A high yield bond has an increased chance of default, making it a very risky investment for most. In return, companies raise the interest rate to make it more attractive to investors. Could this be a smart way for you to make money, or should you avoid high yield municipal bonds? Here are some facts to help you decide.
Advantages of High Yield Municipal Bonds
High yield municipal bonds can give an investor huge returns, but there are several other benefits that attract high-income individuals. These include:
- Federal-Tax Free: Unlike other types of high yield bond funds, municipal bonds are free from federal taxes. Money received from a municipal bond is exempt and can be a way to save substantial amounts of money over an extended period of time.
- State-Tax Free: In most states, investments in local municipal development projects are exempt from taxes, but this isn’t the case for all municipal bonds. States that don’t have income taxes like Washington, Texas, Florida, Alaska, South Dakota, Wyoming, and Nevada allow you to keep all of the funds gained from municipal bonds.
- Lower Risk: In general, bonds are much lower risk than stocks because bondholders get paid before stockholders if a company goes bankrupt. Additionally, municipal bonds have a much lower volatility because they are fixed income assets. Stocks rise and fall with the market without a promise of return on investments. Bonds have a call provision that allows investors to get paid should the interest rate change on their investment.
- More Defensive: Diversification protects you against major loss, and municipal bonds are not closely correlated with equities. They are more defensive due to the lower volatility and hinge on issues like sales, income taxes, and property values.
- Smaller Market: The high yield municipal bond market is much smaller than the investment grade market. It’s considered “liquid,” meaning that trading volumes are much lower—this is helpful for investors with individual securities.
Disadvantages of High Yield Municipal Bonds
Unlike regular bonds and other investments, there are a different set of risks and disadvantages for high-yield municipal bonds. These drawbacks are what often make people decide against investing in high yield municipal bonds:
- High Default Risk: There is a higher default risk when compared to other bonds, which is perhaps the biggest disadvantage. After a default, the issuer liquidates all of its assets and distributes the proceeds to investors, but high yield bonds mean that the investor may not receive a full return on what was paid.
- Fluctuating Interest Rates: Interest is what originally attracts traders, but the rates of high yield bond funds can change. As the interest rates go up, the bond loses value. It’s less of a concern if investors hold the bonds until maturity, but those looking to use the call provision may discover a loss.
- Fewer Issuers: Unfortunately, due to the smaller market, it can be hard to find issuers. There has been an increase in demand for high yield municipal bonds because they are paying at 3.99% with the bonus that income is tax-free. The limited supply is making existing bonds very high, which means that investors may have to pay top dollar to get into the market.
- Call Provision Issue: As mentioned before, investors have the option to call on their debt (which may or may not return their investment). However, it can be harder to cash in on municipal bonds from a rural county government.
