Are Unrated Municipal Bonds a Hidden Gem for Fixed-Income Investors?

Are Unrated Municipal Bonds a Hidden Gem for Fixed-Income Investors?

The last few years haven’t exactly been kind to fixed-income investors. In 2020, responding to the liquidity crisis of the COVID pandemic, the US Federal Reserve pushed interest rates to their lowest levels since the Great Recession. Subsequently, inflation began to bound upward, as the abundant money supply chased goods made scarce by supply-chain disruptions. Now that inflation seems to be receding and the Fed is making tentative noises about allowing rates to fall, bond yields may begin dropping—favorable for those already holding bonds issued at higher coupon rates, but more problematic for those who want/need investments that to generate steady income.

What’s a fixed-income investor in search of total return supposed to do? Part of the answer may involve taking another careful look at a sector of the high-yield bond market that is ignored by many: unrated municipal bonds.

It’s important to state at the outset that these bonds are often considered as equivalent to high-yield corporate debt, more often known by the more ominous moniker, “junk bonds.” But there are some important distinctions to be made.

First, some basics. Most probably know that the interest paid on state and municipal debt obligations (“munis”) is exempt from federal income tax. Thus, persons in higher tax brackets may benefit from generating a portion of their income with munis. And if the obligations are issued by a governmental entity outside the state where the bondholder resides (or if the bondholder lives in a place with no state or local income tax), the income may be completely tax-free. Like other debt obligations, most munis are rated by one or more of the major credit-rating agencies, like Moody’s, Standard & Poor’s, and Fitch. Typically, obligations with the strongest credit receive a AAA rating, while less creditworthy bonds may have a rating of B or C; bonds in default are rated D. The lower the rating, the more the issuer must pay in interest, to compensate bondholders for assuming a higher risk of default. Generally, bonds rated BB or lower are considered “non-investment grade,” or “junk bonds.”

However, some state and municipal issuers may occasionally choose to issue bonds without seeking a rating. According to a 2022 study sponsored by the FDIC’s Center for Financial Research, some 34% of local municipal issues from 1999 to 2017 were issued with no rating. Issuers may do this for several reasons: saving the cost of the rating review process; a small issue intended to fund a limited purpose; a municipality with a lower tax base or a high liability-to-asset ratio; and others. Unrated bonds are considered to be in the same category as high-yield bonds: they carry a higher risk of default.

On the other hand, with proper research and management, unrated munis can add significant value to the portfolios of investors who understand and are able to accept the additional risks involved. For one thing, the high-yield municipal sector has been one of the better performers thus far in 2024, according to some analysts. If the economy continues to display the resilience it has shown over the past year, and if interest rates either remain steady or begin to fall, as some comments from the Fed seem to indicate, high-yield munis, including unrated bonds, could become a source of both higher levels of current income (remember the “high-yield” label) and total return (bond yields tend to move roughly in parallel with interest rates, and when yields fall, bond prices rise).

Of course, there are downsides to be considered. Likely at the top of most fixed-income investors’ lists is the risk of default. This is one area where the difference between high-yield corporate debt—junk bonds—and high-yield municipal debt is most clear. Since 2013, the average five-year cumulative default rate (CDR) for municipals is 0.08%, a rate that has been consistent since 1970. By contrast, a recent forecast by S&P Global suggested that default rates for below-investment-grade corporate bonds may reach as high as 4.75% by the end of 2024. In this connection, it’s also important to remember one of the major differences between federal and state/municipal debt: the states and local governments are typically required to balance their budgets. Because of this, state and local debt-to-income ratios have remained relatively stable over the past 50 years, according to a study by the Brookings Institution’s Tax Policy Center.

Liquidity can be another concern. Because the universe of unrated munis is rather small by comparison to the entire fixed-income market, appropriate issues are harder to find and, when it’s time to sell, there could be fewer buyers.

For these and other reasons, many investors may prefer to take a managed approach to unrated and other high-yield municipal bonds. Bond funds and ETFs specializing in high-yield and unrated municipal debt may provide opportunities for capturing desirable current yields along with potential for total return from appreciating bond prices. Such holdings also afford access to dedicated fund managers and in-depth research into the specific circumstances, capabilities, and credit-worthiness of bond issuers, partially relieving the individual investor of the responsibility for choosing appropriate individual issues.

Bondurant Investment Advisory (“BIA”), believes this is an attractive category and we have identified a manager investing in high yield non-rated municipal bonds that provides an attractive risk/return for clients in high income tax brackets.

At BIA we are always looking for ways to help our clients meet their most important financial goals. By combining expertise and empirical, fact-based research with our ongoing commitment to putting the client’s best interest first in all things, we can design custom-built solutions for your most pressing financial goals. To learn more about our investment philosophy, please visit our website.

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