equivalent yield for investors in the highest income tax bracket, we’ll assume a federal marginal tax rate of 37% (the top 2018 rate). In addition, we’ll factor in the 3.8% Medicare tax.

Assuming a combined 40.8% marginal tax rate on investment income, the after-tax yield on the high-yield muni index was 8.9%, based on the Bloomberg Barclays Muni High Yield Index as of January 30, 2018.

Diversification is the other critical reason to consider reallocating from taxable high yield. Municipals, for example, have often exhibited relatively low correlation to equities.

In a sense, higher income municipals occupy a sweet spot in portfolio construction. The asset class offers yield at a level that should satisfy many income seekers, but without the high correlation to equities that has so often seen taxable high-yield selloff alongside equities.

There are diverse opportunities in high-income municipals

State issuers are often top-of-mind for many investors, but it’s important to remember that most municipal issues are revenue bonds.

Unlike general obligation bonds, revenue bonds are backed by a specific revenue stream that is used to service the debt obligation.

In other words, revenue bonds have no direct connection to the pension and other long-term liability issues confronting some state and local governments.

An emphasis on bond-by-bond fundamental research is critical for uncovering compelling risk-adjusted relative value.

In recent years, for example, our high-income strategy — American Funds High-Income Municipal Fund® — has found some diverse prospects.

There have been opportunistic investments around trouble spots like Puerto Rico and Chicago. And there have been many more enduring themes such as consolidation among not-for-profit hospitals. At year-end 2017, about 56% of the fund's portfolio was invested in bonds rated investment grade.

Conclusion

High-yield bonds — no matter where they are from — involve more risk than higher rated, lower yielding bonds. Headline-grabbing financial woes in Puerto Rico and elsewhere have underscored this fact for investors in municipals.

On the other hand, the interest rate risk of municipals is not as widely appreciated. At recent valuations, it’s reasonable to anticipate that a rise in Treasury yields — perhaps in response to interest rate hikes by the Federal Reserve — could be a headwind for near-term municipal bond returns. Already this year we've seen municipal bond returns take a hit as Treasuries sold off.

The silver lining for investors considering a reallocation in 2018 is that volatility may create attractive entry points.

In addition to rising Treasury yields, developments around the Trump administration’s efforts to reform health care and boost infrastructure spending are possible sources of volatility to keep an eye on.

Whatever happens in the market this year, the bottom line for longer term investors is clear: high-income municipal strategies such as American High-Income Municipal Bond Fund offer a tax-advantaged way to upgrade bond portfolios.