Hungry for income? High yield munis could be your meal ticket

Chad Farrington, CFA, Head of Municipal Bond Credit Research and Senior Portfolio Manager | May 28, 2014

  • High yield muni bonds represent an attractive investment opportunity
  • Professional money managers can help with the intricacies of the high yield muni space
  • Current income and potential tax advantages in the high yield space

Attractive yields, potential for price appreciation

Many investors are concerned about the prospect of rising interest rates and the impact higher rates may have on bonds, especially since we’ve been in a very low rate environment for so long. While we believe that rates are likely to move higher at some point, the impact will not be the same across all bonds. We think high yield municipal bonds, with their high yields and opportunity for price appreciation, are one segment of the market worth considering. Municipal credit trends are stable to improving, the yield exceeds most other fixed-income alternatives and the tax environment makes the tax-exempt benefit even more valuable.

We believe a stronger economy is what is most likely to spark inflation and will ultimately lead to higher interest rates. Since many high yield municipal bonds are related to specific projects that tend to be more sensitive to economic growth (rather than to changes in interest rates), such as retirement communities, hospitals, special taxing districts and port facilities, improving economic conditions should strengthen the credit fundamentals — and prices — of these bonds. High yield muni bond credit spreads remain wide from a historical perspective, so price declines are likely to be more muted than with other fixed-income alternatives when rates rise. This is due to the fact that credit spreads usually tighten when rates rise, as long as the underlying credit quality is improving.

Of course, price changes are only one component of the return provided by bonds. The main reason investors invest in bonds is for their income, and the income currently available from high yield municipals equals or exceeds income from taxable bonds without even considering the tax advantaged status of municipals. Despite significant volatility in the municipal market resulting from the financial crisis in 2008, fears of tax reform and dwindling market liquidity due to dealer contraction, high yield municipal yields have averaged more than 6% over the past 10 years, as detailed in the following chart.

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Sources: Barclays, Columbia Management Investment Advisers, LLC, May 2014. It is not possible to invest in an index. Past performance does not guarantee future results.

With personal income tax burdens increasing and likely to go higher, high yield municipals look even more appealing. As seen in the chart below, the taxable-equivalent yield of the Barclays High Yield Municipal Bond Index is 10.73%, 11.08% and 11.98%, for investors in the 36.8%, 38.8% and 43.4% federal tax brackets (includes the 3.8% Net Investment Income Tax, NIIT), as of 4/30/14 – yields that surpass most other asset classes, especially on a risk-adjusted basis.

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Sources: Barclays, Columbia Management Investment Advisers, LLC, April 2014. It is not possible to invest in an index. Past performance does not guarantee future results.

Higher returns, higher risk — rely on professional research and diversification

The high yield sector generally provides higher returns than the investment-grade space. With the higher returns comes greater risk and volatility, requiring greater emphasis on fundamental credit research, attention to individual credits and diversification across issuer, sector and geography. As such, we suggest that investors avoid individual high yield bonds and, instead, invest in a diversified high yield municipal bond fund with a proven track record and support from a large, experienced credit research team. We believe the support of a large trading organization with ready access to the Street and market insight is of great value, particularly in the high yield space. We favor an investment approach that avoids using leverage, a form of borrowing, as it can increase volatility when interest rates rise. We also suggest avoiding funds that attempt to hedge interest rates by using U.S. Treasury futures, as we have found that this approach typically is ineffective and, even, counterproductive when needed most in a volatile market.

High yield muni bonds attractive vs. other asset classes

With the equity markets near all-time highs and interest rates hovering near historic lows, high yield municipal bonds remain one of the most compelling investment options, especially for investors in higher tax brackets with long-term investment horizons. We believe high yield muni bonds offer an above average level of current income, possess tax advantages that are becoming increasingly attractive as the tax burden increases and will be less sensitive to rising interest rates than other fixed-income investments.

Disclosure

There are risks associated with an investment in a municipal bond fund, including credit risk, interest rate risk, prepayment and extension risk, and geographic concentration risk. See the Fund’s prospectus for information on these and other risks associated with the Fund. In general, bond prices rise when interest rates fall and vice versa. This effect is more pronounced for longer-term securities.

Income from tax-exempt funds may be subject to state and local taxes and a portion of income may be subject to the federal and/or state alternative minimum tax for certain investors. Federal and state income tax rules will apply to any capital gain distributions and any gains or losses on sales.

Diversification does not ensure a profit or guarantee against a loss.

It is not possible to invest directly in an index.

The Barclays Municipal High Yield Bond Index, which is comprised of bonds with maturities greater than one-year, having a par value of at least $3 million issued as part of a transaction size greater than $20 million, and rated no higher than ‘BB+’ or equivalent by any of the three principal rating agencies.

Columbia Management and its affiliates do not offer tax or legal advice. Consumers should consult with their tax advisor or attorney regarding their specific situation.

Chad Farrington

CFA, Head of Municipal Bond Credit Research and Senior Portfolio Manager
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