What's That Junk Bond Worth Really?

There’s a line from the movie The Last Boy Scout that’s always stuck with me: "Water's wet, the sky is blue..." (gunna add my own spin on it here) ... and market risks, Jimmy, they’re out there and just getting stronger."

That feels about right for today’s high-yield muni market.

Barron’s ran a piece recently (reprinted in the WSJ) titled: "A Mystery in the High-Yield Muni Market: What Are the Riskiest Bonds Worth?" It raised an important question that we ask ourselves often at City Different: Are investors getting paid appropriately for the risks they’re taking?

In the case of high-yield munis, we think the answer is a clear “no.”

Let’s break it down.

A crowded trade that’s only getting riskier

Here’s the first red flag: the growth of the high-yield muni fund complex. As the chart from the article shows, this segment has exploded in size since 2000. Why? Because yield-chasing is a perennial pastime. But in this case, it’s created a crowded trade.

And when too much money flows into a narrow slice of the market, managers only have two choices:

1. Stretch for marginally riskier bonds to maintain the headline yield; or
2. Settle for safer bets that lower the yield — and potentially disappoint investors expecting outsized income.

Guess which path most take?

The result: more risk creeping into portfolios, deal by deal, year by year. And we’re seeing the consequences.

Default Rates Are Rising

The next chart in the WSJ article shows the five-year default rate for risky muni debt. It’s rising… steadily.

That’s not a coincidence. When a market fills up with yield-chasers and managers reaching for risk, you get lower-quality deals being placed more easily. Eventually, some of those break.

So while investors think they’re buying steady income, what they’re actually getting is a structurally riskier vehicle over time.

And they’re not getting paid for it

That’s the part that bothers us most.

Each week, we publish a chart tracking the spread between AAA and BBB municipal bonds. As of July 18, that spread sat at just 0.91% — well below the long-term average of 1.69%. That’s a -0.88 standard deviation event.

We’ve seen the same dynamic in taxable high-yield. That spread is currently 2.74% versus a long-term average of 4.60% — another substantial deviation from normal. In both cases, investors are being underpaid for taking on real credit risk.

So what’s the upside?

And sure, we could nitpick the decision to compare munis to equities… that’s apples to orangutans. But even within the muni space, the performance of funds like Easterly’s RMHIX should raise some eyebrows.

When you factor in rising default rates, thinning spreads, and the fact that muni high-yield isn’t exactly a liquid market… the risk/reward trade-off starts to look pretty lopsided.

The old rules still apply

We’re not trying to be alarmist here — just realistic. There’s no such thing as a free lunch. Caveat emptor. And yes, market risks, Jimmy, they’re still out there.

If you’re allocating to muni high-yield today, do it with eyes wide open. We’re proponents of taking strategic risks… but only when the potential payoff is commensurate with the amount of risk you’re taking on. Because right now, the BBB yield might look sweet… but the juice just might not be worth the squeeze.

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The information contained in this communication has been designed for general informational, illustrative, and educational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy any security. Moreover, the information provided is not intended to provide any investment advice whatsoever. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product, or any non-investment related content, made reference to directly or indirectly in this communication will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. No discussion or information contained herein serves as the provision of, or as a substitute for, personalized investment advice. To the extent that a reader has any questions regarding the applicability above to his/her individual situation of any specific issue discussed, he/she is encouraged to consult with the professional advisor of his/her choosing. City Different Investments is neither a law firm nor a certified public accounting firm and no portion of this content should be construed as legal, tax, or accounting advice. 

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