High-Yield Munis Win in 2018, but Risks Remain

Alaina Bompiedi: 2018 was a trying year for both equity and bond markets, with just a fifth of the Morningstar categories posting gains. Within that exclusive winner's circle was the high-yield muni category, which returned just over 2%, making it the third best performing category for 2018.

The relative success of high-yield munis during a time of stock and bond market weakness could make it attractive as a portfolio diversifier. But to know if it's appropriate for your portfolio, it is imperative to understand the that factors drove the category's 2018 performance, and the risks embedded within it.

First, the high-yield muni market is small, fragmented, and generally less-liquid than the investment-grade muni space. Second, because many high-yield municipal indexes are market-cap weighted, they show pronounced tilts to Puerto Rico bonds and tobacco settlement authorities, which are some of the most prolific issuers of low-quality municipal debt.

As of December, these two sectors comprised close to 20% of the Bloomberg-Barclays High Yield Municipal index. In 2018, that index gained a boost from the outperformance of its Puerto Rico holdings, which returned 20%, driven by performance in the Commonwealth's Aquaduct and Sewer Authority bonds, which gained 30% as the authority cooperated with bondholders and narrowed its funding gap. This event was a surprise, and illustrates a third risk within this category: One-off events can have an outsize impact on the performance of high yield muni benchmarks.

Taken together, these risks illustrate that careful and prudent active management is ever important in this space.