HYD: I’m A Buyer Of High Yield Munis Going In To 2024 (BATS:HYD)

Main Thesis & Background

The purpose of this article is to evaluate the VanEck Vectors High Yield Municipal Index ETF (BATS:HYD) as an investment option at its current market price. The fund’s objective is to “track the overall performance of the U.S.-dollar-denominated, high-yield, long-term, tax-exempt bond market”.

This has been a reasonable performer in 2023, albeit not giving much in the way of “alpha”. But I saw this as a decent way to reach for yield over the leveraged CEF options – which is generally my preferred way to play the muni sector. In normal years this allows me to capture a higher income stream while still holding IG-rated bonds – because the leverage amplifies the yield. But as my followers know, I was burned in 2022 on leverage and didn’t want to make the same mistake this year. This led me to passive, high yield muni options like HYD, which have offered a modest positive gain this calendar year:

Given this reality I figured it was time to reassess HYD to see if it still warranted holding in my portfolio in the new year. I believe it does, and I will give the reasons why in the following review.

The Caveat: This Is For Individuals With High Tax Rates

To start this review I want to highlight a key point. This is that high yield munis are especially attractive for those who earn a lot of money and/or are in a high tax bracket. This is because there are a host of ways to earn income in this market – whether in munis or corporate bonds, or based on one’s tolerance for lower rated debt. In the case of HYD, investors are exposing themselves to bonds that are generally not rated or rated below investment grade quality. This brings on credit risk that readers need to be aware of, something that is almost a moot point in the IG-rated realm (IG-rated munis rarely default). The same cannot be said for high yield munis.

So, why would one want to take on this risk? The reason is income – specially after-tax income. When we look at the fixed-income landscape right now, we see that yields (and therefore income streams) are up across the board. Munis look attractive based on their own historical norms, but the same can be said for other sectors like treasuries and corporates. In fact, when it comes to munis, those in lower tax brackets may actually be better off reaching for yield elsewhere. But for those in the highest of brackets, muni’s tax-equivalent yields (TEY) are right near the top of the income ladder:

What this shows me is that investors can earn an equivalent yield in munis that they would be going in to emerging market bonds or high yield corporates. While there is nothing inherently “wrong” with these options, I personally prefer munis to these options. At the very least, readers can diversify through this option if they already have exposure to the other options.

But again, as the graphic clearly shows, for certain investors in lower tax brackets, the advantage of munis is not quite as pronounced. So this really depends on each individual’s circumstances and how comfortable they are with other higher yielding sectors. For me, as a working professional in a dual-income household, the benefits of muni’s tax advantages are clear. For my followers, this could be a big advantage, or not, but if so I would suggest consideration of this sector.

Bonds To Benefit From Declining Inflation

My next point considers why bonds more broadly are a good option here. The rationale is simple: inflation has been declining and that is allowing central banks (such as the Fed) to hold off on more interest rate hikes. Since bonds move inversely with rates, the end of a rate hiking path is very favorable for bonds. Fortunately, the sharpness in the decline in inflation (at least domestically), suggests to me that the Fed has plenty of support for taking a more dovish approach:

The takeaway here for me is that now is definitely a good time to begin accumulating bonds or adding to fixed-income positions. The trend of lower inflation has been consistent enough now that I am confident it isn’t going to suddenly spike in the months ahead. Bonds are rarely this attractive, from a historical yield perspective, so I believe readers should be considering them at the moment. This goes for munis – and HYD by extension – as well as a host of other options that are out there.

HYD Is Not “Risk-Free”

It should be clear I see a strong case for fixed-income, munis as a whole, and HYD as a way to amplify one’s income stream. I see this as a sector that is a smart way to take on extra credit risk because defaults tend to be rare. But this doesn’t mean readers should blindly ignore the risks. There are risks with any investment, and HYD is no exception.

Chief among my concerns is the state exposure represented in this fund. The usual suspects top the list, with California as the state with the highest portfolio weighting, as shown below:

This is especially relevant considering the headlines hitting the market right now. Just over the past week, California made some waves by the announcement that the state is facing a massive budget deficit:

This is due to a host of reasons: an increase in the minimum wage for healthcare works, continued tax breaks for certain industries, a loss of Tech jobs (many of which are high paying), and a declining stock market in 2022 that disproportionately hurts California’s tax revenues given the state’s over-reliance on taxing its wealthiest citizens. All of this added up to a backdrop that meant the state is planning to spend more than it is taking in. This is an all-too-common problem in our country from many state governments and the national government.

The good news is that California can survive this deficit in the short-term. This is due to the state having a large “rainy day” fund – which is essentially cash reserves. Many states across the country saw their balances explode due to federal stimulus from Covid-19. While this was fairly common, California was (and is) in a stronger position than most, given how many days it could function just on reserves alone:

The conclusion I am drawing here is not to be alarmist about recent headlines. Is this a risk? Definitely – an one that is elevated compared to the prior couple of years. But California was in good fiscal shape going in to this development, so it stands to reason they have time to figure this out.

It may require some difficult choices to be made down the line, and we probably all have are own opinions on whether the California legislature is going to be able to make those decisions. But in the immediate term, this remains a “watch” item and not one that is big enough to keep me out of a diversified fund like HYD.

Hospital Revenue Bonds An Opportunity?

My final topic of discussion concerns the sector exposure within HYD. One area in particular that is likely to raise eyebrows is the Hospital Revenue weighting:

At 12%, this doesn’t expose investors to a vast degree of risk – but it is still notable enough that investors will want to be bullish on this exposure before buying this fund. This may seem like an interesting spot to be long given all the problems hospitals and healthcare providers had from the pandemic. But the worst of those days are behind us, so a forward-looking view is what is needed now.

With that mindset, there are two factors I see supporting the logic of holding these bonds going forward. One, supply has been fairly tight in 2023. This helps to keep the prices of these bonds high – all other things being equal – because the market has not been flooded with new issues:

This is supportive of resilient pricing for bonds that make up a significant part of HYD’s holdings.

A second reason is that even with all the challenges in the high yield corner of the debt market, munis still tend to hold up very well. We have seen pandemics come and go before and hospitals continue to represent an essential part of a developed world lifestyle. Local, state, and federal governments continue to invest and support these healthcare systems, and I don’t see that changing.

Due to this, defaults in the sector tend to be rare. We know this because, collectively, high yield munis have a long-term average default rate under 7%. This compares extremely favorably to the corporate bond sector:

What I am trying to convey here is that defaults for munis are relatively low in comparison to corporate bonds regardless of the sector and/or credit rating. I would still reiterate that investors need to monitor this risk more carefully with HYD than with other muni options. But the historical default rates, coupled with the low level of supply for hospital-backed bonds, gives me comfort that this is a reasonable place to take on some risk.

Bottom-line

Municipal bonds currently offer yields well above what they have over the last decade, or more. This is unlikely to last as averages have a way of balancing out any short-term imbalance (which I see now in the fixed-income muni market). I am looking ahead to the new year with renewed optimism for muni bonds, but continue to believe passive ETFs and individual issues are the best bet for the sector, rather than leveraged CEFs. The yield curve’s inversion presents a continued challenge for funds that borrow to amplify the yield, so I think going down in credit quality is a better play for the early stages of 2024.

As a result, I would suggest investors in high-tax brackets specifically look at HYD. The fund is diversified by state and sector and offers a compelling tax-adjusted yield for those in the upper tax brackets. Further, default rates for munis are lower than for corporate bonds, even in the below-grade issues. Therefore, I feel confident keeping my “buy” rating in place, and recommend to my followers that they give this idea some thought going forward.