High-yield (junk) municipal bonds have attracted about $5.3 billion of investors’ money so far this year, but some experts think that their party is about to end. The reason for the robust growth is that the yield of junk municipal bonds is approximately 5.2 percent compared with investment grade munis that are yielding 2 percent. Similarly, the total return of one junk municipal bond ETF is 9.8 percent compared with 6.9 percent for an investment-grade muni bond ETF. While the increased yield is attractive to investors, the difference in performance is not enough to compensate for the additional risk, according to some experts (“Will ‘Junk’ Munis Bite Back?,” by Ben Levisohn, Wall Street Journal).
The risk of high-yield (junk) munis is significant. The stagnant U.S. economy means lower tax revenues, which is putting severe stress on municipal budgets. On top of that, states, suffering from lower tax revenues, are likely to continue cutting funding to local governments. If these stresses reach a tipping point, there may be a run out of junk municipal bonds and funds as the herd stampedes into safer investment-grade municipal bonds.
One reason for the flow of investor funds into junk municipal bonds is that municipalities have been refinancing older bonds at record levels. Investors looking for the same yield must go toward the junk end of the spectrum to find it. But the spread ? the difference between the yields of junk and investment grade ? are narrowing. This has experts worried that the end is near for the rally into junk municipal bonds.
High-yield (junk) munis that back ancillary projects such as nursing homes and hospitals are generally even more risky because they are not general obligation bonds that are backed by the taxing powers of the city, county or state.
Defaults have been relatively rare but could increase, especially as state governments cut local government funding. The article notes that Detroit came within days of a default, leading a rating agency to cut Detroit’s debt rating on June 12.
In sum, more advisers are recommending that junk muni bond investors should get out now while the getting is good. “The weak are getting weaker. This is a great time for an upgrade,” one money manager was quoted as saying.
Page Perry is an Atlanta-based law firm with over 170 years of collective experience maintaining integrity in the investment markets and protecting investor rights.