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What's Going on With Municipal-Bond Funds?

High-yield muni funds are leading the pack. Here are some of our favorites.

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Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Municipal-bond funds have been in pretty steady demand this year. Joining me today to discuss why is Elizabeth Foos. She's a senior analyst in Morningstar's manager research group.

Beth, thank you for being here today.

Elizabeth Foos: Thanks for having me, Susan.

Dziubinski: Let's start by talking a little bit about inflows. Muni-bond funds have enjoyed pretty consistent inflows. In fact, they've seen inflows for the past 16 consecutive months. Why do you think that is?

Foos: I think there are a couple of key drivers that have really been stoking that historic demand for munis in 2021. First of all, overall credit quality in the municipal market is generally pretty strong. Muni issuers have been supported by dramatically improved economic backdrop in the U.S. this year, as well as very generous stimulus packages from the federal government that have really been able to plug those budget gaps when they've come up. And more recently, investors in the U.S. are really recognizing the potential for tax increases in the coming months, if not years. And the tax-free income offered by muni bonds is really attractive.

Dziubinski: Beth, how have muni-bond funds in general performed so far this year?

Foos: I think the rally in munis has really been a bright spot in the fixed-income markets in 2021. And overall, the municipal-bond funds that hold that riskier debt--so, bonds that are more sensitive to interest-rate changes or that have lower credit quality--have really outperformed their taxable counterparts. That trend has waned a little bit in the last few weeks and months, but year to date that's still true.

Dziubinski: And as you alluded to Beth, we've seen that high-yield municipal-bond funds have really done exceptionally well this year. What's been driving that performance?

Foos: Well, again, I think even with some of the more challenged issuers, the credit quality has still remained relatively strong. While valuations have been stretched, portfolio managers are still reporting that there are some deals to be found there, and the yield potential in this particular space just has been more attractive than other fixed-income bonds.

Dziubinski: Beth, we've seen the high-yield muni categories largest strategy Nuveen High Yield Municipal Bond, closed to some new investors, and you don't often see a muni-bond fund close. So, tell us a little bit about what happened there. And is this saying anything larger about the high-yield muni market in general?

Foos: Right, we don't see that very often. But this fund is by far the largest in our high-yield muni Morningstar Category, and it has seen significant inflows, particularly in the past three years. So, the firm did announce that it was going to close to some new investors, basically just to moderate that asset growth. And I think what that's saying, particularly about the high-yield muni market, is although it's very popular, the true high-yield muni space is a very small part of the overall muni market. And it's small, it's opaque, and a lot of the that debt comes to the market unrated. So, it really does require a bond-by-bond review in order to understand all of the risks and potential that these holdings can have for an investor.

Dziubinski: Let's say there's an investor out there who's thinking maybe I do want to sort of dabble in a high-yield muni-bond fund, what are some of the risks that you need to be aware of?

Foos: Good question. Although defaults are historically pretty rare in the municipal-bond market, most of them do occur in the high-yield muni space. The funds that buy these high-yield muni bonds offer higher yields, but, of course, there's more risks associated with that, and there's generally more volatility over a market cycle for investors. So, folks that are interested in managing their tax burden and have a little bit higher risk tolerance might be well served with a muni fund.

Dziubinski: And we rate several high-yield muni-bond funds pretty highly. One example there is T. Rowe Price Tax-Free Yield, which earns our top rating, our top fund Analyst Rating of Gold. Tell us a little bit about that bond and what we like about it.

Foos: Sure. T. Rowe Price Tax-Free High Yield is managed by a very large, very seasoned portfolio and credit analyst team. They use in depth research, bottom-up research, and sophisticated tools to manage the potential and the risk associated with investing in that space. The portfolio won't load up too much on unrated debt or the riskiest parts of the high-yield muni sector, but the lead portfolio manager Jim Murphy does work very closely with his counterparts on the corporate-bond desk there at T. Rowe to manage a corporate-backed muni sleeve, which makes it a little bit unique in the space. And over time, that combination has really served investors well by providing a consistent risk/reward profile.

Dziubinski: And then there are a few other funds that we assigned fund Analyst Ratings of Silver to in this high yield muni-bond category. Tell us about those.

Foos: Sure. There are three other strategies that earn Silver ratings on their cheapest share class. There's American High-Income Muni, BlackRock High Yield Muni, and MFS High Income Municipal Bond. While each portfolio might emphasize different sectors in the municipal-bond space at different times, overall, again, all of these funds are managed by very veteran seasoned teams that do really strong bottom-up research. So, at the end of the day, they really understand the risks of each particular position that they're putting into their municipal-bond fund.

Dziubinski: Well, Beth thank you so much for your time today, not only for updating us on sort of what's going on in the muni-bond landscape but specifically for your focus on that high-yield muni-bond market. We appreciate your time.

Foos: Thanks so much, Susan.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.

Elizabeth Foos does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.