This piece of the tax-exempt bond market is a hot one - if you manage the risk

By Philip van Doorn

High-yield municipal bonds have more price volatility and credit risk, but they have outperformed investment-grade munis dramatically over the past 15 years

Some investors focus on growth while others are interested in current income. For that second group, broader horizons within the bond market can lead to better returns over the long haul. You might be surprised to see that diversified high-yield (or junk) bond portfolios can be the best performers, as long as the portfolio managers do a good job analyzing credit risk.

John Miller is the head and chief investment officer of the High Yield Municipal Credit Team at First Eagle Investments in New York. He oversees the First Eagle High Yield Municipal Fund and the First Eagle Short Duration High Yield Municipal Fund. He is based in Chicago and joined First Eagle in January, after leaving Nuveen last April.

First Eagle is based in New York and manages about $138 billion in mutual funds and for private clients.

The First Eagle High Yield Municipal Fund was known as the First Eagle High Income Fund prior to Dec. 27, 2023. That is when the fund's main objective was changed to its current one of providing dividend income that is exempt from federal income taxes. Capital appreciation is a secondary objective.

The First Eagle Short Duration High Yield Municipal Fund was established Jan. 2, and has similar objectives, with the shorter portfolio duration meant to lower price volatility. Both funds pay monthly dividends.

Miller was recently profiled in the Wall Street Journal. In that article, Heather Gillers pointed out that as of June 30, the First Eagle High Yield Municipal Fund was more than 8% concentrated in bonds issued by the Florida Development Finance Corp., backed by the revenue of the Florida Brightline Passenger Rail Project. This project has added track to existing rail lines to create a high-speed passenger service between Miami and Orlando, with additional stations in Aventura, Fort Lauderdale, Boca Raton and West Palm Beach. More stations are planned north of West Palm Beach.

During an interview with MarketWatch, Miller dug into details of several Brightline bonds owned by the First Eagle funds, covering their credit risks, high yields, special protection measures and opportunities for capital gains when bonds mature or are called.

"When you buy in, during a redemption cycle, you do very well and it doesn't take that long see a sharp snapback."John Miller, head and chief investment officer of High Yield Municipal Credit Team at First Eagle Investments in New York

Before discussing credit risk, it will be useful to take a look at how high-yield bonds have performed relative to investment-grade bonds, and set out definitions of terms that Miller used.

Definitions

Bond: A bond is a debt security. A company or government entity issues bonds to borrow money. The issuer pays interest to the bondholders until the bond matures. Interest is typically paid every six months. On the maturity date, the issuer will repay (or redeem) the bonds at face value, or possibly a different value, depending on the features of the bond. Bondholders are free to sell their bonds at any time to other investors, but the market value when selling will depend on market conditions.

Municipal Bond: A bond issued by a state or local government in the U.S. Interest on these bonds is typically exempt from federal income taxes, and from state and local income taxes for residents of the state in which the bond was issued. But not all municipal bonds are tax-exempt.

Default: Failure of a bond issuer to make interest payments or to repay principal. Following a default, a bond investor may or may not recover a percentage of their investment as the issuer goes through bankruptcy proceedings.

Credit rating: Credit-rating firms are paid by bond issuers to analyze bonds and the financial health of the issuer and assign credit ratings. The two largest credit-rating firms are S&P Global and Moody's Ratings. At S&P, a bond is considered to be "investment grade" if it is rated BBB- or higher. At Moody's, the minimum investment-grade rating is Baa3. You can review S&P's ratings hierarchy here and Moody's rating scale here. And Fidelity lines up the agencies' ratings next to each other here.

High-yield bond: A bond with a below-investment-grade credit rating or no rating. These are often called "junk bonds" and investors typically receive higher yields on these securities than they would on investment-grade bonds.

Price: This is a bond's price relative to its face value. If a bond is trading at its face value, we say it is trading at 100, or par. If it is trading at 1% above or below its face value, we say it is trading at 101 or 99, respectively. Municipal bonds might be issued at a premium or discount to the face value and the amount redeemed at maturity might also be a premium or discount to the face value.

Inverse relationship: As bond prices move up and down, bond yields move in the opposite direction to the price.

Duration: This is a risk measure used for bond indexes, portfolios or bond funds that incorporates bonds' maturity dates and call dates. Typically, the longer the maturity, the more a bond's market value will fluctuate as interest rates move. For example, the SPDR Portfolio Intermediate Treasury ETF SPTI has a duration of 4.9 years, according to FactSet. This means investors can expect the share price to fall by 4.9% if interest rates rise by 1%, and vice versa.

Call: Bonds can feature call dates. The issuer can redeem a bond on or after the call date. This feature is detailed by the borrower when a bond is issued, and includes the price at which the bond may be called. A bond might be called at a premium to face value, and the premium might change as time passes between the call date and the maturity date. The borrower's decision on whether or not to call some or all of a bond issue will depend on the general direction of interest rates, other market conditions and the borrower's financial circumstances.

Coupon: The interest rate that a bond issuer pays, based on the bond's face value.

Yield: The expected rate of return on a bond, expressed as a percentage. It can fluctuate based on the bond's price. The current yield is a bond's yield divided by its price. A bond trading at a discount to par will have a current yield higher than the coupon. A bond trading at a premium to par will have a current yield below the coupon.

Yield to maturity: This is an annualized figure that factors in a bond's current market price, the coupon and the capital gain or loss that the investor would take if they were to hold the bond to maturity, because of the premium or discounted price they would pay.

Yield to call: A bond's yield to call is similar to the yield to maturity, except that it incorporates the next call date and call price on that date, rather than the maturity date.

Yield to worst: The lower of the yield to maturity and the least favorable yield to call. Typically, this will be the only market-price-based yield figure available when selecting bonds through a brokerage account, which helps simplify comparisons.

Taxable-equivalent yield: A calculation used to help decide whether the yield on a tax-exempt bond is attractive when compared with that of a fully taxable bond. For an example that leaves aside state and local income taxes, if your annual income was high enough for you to be in the 35% federal tax bracket and you were presented with a municipal bond with a 5% yield, you would divide that yield by 1 less the tax bracket (0.65) for a taxable equivalent yield of 7.69%.

Why consider a high-yield bond fund?

Earlier this month we looked at two taxable high-yield bond funds managed by Brandywine Global - a unit of Franklin Templeton - and saw that they had outperformed their respective high-yield bond index benchmarks for various long periods. In other words, the higher yields in these portfolios outweighed the higher risk.

Now let's look at the performance of the S&P Municipal Bond High Yield Index against two other indexes - the S&P Municipal Yield Index (which includes 30% investment-grade and 70% high-yield bonds) and the S&P Municipal Bond Investment Grade Index. These returns include interest payments and price changes through Sept. 21:

   Index                                  Year-to-date  1 year  3 years  5 years  10 years  15 years 
   S&P Municipal Bond High Yield                  7.4%   13.8%     2.5%    16.7%     54.5%    139.6% 
   S&P Municipal Yield                            6.5%   13.4%     1.5%    14.7%     52.4%       N/A 
   S&P Municipal Bond Investment Grade            2.4%    8.2%     0.3%     7.1%     27.3%     60.2% 
                                                                                     Source: FactSet 

Here are the average annual returns for several periods:

   Index                                  3 years  5 years  10 years  15 years 
   S&P Municipal Bond High Yield             0.8%     3.1%      4.4%      6.0% 
   S&P Municipal Yield                       0.5%     2.8%      4.3%       N/A 
   S&P Municipal Bond Investment Grade       0.1%     1.4%      2.4%      3.2% 
                                                               Source: FactSet 

The strong performances over the past year resulted from heavy demand for bonds as investors have anticipated lower interest rates, a slowing economy or both. The three-year figures still reflect downward pressure on bond prices because interest rates are much higher than they were three years ago. Over longer periods, the higher-yielding approaches with more credit risk have had much higher returns than the investment-grade index. And these returns include any capital losses or price declines from distressed or defaulting bonds.

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