By
Gregory Gizzi
August 08, 2025
High yield municipal bonds: Poised for what’s next
Uncertainty has been the theme of 2025. Geopolitical concerns, policy initiatives, and the potential impact of
tariffs have put the US Federal Reserve on pause as it balances a still strong economy with concerns around the
potential for upward pressure on inflation. For municipal investors, the uncertainty has been exacerbated by talk of
changes to the municipal tax exemption, which ultimately was fully preserved in the One Big Beautiful Bill. Municipal
credit remains resilient with strong economic growth and robust rainy day funds. At midyear 2025, high yield
municipal bonds are on track to be one of the top-performing fixed income asset classes on a tax-adjusted basis, as
measured by the Bloomberg fixed income indices, as investors continue to search for yield. For investors seeking to
keep more income with a balanced approach to risk, high yield municipal bonds may offer the solution.
Over the past 10 years, the high yield municipal category has experienced an average organic growth rate of ~6%
(source: Morningstar Direct). It is the second largest-growing segment after the intermediate-term municipal bond
segment, which grew at ~8% as investors seek high levels of income.
The credit aspect of municipal bonds gained significantly greater emphasis after 2007 when the monoline insurance
model1, which was prevalent in credit default swaps and similar products during the global financial crisis, virtually
disappeared. The peak in insurance for municipal issuance was in 2005, when 57% of new issues were priced as insured
credits and more than 60% with the use of secondary market insurance (source: Bond Buyer). As the market transitioned
from a predominantly AAA-insured environment to one that now has multiple underlying credit tiers to analyze, the
growth in income-focused bond fund strategies was inevitable. Tax-exempt high yield funds, in particular, have
experienced exceptional growth, based on Lipper fund flows data.
In this paper, we examine the high yield municipal category, including strategies that are used by tax-exempt high
yield managers, to provide a better understanding of this space. We think it should be evident that the tax-exempt
high yield asset class is substantially different from its taxable high yield counterpart, and we argue that the term
“high yield” in the tax-exempt market may be a misnomer.
What is high yield?
From a pure rating characteristics standpoint, high yield bonds are those with credit ratings below investment grade
criteria. This means that securities rated lower than Baa3 by Moody’s Investors Service, BBB- by Standard & Poor’s,
and BBB- by Fitch are deemed below investment grade or “high yield.” Non-rated bonds, in many cases, are also
considered high yield. For high yield funds, however, the definitions are less concise.
Lipper defines high yield municipal funds as funds that typically invest 50% or more of their assets in municipal
debt issues rated BBB or less.
Morningstar defines high yield municipal funds as portfolios that typically invest a substantial portion of assets in
high-income securities that are not rated or are rated at or below BBB (considered high yield within the municipal
bond industry) by a major ratings agency such as S&P or Moody’s.
Note that “typically invest 50% or more” and “invest a substantial portion” allow some leeway when defining high
yield municipal funds, considering the limited universe of high yield securities available. These definitions point
to the first key distinction between tax-exempt and taxable high yield markets. Due to a lack of high yield paper in
the municipal market, investment grade issues rated BBB are considered part of the high yield universe and are
typically traded as high yield. This is distinctly different from taxable high yield, which typically has its own
dedicated department and does not include any investment grade bonds rated BBB at all. This is a direct result of the
opportunity sets within the respective markets.
A look at high yield sectors
Sectors in the high yield category are the same sectors found in the investment grade indices. The chart below shows
the Bloomberg Municipal Bond Index and the Bloomberg High-Yield Municipal Bond Index for comparison. High yield
credits are predominantly in project finance or revenue bonds, so the largest difference between the investment grade
and high yield sectors is in the largest sector weightings for each index. General obligation (GO) bonds are much
more prevalent in the investment grade category.
As illustrated in Figure 1, the industrial development revenue / pollution control revenue (IDR/PCR), special tax,
and hospital bond sectors dominate the Bloomberg High-Yield Municipal Bond Index, representing approximately 60%,
while the transportation, GO (both state and local), and special tax sectors dominate the Bloomberg Municipal Bond
Index, representing approximately 50%.
Figure 1: Sector breakdown in the municipal and high yield municipal indices
Sources: Barclays Live, Investortools Perform®. Weightings as of June 30, 2025.
Defaults in tax-exempt municipals
Historically, the credit quality of municipal bonds has been a consistent factor in attracting demand from
non-traditional sources or investors, which may or may not benefit from the tax-exempt status of these bonds. An
annual study published by Moody’s illustrates the relative safety of municipal bonds, in our view. This study2
compares investment grade and below-investment-grade rating tranches and their respective default rates for
Moody’s-rated municipal bonds versus Moody’s-rated corporate bonds from 1970 to 2024. We believe that this
representative sample of the municipal and corporate bond markets, shown in Figure 2, is a good proxy for the overall
default experience in the respective markets.
Figure 2: 10-year average cumulative issuer-weighted default rates
| Rating |
Municipal rated debt |
Corporate rated debt |
| AAA |
0.00% |
0.34% |
| AA |
0.02% |
0.71% |
| A |
0.10% |
1.84% |
| BBB |
1.04% |
3.42% |
| Below investment grade |
6.69% |
29.71% |
| Average recovery value |
65% |
47% |
Source: Moody’s Investors Service, US Municipal Bond Defaults and Recoveries 1970-2024.
Figure 2 demonstrates that in all credit tranches municipal debt defaults at a significantly lower rate than
corporate bonds. For the “below investment grade” or high yield category, municipal issues defaulted at 6.69% versus
29.71% for corporate bond issues for the same period. In our view, this disparity is largely explained by the
generally more stable and predictable cash flows and investor-friendly covenants of municipal issuers relative to
corporate bond issuers.
Municipal vs. corporate recovery rates
The recovery rates of municipal issues that have defaulted can vary substantially but have generally exceeded those
of corporate bonds. The Moody’s default study3 notes:
“Average issuer-weighted recoveries on Moody’s-rated municipal bonds since 1970 have been about 65%, which is higher than the issuer-weighted average recovery rate for corporate senior unsecured bonds of 38% since 1983, as well as the ultimate recovery rate of 47% for senior unsecured bonds of North American corporate issuers since 1987. Municipal recovery rates, however, have been highly variable across individual bonds, with some recovering 100% and others receiving as little as 0%.”
Overall recovery rates of Moody’s-rated municipal debt, on average, have been higher than those of Moody’s-rated
corporate debt.
Organic high yield vs. “fallen angels”
The high yield or below-investment-grade segment of the market is composed of two basic categories: organic high
yield securities and those classified as “fallen angels.” Organic high yield comprises issues that are priced in the
primary market with initial ratings in the below-investment-grade category, so below Baa3/BBB-, or non-rated. Fallen
angels are issues that have dropped from investment grade to high yield through some form of credit degradation. The
high yield market expanded in 2014 as several Puerto Rico issuers lost their investment grade ratings and joined the
high yield category. In 2017, those fallen angels were removed from the Bloomberg High-Yield Municipal Bond Index
after defaulting on their debt, or not paying interest on bonds. After the restructuring of Puerto Rico’s sales tax
revenue bonds (COFINA)4 in 2019, those bonds re-entered the index when they began to pay interest again, and the high
yield market expanded. Puerto Rico bonds currently account for roughly 14% of the High Yield Municipal Bond Index.
Benchmarking high yield municipals
High yield municipal bond funds are benchmarked to an underlying index or, in some cases, a hybrid index composed of
more than one index. Among the universe of high yield municipal funds, a variety of underlying benchmarks are used.
This is due to several factors.
First, some high yield municipal funds existed before the creation of the high yield indices. In fact, 16 of today’s
54 high yield municipal funds, or approximately 30%, pre-date the inception of the Bloomberg High-Yield Municipal
Bond Index on October 31, 1995 (source: Morningstar Direct). This early generation of funds is typically benchmarked
to a generic national municipal aggregate index, such as the Bloomberg Municipal Bond Index. While some fund managers
may have since amended their fund’s prospectus with a new benchmark, some have not.
Second, when considering the constitution of the market by credit segment, the investment grade portion of the market
represents approximately 88-92% of supply, while high yield is only 8-12% (source: Barclays Live). Given the
challenge for managers to get enough exposure to a relatively small component of the overall market, it seems logical
not to use a purely high yield index as a fund’s benchmark. What has evolved in the marketplace is the practice of
using a hybrid benchmark, typically a combination of an underlying investment grade index and an underlying high
yield index. Two common hybrids are 60-40 blends of the Bloomberg Municipal Bond Index and the Bloomberg High-Yield
Municipal Bond Index, either weighted more toward the investment grade index (60% Bloomberg Municipal Bond Index, 40%
Bloomberg High-Yield Municipal Bond Index) or the reverse, weighted more toward the high yield index. Intuitively,
this hybrid approach makes sense given the practical limitations of the high yield municipal sector.
Sizing the high yield market
As of the first quarter of 2025, the most recent Fed data shows the municipal market worth $4.23 trillion. The high
yield component of the municipal market, as noted earlier, is considerably smaller than the investment grade
component. If we use the Bloomberg High-Yield Municipal Bond Index as a proxy for the high yield market, non-rated
securities represent approximately 70% of the below-investment-grade category. Despite record pace for municipal
issuance in 2025, high yield municipal supply has actually declined year-to-date, providing strong technical support.
With the below-investment-grade category being such a small slice of the overall market, it seems clear why the
demand for such products has been substantial, given the asset growth in the high yield space. This is in addition to
the demand from investment grade municipal bond funds and state-specific funds, which generally use
below-investment-grade allocations as well. Many high yield funds will compensate for the lack of
below-investment-grade supply by deploying leverage in their portfolios.
The use of leverage in high yield funds
The limited supply in the high yield municipal bond segment, coupled with insatiable demand from both high yield
funds and investment grade or state-specific funds that use below-investment-grade allocations, results in a supply
deficit for high yield instruments. In fact, the average allocation to below-investment-grade investments for a high
yield municipal fund in the Lipper High Yield Municipal Debt Average was 57% as of March 2025. This contrasts with
taxable high yield funds in the Lipper High Yield Bond Average, which has an average below-investment-grade
allocation of 95%. (Data as of March 31, 2025.)
The lack of high yield municipal supply leads many portfolio managers to deploy leverage in their funds to create
excess yield, typically using higher-grade securities. This is most commonly done by issuing variable-rate municipal
term preferred (VMTP), municipal multi-mode preferred (MMP), or institutional municipal term preferred (IMTP) shares,
or using tender option bonds (TOBs) to lever the fund.
When high yield supply diminishes, leverage can be used to create excess yield
VMTP, MMP, and IMTP shares are preferred shares issued to borrow from the short-term tax-exempt markets. These shares
are issued with either a variable or fixed rate, which is calculated by a predetermined spread over a benchmark, the
US Securities Industry and Financial Markets Association (SIFMA™) Municipal Swap Index, which can reset as it changes
weekly (VMTP, MMP) or is fixed at a spread off the index for the entire term. These structures will typically have
three- to five-year terms but can be longer. The issuer then generally uses the preferred share proceeds to buy
longer-dated, higher yielding municipal bonds.
A TOB is a security issued by a special purpose trust (a tender option trust), into which high-quality bonds are
deposited and then split into two types of securities. The floating-rate security is typically sold to a money market
fund and typically floats off the SIFMA Index. The residual security, the inverse floating-rate security, is retained
by the fund. The difference between what is earned on the long-term bonds and what is paid out on the floating-rate
piece is what’s earned by the fund. The proceeds from the sale of the floating-rate piece allow the fund to purchase
additional longer-dated, higher yielding securities that can add to the income of the fund.
As with any form of leverage, interest rate sensitivity is added to the portfolio. When rates fall, total return can
benefit from this increased rate sensitivity and, conversely, it can be detrimental to performance when rates rise.
Some high yield managers deploy both forms of leverage within their funds.
Building a high yield portfolio
There are three basic considerations to building a high yield portfolio: access, analysis, and diversification. These
three factors must be present if one is to try to build a municipal high yield portfolio as opposed to investing
through a high yield bond fund or exchange-traded fund (ETF).
Access. The first element in building a high yield portfolio is access to high yield issuance. We
observe that new issues provide the strongest opportunity to secure high yield allocations, but because of the very
scarcity of high yield issuance, little supply winds up trading in the secondary market. Roughly 10-12% of overall
supply falls into the high yield category and, as previously stated, is in high demand (sources: Barclays Live, JP
Morgan). In consideration of underwriting firms’ overall businesses, underwriters are notably judicious in allocating
high yield supply to money managers that represent holistic relationships. It can be difficult to obtain allocations
on deals if you are not transacting in other aspects of the municipal business with those underwriters.
Another impediment to access is the fact that many high yield issues come to the market designated as available to
qualified institutional buyers (QIBs) only. These deals are typically structured with minimum size pieces of $250,000
or $500,000. In some firms, individual financial advisors may be restricted from participating in QIB issues despite
meeting the QIB definition.
Analysis. High yield structures are significantly more complicated in structure than basic GOs or
essential service revenue bonds, making experienced analysis critical. These credits will often involve intricate
financial modeling in which many inputs must be properly assessed for feasibility, probability, and longevity. It
often takes real market experience to construct the proper model to assess the credit worthiness of an issue. In some
cases, to assess value on a non-rated issue, a theoretical rating must be assigned, which can only be done through
experience with relative values within specific sectors of the high yield market. This theoretical pricing matrix is
obtained through years of following the relative trading values of credits. Without a credit analysis skill set,
building a viable portfolio becomes a sheer gambling proposition.
Diversification. Lastly, one of the basic tenets of investing, diversification, is critically
important to constructing a high yield portfolio. A single credit blow-up in a heavily concentrated holding can sink
an entire portfolio’s performance. Having a well-diversified portfolio of credits is critical in a high yield
portfolio and cannot be accomplished without the ability to assess credit properly and have access to as large a
range of high yield product as possible.
These factors have led to the proliferation of high yield municipal bond funds and the growth in high yield municipal
ETFs.
High yield municipal ETFs
As investors have sought exposure to the high yield sector of the municipal market, high yield funds have seen
significant growth. An alternative to municipal high yield funds is the high yield municipal ETF. ETFs are investment
products that allow investors to buy or sell shares of an entire portfolio of bonds in a single security and trades
throughout the day, as individual stocks do. Some high yield municipal ETFs track a benchmark index such as the
Bloomberg Municipal Custom High-Yield Composite Index or the S&P Municipal Yield Index, while others are actively
managed.
There are 17 high yield municipal ETFs in the market: 5 passive and 12 active. These funds have seen explosive growth
in their asset base since the first one was introduced in 2009. The average annual growth rate in assets has been
approximately 18% over the last 10 years. High yield municipal ETFs now hold $10.7 billion in assets (source:
Morningstar Direct).
Performance: High yield vs. investment grade municipals
The insatiable demand for yield has been a catalyst for the asset growth in high yield municipal funds, but the key
question is, have investors benefited by investing in the high yield space? To answer the question, Figure 3 shows
the annualized returns for the Bloomberg High-Yield Municipal Bond Index versus the Bloomberg Municipal Bond Index.
These indices serve as a fair representation of the overall high yield and investment grade markets, respectively.
The results indicate that over the past 20 years, high yield municipal bonds have outperformed investment grade
municipal bonds, in some periods by a significant amount.
Figure 3: High yield vs. investment grade performance in municipal debt
Source: Barclays Live. Returns as of June 30, 2025. All returns over one year are annualized.
The higher income generated by high yield securities appears to be the key variable in the outperformance of the high
yield sector.
High yield municipals have also outperformed across the larger fixed income universe. Figure 4 shows the annualized
returns for the past five years across fixed income. High yield municipals’ performance is second only to high yield
corporates, which have a very different risk profile.
Figure 4: Fixed income annualized returns for the past five years (as of June 30, 2025)
The environment for high yield municipal underperformance
The municipal market has exhibited a historical pattern during certain trading environments that has usually resulted
in the high yield municipal sector underperforming. As a result of the unique concentration of ownership, markets in
which individual holders are sellers (or are redeeming their shares in tax-exempt mutual funds) for an extended
period show a sequential pattern: the high yield sector initially outperforms, then eventually succumbs to the
selling pressure, and very quickly adjusts and even underperforms the investment grade sector.
The typical reaction to investor selling by tax-exempt fund managers is to meet fund redemptions by selling
securities from a liquidity component of the portfolio consisting of very liquid high-grade holdings. We have
observed that if the selling is short lived, cash or investment proceeds may be reinvested quite easily into similar
securities when the environment becomes more favorable. Conversely, if the selling is prolonged and portfolio
managers seek to maintain similar credit concentrations through the redemption period, then eventually higher
yielding securities may be sold to maintain the integrity of that strategy. When the high yield tax-exempt market
begins to see significant selling, liquidity becomes challenged and aggressive corrections may occur. This is the
type of environment in which high yield tax-exempt sectors tend to underperform investment grade sectors.
We have found that the constrained supply of high yield tax-exempt securities has encouraged managers of high yield
funds to have a high-grade liquidity provision in their portfolios. The constrained supply, and thus the difficulty
of replacing high yield securities when the market environment improves, has generally caused portfolio managers to
exhibit patience before selling high yield holdings that may not be easily reacquired.
Conclusion
High yield municipal bond funds have grown in number and popularity in the post-global financial crisis era,
propelled by the demise of monoline insurance, demand for yield, and a better understanding of the relative default
risk of municipal bonds. Investors have generally been rewarded for allocating to the high yield segment of the
market with higher returns. We believe the characteristics of the high yield marketplace and the complexity of its
credit structures make high yield funds the most efficient way to capitalize on the excess return that has been
afforded to high yield investors.
[4650079 07/25]