When it comes to tax-free municipal bonds, investors who are comfortable with taking more risk are seeing attractive returns. High-yield municipal bonds – issues that are rated below BBB by Standard & Poor’s – have greater default risk than their investment-grade counterparts. The riskier bonds outperformed in the first half of the year, posting total returns of 4.72%, according to Bank of America. Investment-grade munis saw a return of -0.07% in that period. Muni bonds provide tax-free income on a federal basis – and on a state basis if the investor resides in the same state as the issuer. Investors are also hopping into high-yield muni bond funds, another way for them to juice portfolio income. High-yield muni bond funds have seen estimated net flows of $6.76 billion in 2024 as of June 30, according to Morningstar. That compares to the $2.82 billion flocking into the muni national long category, and $8.59 billion into the muni national intermediate group. “The economy is still relatively strong,” said Beth Foos, associate director, manager research at Morningstar. “Overall, I would say the credit quality is relatively high, even in the high-yield space.” Sifting through riskier issues Default rates for municipals, including those that aren’t investment grade, tend to be lower than what investors see in corporates. A Moody’s analysis ranging from 1970 to 2022 found that the 10-year cumulative default rate for “speculative grade” munis came in at 6.84% – much higher than the 0.09% default rate in the investment-grade muni space, but still lower than the 29.81% default rate for speculative-grade corporates. Because of these risks and the wide array of issuers, it’s better for investors to consider using a fund to tap into the space, rather than trying to hunt down the individual bonds themselves. “An active manager, if they have a strong team that’s deep and experienced, can uncover the story that is behind the numbers and really understand the risks,” said Foos. “Particularly in the high-yield muni space, there are great opportunities where you’ve got solid credit quality, but it’s a smaller issuer.” “And maybe there are some big names and splashy issuers that have great marketing but also have some real potential risks to their credit quality,” she added. To that effect, Matthew Norton, chief investment officer of the municipal bonds group at AllianceBernstein, noted that his team has been picky in the high-yield space. “We’re being very selective in senior living and using research to make sure we have issuers that we’re very comfortable with,” he said. Norton is a manager on the AB High Income Municipal Portfolio (ABTYX) , which has a 30-day SEC yield of 4.18% and an expense ratio of 0.9%. The team sees affordable housing as a high-yield area that would hold up even in a recession, as well as charter schools – “a sector that could be resilient in an economic slowdown,” Norton said. Coupon clipping Going into the rest of the year, income will likely dominate total return in the high-yield muni bond space, according to Mathew Kiselak, portfolio manager of the Vanguard High-Yield Tax-Exempt Fund (VWAHX) . The fund has an expense ratio of 0.17% and a 30-day SEC yield of 4.06%. “You have some upside potential still, but a lot of it will be carry, and the characteristics are good,” he said. “I don’t think you’ll see a 15% return in any subsector, that’s played already, but you will see these pockets and these esoteric sectors will do well.” Workforce housing, continuing care retirement communities and charter schools are some of the corners of the high-yield muni market that have caught his attention. Further, Kiselak said that the environment for taxes will continue to make these funds attractive to high-net worth individuals. “The tax landscape is there and it’s very supportive of the muni market on an after-tax basis,” he said. Before you step in Investors looking at high-yield muni bonds, be it individual issues or the funds, ought to consider their risk appetite and their goals. The tax-free income isn’t the only thing that attracts investors to municipal bonds; they appreciate the safety of so-called general obligation bonds – those that are backed by the full faith and credit of the issuer. High-yield munis, however, can be issued by nursing homes, hospitals and other facilities, which makes them riskier compared to investment-grade munis that are backed by a city or state’s ability to tax its residents. So the question for investors is whether the additional income is worth the higher risk. The high-yield muni world is also fragmented and requires a significant amount of due diligence into the issuers. If you’re tapping into this sector through a fund, consider the depth of the team behind the portfolio, as well as the credit quality of the underlying bonds. “The muni market is so fragmented. There are a ton of issuers and each issuer has a credit story behind it,” said Morningstar’s Foos. “It’s an absolutely great place to expect active managers to do well.”