High Yield Municipal Bonds: An Attractive Choice for Risk-Adjusted Return

High yield municipal bonds have lagged their investment-grade counterparts over the past year, primarily due to technical and volatility-driven factors, rather than any issues with municipal bond market credit fundamentals. These dynamics are not unusual during short-term periods of uncertainty.

Historically, however, such divergences have tended to be temporary. Looking beyond the short term, lower-rated municipal bonds have consistently outperformed investment-grade municipals across longer trailing periods. As Figure 1 shows, over three-, five-, 10-, and 15-year horizons, high yield municipals have led investment-grade municipals by a meaningful margin. 

More broadly, this outperformance of credit is not uncommon. Across many segments of the fixed income market, various credit products have provided excess returns with minimal actual losses from defaults. High yield corporate bonds, in particular, have become a strategic allocation in investor portfolios over the last few decades, as investors have increasingly recognized their ability to deliver attractive income and excess return relative to the underlying risk.

We believe high yield municipal bonds can be viewed through a similar lens and, for many investors, may serve as a complementary allocation alongside taxable high yield. Municipal bonds have historically offered attractive compensation per unit of default risk, particularly in non-qualified portfolios. In a study on default risk in the municipal market, Michael Schwert found that municipal bonds’ “average default spread and the extremely low historical default rate imply a default risk premium that is an order of magnitude larger than estimates of the risk premium in the corporate bond market.” ¹

In this paper, we will take a closer look at this opportunity—and how investors can potentially take advantage of it. Let’s start by breaking down the components of this excess credit compensation.

1. Default rates: Looking at average cumulative default rates of municipal bonds compared to corporate bonds, we see part of the picture. Lower-rated, investment-grade municipals have recorded default rates anywhere from one-twentieth to under one-third of those experienced by lower-rated, investment-grade corporates over the last 50 years, while high yield municipals have seen defaults at about one-fourth of the rate of their corporate counterparts.

At a high level, the lower default rate of municipal credit is intuitive—some issuers in this high yield space are backed by corporations that provide essential services or produce materials critical to infrastructure, energy procurement, and global stability. Other high yield municipal issuers include hospital systems, charter schools, regional colleges, and even some with dedicated tax revenues, such as sales tax and hotel taxes, which are used to repay bondholders. In higher-quality municipals, the market is made up of a range of sectors including toll roads, airports, electric utilities, schools, hospitals, and state and local governments. These are not subsectors of the economy one would typically label as “cyclical,” which can be beneficial no matter how the overall economy performs. This relative stability helps support the strong historical default experience observed in municipal credit.

Figure 2 offers a closer look at munis’ default experience versus corporates. Keep in mind that the data is cumulative over a 10-year period. In other words, A-rated municipal bonds have averaged about one basis point, or 0.01%, of defaults a year over a decade. 

2. Recovery rates: When municipals have defaulted, investors have realized greater recovery rates than those for corporate bonds. This is partially due to the fact that many municipal bonds are secured by revenue streams from real assets or state and local governments with substantial taxing authority. The issuer most often cannot just shut down like a corporation, so they can continue to pay some amount of interest. Figure 3 shows data from Moody’s comparing recovery rates of municipal bonds to those of senior unsecured corporates.

3. Yields: With fewer defaults and higher recoveries, one might surmise that municipal credit should carry meaningfully lower yields than corporates for a given rating. While corporates provide more compensation in the lower-quality, investment-grade and non-investment-grade segments relative to their municipal counterparts, based upon the stated yield on the bonds, investors may be surprised that the differential is not greater and actually is often smaller when considering how much of the income is subject to taxation. When adjusted for the tax-exempt nature of municipal income, things look a lot more interesting.² Credit spreads reflect a similar dynamic.  

Considering that municipals and corporates are graded by the same lettered credit ratings, and corporates have default rates many times higher than municipals (in the case of A-rated bonds, almost 20x) and lower recovery rates, we observe an inefficiency here: The compensation per unit of credit risk in tax-exempt debt appears abnormally large.

4. Performance: It’s no surprise that given the factors we’ve detailed here, high yield municipals generate comparable returns over the long term relative to high yield corporates. Keep in mind however, these returns are before taxes. When grossing up the coupon component of municipal bonds’ return, since they are not subject to federal income tax, and in some cases, state taxes, high yield municipal bonds become even more attractive.  

5. Risk-adjusted returns: Any true market inefficiency is best illustrated by risk-adjusted returns. Looking across the fixed income universe, Figure 6 shows that the Sharpe Ratio for high yield municipals (when adjusted for municipal bonds’ tax-free income) is competitive relative to many major fixed income sectors, particularly on a tax-equivalent basis.  

A Deeper Dive into Historical High Yield Muni Outperformance 

Academics have hypothesized why this opportunity exists. Most theories are rooted in the inefficiencies of the market and the dominance of individual rather than institutional investors in parts of the municipal market, due to the tax exemption that affects various investors differently and does not benefit institutions as much.

How do these differences play out? Institutional investors, who are at most taxed at roughly half the rate of the highest-earning individuals, tend to be less involved in the tax-exempt market compared to taxable bond markets. Furthermore, municipal investors who receive the maximum tax benefit are predominantly higher earning and potentially more financially conservative individuals. They often do not want to take as much credit risk to achieve an attractive, higher level of tax-free income and prefer to take more risk in other investment opportunities.

So, with a lower prevalence of more sophisticated investors and above-average concentration of cautious buyers, these lower-quality muni investments, which require more skill to evaluate, may receive less attention meaning lower demand. Geography may also play a role, as some retail investors might only be interested in bonds in their home state, given the exemption from state tax as well, further segmenting the market. In addition, financial media outlets typically focus more attention on corporate issuers, so there is less information flowing to individual investors, which makes it harder for them to understand the investments. Finally, liquidity may play a part here, but factors like active management, diversification, and the correct vehicle can help mitigate some of this.

One final note about high yield munis’ historically attractive performance: It has been achieved throughout various interest-rate environments, including the rise in rates in the first 10 months of 2022 and their subsequent decline. One approach that has not yielded favorable results has been market timing, where investors sell bonds in anticipation of rate moves. As we have noted in the past, such maneuvers have typically led to underperformance in high yield muni portfolios. History has shown that a long-term orientation, one that eschews market timing, has led to better results for investors in the asset class. Also, high yield municipal bonds do not trade as frequently as their corporate counterparts, so it may be tough to reestablish a bond position, after selling in an effort to time the market.

In this context, high yield municipal bonds may represent a complementary extension of this broader credit allocation for investors seeking tax-efficient income.

The Current Opportunity

Whatever the reason, these findings illustrate the opportunity in municipal credit and make a strong case for lower-quality parts of the market. We believe lower-rated municipal bonds can play a valuable role within a broader fixed income allocation for high-income investors. This includes portfolios that already include an allocation to taxable high yield, where municipal credit can enhance after-tax income and diversification. The larger risk premium these bonds offer brings an opportunity for high earners to optimize their portfolios, capturing enhanced income and returns while benefiting from the tax advantages inherent to municipal bonds.

We recommend taking advantage of this through an actively managed portfolio run by seasoned municipal investors with decades of experience, diversified by hundreds of these independent credit positions and supported by a deep bench of dedicated research analysts with expertise in the various industries and geographies of the lower-quality municipal market. Additionally, it is important to remember that not all high yield municipal funds are created the same. Many in the High Yield Muni Morningstar category allocate roughly half of assets to non-investment-grade bonds, so investors may not be getting the exposure to lower-rated munis they expect.

In our view, today’s environment makes for an attractive entry point in the asset class, as the market fundamentals are near the strongest levels in recent history, and yields are just off historically high levels. With the Bloomberg High Yield Municipal Index yielding over 5.5% as of January 31, 2026, this brings a tax-equivalent yield approaching double digits. In other words, an investor locking in today’s attractive yields on lower-rated municipal bonds has the opportunity to position their portfolio to capture attractive income and strong risk-adjusted return potential.