High-yield munis had a great 2023, but this year may disappoint

Money managers don’t anticipate another banner year for high-yield municipals, one of the best-performing sectors of U.S. debt in 2023.

Junk muni bonds posted a 9.2% advance for the full year, the most since 2019. Returns were buoyed by a lack of high-yield supply and a widespread market rally starting in November. 

The market could look different this year if the Federal Reserve cuts interest rates and muni issuers rush to borrow. A slowing U.S. economy also doesn’t bode well for a sector that’s largely made up of nursing homes, tobacco bonds and charter schools, said John Flahive, head of fixed income at BNY Mellon Wealth Management.

“It’s really hard to get excited about the outlook for some of those sectors,” he said.

His concerns were echoed in a recent survey published by Hilltop Securities, which showed that respondents expect the most defaults in senior living this year. About 45% of those responses were from investors in high-yield munis. 

Flahive doesn’t see high-yield munis replicating their 2023 performance, saying that the rally late last year was likely a rebound from the drop the sector saw during the bond-market downturn in 2022.

Barclays, meanwhile, anticipates supply ticking up moderately and institutional investors gradually returning to risky muni debt to chase yield. Still, it forecasts mid-to-low single digit returns for high-yield munis in 2024.

“We do not expect a repeat of 9% this year,” said Mikhail Foux, head of municipal strategy at Barclays. 

Another catalyst that could impact high-yield performance is the upcoming presidential election, because new economic policies influence portfolio construction, said Max Christiana, portfolio manager at Belle Haven Investments. 

Money managers aren’t just lukewarm about high-yield munis. The outlook for broader muni performance has also dimmed after the securities bounced back during the fourth quarter. Some say the debt has become too expensive and advise investors to exercise caution. 

There are still some investors more bullish than others about high-yield munis. While some sectors of high-yield could be impacted by an economic slowdown, overall it is in a good position to manage through that, said Jennifer Johnston, director of research for Franklin Templeton Fixed Income’s municipal-bond team. 

With interest rates coming down and money sitting on the sidelines, investors will be keen to dive into high yield, she added. 

“If money can start to flow into mutual funds and give investment managers the opportunity to put that money to work, that could certainly drive up performance in high yield,” she said. 

Those inflows are yet to materialize, with investors yanking about $165 million from high-yield muni funds during the week ended Wednesday, according to LSEG Lipper data. This comes after an $8.7 million outflow from such funds during the week ended Dec. 27. 

Overall, investors still recommend prudence given the economic uncertainty ahead.

“Performance in 2024 will certainly hinge on the Fed, and if and when they decide to start cutting rates and how many cuts we will actually see,” said Belle Haven’s Christiana.