Investors who are changing up their bond portfolios now that rates appear to have peaked are overlooking a sector of the market that offers high yields and tax benefits, according to Bank of America. ETF strategist Jared Woodard said in a Thursday note to clients that investors should take a closer look at high-yield municipal bond funds as they try to move away from short-term bonds and capture the benefits of falling interest rates. “Investors have registered $195mn of outflows from HY muni ETFs over the past year while piling $3,130mn into long duration US Treasury bond funds. … In our view, Treasury bond ETFs have too much inflation risk and will continue to underperform Prudent Yield credit assets. HY muni ETFs are an attractive option for investors looking to extend duration without sacrificing yield or credit quality,” the note said. Municipal bonds are debt issued by state and local governments whose interest payments can be tax-free for investors. They typically have stated coupons that are lower than similarly rated debt from other issuers, but their effective payouts can be greater for investors depending on their tax situation. That quality could make municipal bonds attractive for investors who want to shift their portfolios toward longer-dated bonds, which should see their prices rise as interest rates fall. Of course, one reason that might spur rate cuts from the Federal Reserve would be an economic downturn that puts pressure on high yield or “junk” bonds. But municipal bonds look relatively safe within that group, according to Bank of America. BB-rated municipal bonds have had a similar default rate to BBB-rated corporate bonds since 1970, Woodard said, and a lock track record of outperformance when considering their tax benefits. “HY corporate bond coupon payments are also taxable at ordinary income rates; returns have trailed HY munis by > 150% since December 1995 net of taxes despite higher credit risk,” the note said. Bank of America’s top-rated municipal bond ETFs include the SPDR Nuveen Bloomberg High Yield Municipal Bond ETF (HYMB) and the VanEck High Yield Muni ETF (HYD) . The two funds are both more than a decade old, and have similar portfolios in terms of the average years to maturity of their bond holdings. The VanEck product is slightly cheaper on a fee basis, with an expense ratio of 0.32% compared to 0.35% for HYMB, and has a slightly higher average coupon. On the other hand, HYMB has outperformed the HYD over the past 12 months, with a total return of 5.9% compared to 4.8%, according to FactSet. The SPDR fund has also outperformed HYD over five-year and 10-year windows.
