Bond market activity has been relatively volatile, as the market tries to anticipate when – and by how much – the Federal Reserve (Fed) might cut interest rates.
Essentially, there is much less certainty about the timing and direction of the Fed’s next move as economic data and inflation expectations have risen due to potential effects from tariff policies. Within this space, we believe this presents an opportunity for high yield bonds, given that today’s market conditions suggest that the rewards may now outweigh the risks for discerning investors.
The continued strength of fundamentals has led high yield bonds to outperform in both the US Corporate and Municipal sectors, outearning their investment grade (IG) counterparts by 46 bps and 11 bps in municipals, year to date from a total return perspective.1,2
A favorable macro backdrop
The US economy in 2025 is navigating a delicate balance. After a period of aggressive monetary tightening, the Federal Reserve (Fed) has successfully engineered a “soft landing,” avoiding recession while gradually bringing inflation under control.3
The Fed has already cut its benchmark rate by 100 basis points (bps) since late 2024, with the federal funds target range now at 4.25%–4.50%.3 This easing cycle has helped stabilize bond markets and yields, which, while still elevated compared to pre-2022 levels, have begun to settle into a more predictable range.
For muni investors, this environment is particularly constructive. As Treasury yields hover between 3.5% and 5.0%, high yield munis are offering tax-equivalent yields that can exceed 7% for investors in higher tax brackets.3 This spread over Treasuries and its corporate high yield counterparts is not only attractive, it’s historically wide – suggesting potential for both income and capital appreciation.
What is a high yield municipal bond?
A high yield muni is a tax-exempt obligation issued by a governmental entity that is rated below BBB- or not rated by an agency rating. The municipal high yield market offers not only the benefits of tax exemption for a large part of the market but also diversification from the broader global corporate high yield market. The top issuers in the global high yield asset class are typically in consumer cyclical, communications, and energy sectors.
Credit fundamentals remain strong
One of the most common concerns about high yield munis is credit risk. However, the fundamentals of the municipal market remain stable and material credit event filings, which typically point to signs of distress in the credit market, have trended down recently, adding to market stability (Chart 1).
Chart 1. Six-month average of material credit events posted to EMMA
State and local governments have benefited from years of strong tax revenues, federal pandemic aid, and conservative budgeting. Even among lower-rated issuers, defaults remain rare. According to Moody’s, the 10-year cumulative default rate for below-IG munis is just 6.9%, compared to 31.4% for similarly rated corporate bonds.3
Moreover, many high yield muni issuers are in sectors that are counter-cyclical in essential public services, such as charter schools, healthcare facilities, and transportation infrastructure, where demand tends to be stable or growing. These sectors more closely align with essential services, such as tuition, tolls, or service fees, vs. corporate high yield, which can provide a cushion during economic slowdowns, and may explain the historically lower default rates in the space.
Technical tailwinds and supply constraints
Another factor supporting high yield munis in 2025 is the favorable supply-demand dynamic. New issuance of munis has come at a record setting pace thus far this year. Much of that, however, has been in IG municipal, leaving high yield investors hungry for more investment opportunities.
Many issuers refinanced their debt during the ultra-low-rate environment of 2020–2021 and have little incentive to return to the market at today’s higher rates. At the same time, investor demand – especially demand from retail investors and tax-sensitive buyers – remains strong.
We believe such an imbalance has created a technical tailwind for prices. With fewer bonds available and more buyers chasing yield, high yield munis have seen steady inflows. This demand is further amplified by the growing popularity of separately managed accounts (SMAs) and muni ETFs.
Tax advantages amplify returns
One of the more compelling reasons to consider high yield munis is their tax-exempt status, which can translate into significant after-tax yield advantages. State and local governments have generally experienced healthy tax revenue collections and relatively robust rainy-day funds. The favorable financial position of municipalities trickles down into the high yield municipal space as well and provides for a stable economic landscape for investment.
On a taxable-equivalent basis, the Bloomberg High Yield Index yields 9.28% compared to 7.46% in the Corporate High Yield Index.1,2 A spread of 182 bps (vs. an average of 93 bps over the last five years)(Chart 2).
Chart 2. Municipal high yield vs. Corporate high yield
Further, BBB-rated munis offer 7.62% vs. 5.48% BBB-rated corporate bonds – a 213 bps spread – wider than the five-year average of 122 bps (Chart 3).
Chart 3. Municipal BBB vs. Corporate BBB
Thus, represents a historically attractive opportunity for investors to benefit by locking in income at this point in the cycle.
Good total return story
Historically, following periods of elevated yields, munis have often shown attractive relative total return. This is true even in the high yield sector of the market, as high yield municipals have provided an elevated absolute yield that would benefit from capital appreciation in a declining interest rate environment.
We believe high yield munis offer a two-pronged approach to total return:
- Current incomeThe higher coupon payments provide a consistent and attractive income stream, which can be especially beneficial for investors seeking regular payouts or building their retirement nest egg.
- Capital appreciationAs interest rates stabilize and potentially decline in the future, the price of high yield munis is likely to rise. In addition, as many of these securities have become heavily discounted in this high interest rate environment as the securities amortize up to par, investors are likely to benefit as the security gets closer to maturity. This price appreciation, coupled with the ongoing income stream, contributes to a strong total return potential.
Final thoughts
In a market where traditional fixed income options offer modest returns and equities face valuation headwinds, high yield munis stand out as a compelling opportunity. They provide a rare combination of elevated income, tax efficiency, and improving technical and credit conditions. For investors willing to embrace a bit more risk in exchange for potentially higher rewards, now may indeed be a high time to revisit this often-overlooked corner of the bond market. Whether as a core income strategy or a tactical allocation, high yield munis deserve a closer look in 2025.
Endnotes
1 Bloomberg US Corporate High Yield to Bloomberg US Aggregate comparison, June 2025. The Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. The Bloomberg US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market.
2 Bloomberg Municipal Bond: High Yield to Bloomberg U.S. Municipal Index comparison, June 2025. The Bloomberg Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market. HY Muni represents the High Yield Municipal portion of the Bloomberg Municipal Bond Index.
3 "2025 Bond Market Outlook: Yields Range-Bound but Volatile." Morningstar, December 2024. https://www.morningstar.com/bonds/2025-bond-market-outlook-yields-range-bound-volatile.
Important information
Indexes are unmanaged and have been provided for illustrative purposes only. No fees or expenses are reflected. You cannot invest directly in an index.
High yield securities may face additional risks, including economic growth; inflation; liquidity; supply; and externally generated shocks.
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