Municipal bonds are already beloved by high-income investors, but those seeking additional yield and beefier returns are reaching for a little more risk. The high-yield muni bond corner of the market includes issues with below investment-grade ratings – that is, rated below BBB by Standard & Poor’s. This also means that these issuers face a greater risk of default and missing their interest payments compared with their AAA-rated counterparts. But investors willing to take a little more risk are rewarded with heftier returns. The U.S. high-yield muni bond fund category posted an average 12-month return of 5.22% as of Jan. 31, according to data from Morningstar Direct. That compares with an average 12-month return of 2.38% for U.S. national muni bond funds with an intermediate duration of four to six years. To top it off, interest from municipal bonds is free of federal income taxes – and exempt from state taxes if the investor resides in the issuing state. Hefty inflows in the past year With those returns, it’s no wonder that in the 12 months ended Jan. 31, high-yield muni bond funds and exchange-traded funds collected nearly $14.8 billion in estimated net flows, Morningstar found. “This is to say that the high-yield muni strategies performed relatively well last year,” said Beth Foos, associate director of fixed income strategies at Morningstar. She noted that credit quality across the municipal bond market has remained strong, and that’s helped to attract investors. “There was a record year of issuance for munis in 2024 after some more lackluster supply years, and you did see that when folks came back to the muni space, they maybe relocated from national intermediate or long-duration funds into something that’s offering a little more yield,” she added. See below for a list of the top five high-yield muni bond funds based on fund size, per Morningstar Direct. These are the top five high-yield muni bond funds based on trailing 12-month returns, per Morningstar Direct. Returns are based on the oldest share class of fund. Taking an active approach Since the muni bond space has a wide array of issuers, and because of the higher default risk relative to bonds with sterling ratings, an ETF or a mutual fund might be the best way for an investor to navigate the space. To that end, BlackRock earlier this month converted its high yield muni fund into an actively managed ETF, now known as the iShares High Yield Muni Active ETF (HIMU) . The fund has a net expense ratio of 0.42% and a 30-day SEC yield of 4.54%. Patrick Haskell, head of the municipal bond group at BlackRock and a portfolio manager on HIMU, noted that many municipalities have a “very strong foundation, but a lot of the sugar rush is off and states that were in a surplus situation are now in a deficit – not many but a few.” His team has used an array of tools to monitor economic activity across the country and to follow natural disasters – issues that would affect municipalities and could unearth buying and selling opportunities. Performing due diligence Even as investors may be better off handing off the responsibility for security selection to a manager, versus hunting for high-yield munis on their own, they will still need to perform due diligence as they pick through different high-yield muni funds and ETFs, according to Morningstar’s Foos. “We spend a lot of time talking to larger managers about the size of their team, how they look at risk, the technology they use, to make sure they have enough qualified resources to understand credit risk and structure,” she said. Investors can start out by analyzing the contents of a fund’s portfolio, getting a better grasp of how many of the holdings are below investment grade and how many are simply not rated. “Those might be OK, but it’s still something to keep in mind that will potentially add to the volatility of returns,” Foos said. Investors should also be aware of how a high-yield muni bond fund might fit into the greater scheme of their portfolio. These offerings have interest rate risk and some element of credit risk, so it’s not really a place to park your idle cash and collect tax-advantaged yield while doing so. “You have to keep in mind that it’s not a substitute for cash or for money markets,” Foos added. Finally, fees are a factor in choosing a fund, as higher expenses will take a chunk out of your returns.
