High-yield municipal bonds have been on a tear. For many investors seeking higher income and total returns, this area of the bond market has been the place to be in fixed income. As of July 31, the Bloomberg Barclays High Yield Municipal Bond Index had notched a year-to-date return of 7.4% — well above the gains recorded in most other parts of the U.S. bond market.

Following an extended rally, however, spreads have narrowed to pre-pandemic levels. Municipal fundamentals have experienced a remarkable turnaround due to the more than $1 trillion of pandemic-era fiscal stimulus. The recent increase in rating upgrades should continue as local economies recover. At the same time, investor demand has remained robust. Year-to-date muni fund inflows through July 31 totaled $57 billion — nearly 50% higher than the net inflows for all of 2020.

Amid stretched valuations, now seems like a good time for investors to reassess high-yield municipal bonds. With that in mind, here’s our take on this underresearched and underinvested asset class.

Income remains relatively attractive

From an income perspective, high-yield municipal bonds offer attractive carry (put simply, yield earned by holding the bond to maturity, minus the cost of short-term financing) relative to other segments of the fixed income market. And, on a taxable-equivalent basis, relative value remains compelling.

Investors should be prepared for more muted returns

High-yield muni spreads are more than one standard deviation tighter than their 10-year average. Because fundamentals are now on a firmer footing than they were pre-pandemic, there appears to be limited potential for further spread tightening.

When spreads have been this narrow in the past, the ensuing returns generated from tightening have tended to be muted compared to returns in periods when valuations were less expensive. The chart below illustrates this in terms of the Z-score, which shows spread levels relative to the moving average, measured in standard deviations.

In the near to medium term, credit spread changes may be less of a driver of returns — but what about interest rates? In our view, a combination of macro, policy and technical factors make the possibility of rising rates a significant downside risk. Economic recovery and higher inflation expectations are providing conditions that could help lift bond yields. And, given the predominance of retail investors, any abrupt rate increases could prompt outflows from this asset class.

Furthermore, high-yield municipal bonds are often longer in duration (about 5.5 years is typical) compared to their investment-grade counterparts. Active management of duration and curve positioning in this uncertain rates environment is, therefore, especially important.

Selective exposure is prudent given the market’s credit profile

The credit ratings profile of high-yield municipal bonds also argues for taking exposure on a selective basis. Accounting for about 14% of the total municipal bond market, high-yield issues are typically rated below BB or are unrated. There are about 98,000 below-investment-grade and unrated issues outstanding.

The issuer universe is diverse. As might be expected, there are credit-challenged borrowers. However, there are also numerous smaller borrowers with modest capital needs; arguably, many of these issuers could actually warrant an investment-grade rating — if they had been around longer.

Unrated bonds are the largest segment of this market. Crucially, these issues are not necessarily riskier than rated high-yield bonds. Rather, their lack of rating may reflect that an entity has tended to issue less frequently, or perhaps in smaller sizes. Bond-by-bond credit analysis is, therefore, crucial for shining a light on fundamentals in this underresearched corner of the muni market.

Sector composition is more concentrated than in the investment-grade universe. The industrial development revenue (IDR), health care and special tax sectors account for the lion’s share of high-yield municipals. Special tax bonds may be less well-known: These issues are repaid with revenues from taxes on specific goods and services, or special assessment taxes levied on property owners. Overall, these sectors are dominated by project finance bonds and land-backed deals.

High-yield municipal bonds can occupy a sweet spot in portfolio construction

This asset class offers yields at a relatively favorable level (especially for individuals in higher income tax brackets), but without the high correlation to equities that has so often seen high-yield corporates sell off alongside equities. That historical return profile offers food for thought in the current environment, where the stock market has touched new highs and valuations among high-yield corporates appear even more stretched than in munis.

Compared with high-yield corporate bonds, similarly rated municipals recently offered a yield advantage of nearly 150 basis points (taxable equivalent). In addition to that favorable income potential, high-yield munis can offer excellent diversification potential for equity-heavy portfolios. As of June 30, 2021, the Bloomberg Barclays High Yield Municipal Bond Index had a three-year correlation to the S&P 500 Composite Index of just 0.3.

Now’s not the time to stretch for yield

Amid tight spreads and favorable fundamentals, some municipal bond investors may be tempted to take on more risk in exchange for higher yields. We think that reaching for yield in the current environment can leave portfolios vulnerable.

At present, investors aren’t being compensated well for moving significantly lower in credit quality, extending duration, or adding leverage to amplify returns from higher quality bonds. Taking on additional muni risks in these ways may introduce significant volatility into portfolios, especially during an outflow cycle.

One way to try to reduce volatility without sacrificing too much yield could be to moderate exposure to credit risk overall, while seeking spread opportunities among higher rated municipal credits. It may also be sensible to build liquidity now — either in cash or higher quality bonds. That way, when dislocations do arise, investors with a valuation-centric approach may be well-positioned to take advantage of more favorable entry points.