High Yield Municipal Bonds: A Contrarian Play in a Shifting Credit Landscape

The municipal bond market, long a haven for tax-sensitive income seekers, is entering a phase of recalibration. While the Bloomberg Municipal Bond Index closed the second quarter of 2025 with a modest -0.12% return, the sector's underlying credit fundamentals remain robust. This divergence between performance and fundamentals creates a compelling contrarian opportunity—particularly for investors willing to focus on high-yield municipal bonds that have recently received credit upgrades.

The Case for Contrarian Entry

Consider Gloucester County, New Jersey, which in June 2025 was upgraded to Aaa by Moody's—a rare feat in a market where upgrades have slowed compared to previous years. The county's upgrade reflects a blend of fiscal prudence and economic resilience: strong property tax revenues, a 36% reserve cushion, and a growing economy anchored by institutions like Rowan University. Such cases highlight how municipalities with sound governance can outperform broader market trends, even as sectors like airports and non-profits face negative outlooks.

The municipal bond market's credit quality remains historically strong, with 72% of bonds rated AAA/Aaa or AA/Aa. Yet, the yield-to-worst (YTW) for the Bloomberg Municipal Bond Index now stands at 4%, a level that becomes even more attractive after accounting for tax advantages. For investors in federal tax brackets above 22%, munis offer a yield parity with corporate bonds at lower risk—a rare arbitrage in today's environment.

Strategic Entry Points and Risk-Adjusted Returns

The key to capitalizing on this opportunity lies in timing and selection. The recent volatility in muni yields—spiked by the U.S. credit downgrade in May and tariff announcements—has created temporary dislocations. For example, the 10-year muni-to-Treasury spread widened to 150 basis points in June, the highest since 2023. This steepening of the yield curve suggests that investors are being compensated for taking on duration risk, a critical consideration for those seeking to lock in long-term income.

High-yield municipal bonds, while carrying more credit risk, have proven resilient. The Bloomberg Municipal Bond High Yield Index returned -1.14% in Q2 2025, but this underperformance masked the fact that spreads for high-quality high-yield bonds (those upgraded in the past 12 months) narrowed by 20 basis points. This suggests that the market is beginning to price in improved credit fundamentals, particularly in sectors like education and infrastructure.

Long-Term Income Potential

For income-starved investors, the tax-exempt nature of municipal bonds is a powerful tailwind. Take a hypothetical $1 million portfolio in a 32% tax bracket: a 4% muni yield translates to an after-tax return of 5.88%, outpacing most taxable corporate bonds. This is especially valuable in a world where Treasury yields have plateaued and dividend stocks face earnings pressures.

Moreover, the recent assurance of the muni tax exemption through the “One Big Beautiful Bill Act” (passed July 4, 2025) has stabilized investor sentiment. While the act introduced fiscal headwinds for Medicaid-dependent sectors, it also removed a major overhang on the market. This policy clarity should drive a re-rating of high-quality munis, particularly those in sectors like healthcare and education that have seen upgrades.

Risks and Mitigation Strategies

The contrarian argument is not without caveats. Sectors like airports and ports face negative outlooks due to tariffs and reduced trade volumes, while Medicaid cuts could pressure hospital systems. However, the broader municipal market's credit strength—bolstered by 34 states with reserves sufficient to absorb a 10% revenue drop—provides a buffer.

To mitigate risk, investors should prioritize high-rated issuers with strong liquidity and diversified revenue streams. For example, Gloucester County's 57% liquidity ratio (revenue held in reserves) offers a model of fiscal conservatism. Additionally, limiting exposure to lower-rated bonds (below AA) and maintaining an average portfolio duration of 6.5 years (in line with the Bloomberg Municipal Bond Index) can balance yield capture with risk management.

Conclusion

The municipal bond market is at an inflection point. While macroeconomic uncertainties persist, the recent credit upgrades and stable fundamentals create a unique entry window for income-focused investors. By focusing on high-quality high-yield munis—those recently upgraded and insulated from sector-specific risks—investors can access a rare combination of tax-advantaged income and risk-adjusted returns. As the market digests the “One Big Beautiful Bill Act” and stabilizes post-tariff volatility, now is the time to consider a strategic allocation to this overlooked corner of the fixed-income universe.