Still, much of this good news is largely factored into current yield spreads, a measure of valuations. An increase in defaults or downturn in the economy could lead to wider yield spreads and weigh on high-yield municipal bond prices. Although we do not see either posing an immediate risk, higher valuations mean room for error has decreased and investors need to be cautious.

As mentioned in our Midyear Outlook 2016, we expect the 10-year Treasury yield to end the year flat to slightly higher than the current 1.57%, perhaps ending the tailwind of falling interest rates even if not immediately reversing. However, we also don’t expect deterioration in the economy that would lead to sharply higher defaults. Therefore, credit exposure could remain generally supportive of the sector. Last, investor demand for municipals has also been strong and may continue to benefit the broader municipal market, with municipal bond funds recently marking their 42nd consecutive week of inflows, according to Investment Company Institute data.

CONCLUSION

High-yield municipal bonds have had a solid run year to date, aided by strong investor demand for yield, favorable credit quality trends, and greater interest rate sensitivity as bond yields declined. Valuations have richened and yields are near historic lows in response, suggesting caution. Still in a relative world of near record low yields, valuations may remain expensive absent a sharp reversal in credit quality trends or notable increase in interest rates. Both these risks appear muted. We remain neutral on the sector overall, expecting lower returns over the second half of the year.

Anthony Valeri is fixed-income and investment strategist for LPL Financial.

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