Municipal bonds are a favorite choice for high-income investors, but those on the hunt for juicier returns are venturing into riskier territory. The high-yield segment of the muni bond market includes offerings with ratings below investment grade—meaning they fall under a BBB rating from Standard & Poor’s. Naturally, this leads to a higher chance of defaults and missed interest payments compared to the highly-rated AAA bonds. Yet, for those willing to embrace a little more risk, the rewards can be substantial. By January 31, data from Morningstar Direct showed that the U.S. high-yield muni bond fund category delivered an impressive average 12-month return of 5.22%. In contrast, U.S. national muni bond funds with an intermediate duration of four to six years averaged a return of only 2.38%. As an added bonus, the interest earnings from municipal bonds are sheltered from federal income taxes and also state taxes, provided the investor lives in the state where the bonds are issued.
Last year’s results were particularly strong, drawing an estimated $14.8 billion in net inflows to high-yield muni bond funds and exchange-traded funds by January 31, according to Morningstar. “High-yield muni strategies performed solidly over the past year,” said Beth Foos, associate director of fixed income strategies at Morningstar. She mentioned that the overall credit quality of the municipal bond market has remained robust, helping to draw in investors. “After a record issuance year for munis in 2024 following several years of lower supply, people shifted from national intermediate or long-duration funds to options offering higher yields,” she noted.
Below, you’ll find a list of the top five high-yield muni bond funds based on their size, as tracked by Morningstar Direct. These funds have also been ranked according to their trailing 12-month returns based on the oldest share class of the fund.
Given the diversity of issuers in the muni bond space and the increased default risk compared to higher-rated bonds, opting for an ETF or mutual fund can be an effective strategy. BlackRock has adapted to this environment by converting its high yield muni fund into an actively managed ETF named the iShares High Yield Muni Active ETF (HIMU). The fund has a net expense ratio of 0.42% and a 30-day SEC yield of 4.54%. Patrick Haskell, who leads BlackRock’s municipal bond group and manages HIMU, pointed out that while many municipalities have a “very strong foundation,” a few states that previously enjoyed budget surpluses are now experiencing deficits. His team employs a range of tools to track economic activity and monitor natural disasters, events that might affect municipalities and offer unique buying or selling opportunities.
Even though letting a manager handle security selection could be advantageous, due diligence remains crucial when choosing high-yield muni funds and ETFs, emphasized Morningstar’s Foos. “We frequently engage with larger managers to discuss their team size, risk assessment strategies, technology use, and to ensure they have adequate resources to comprehend credit risk and structure,” she explained. Investors should assess a fund’s holdings to determine how many are below investment grade or simply unrated. “These factors could be manageable, but they can nevertheless introduce return volatility,” Foos advised.
As you consider how a high-yield muni bond fund complements your broader investment portfolio, remember that these investments carry interest rate and credit risks, meaning they aren’t suitable as cash substitutes or mere tax-advantaged yield vehicles. “It’s important to recognize that these aren’t replacements for cash or money market funds,” Foos added. Lastly, be mindful of the fees involved, as they can significantly impact your overall returns.
