However, for investors willing to dig a bit deeper, opportunities can emerge.

One of them is municipal bonds earmarked for infrastructure opportunities. Infrastructure bonds are a wonderful way for investors to fund public assets and benefit from their cash flows. Offering inflation protection, stability, and potential tax savings, these infrastructure bonds could be a great holding in your portfolio.

Infrastructure can be defined as the physical structures or essential services that facilitate modern society’s orderly operation. Typically, we think of infrastructure assets as transportation-based, such as airports, toll roads, ports, and bridges; energy-focused, such as powerlines, pipelines, and solar farms; or communication-centered facilities, such as cell phone towers, server farms, and satellite dishes. Other areas such as wastewater treatment, warehouses, and even healthcare facilities often fall under the infrastructure umbrella term.

And right now, there is an urgent need to improve access and increase infrastructure in the U.S.

Much of the modern world’s infrastructure is falling apart. Following the post-World War II boom, America and much of the developed world have allowed their bridges, roads, and pipeline capacity to fall into disrepair. The American Society of Civil Engineers (ASCE) rates nearly every category of national infrastructure as “poor.” Globally, it’s a similar phenomenon.

The problem is that amid those low ratings come with reduced Federal spending on infrastructure. While the Biden Administration did increase the amount the Fed directly spent on critical infrastructure, this chart from Eaton Vance illustrates the continued downtrend of Federal infrastructure spending. The jump upward at the end of the chart was the spike due to the Infrastructure Investment and Jobs Act (IIJA).

 
Source: Eaton Vance

There still exists a huge gap between what’s needed and what is spent. The ASCE projects — based on optimistic models and the IIJA’s continued annual spending — a gap of nearly $2.95 trillion over the next decade. Remember, this is in addition to the estimated $7.3 trillion that is projected to be spent.

There is still a huge amount of cash needed to build out and maintain infrastructure.

For states and local municipalities looking to fill the gap, muni bonds have continued to become an ever-more important piece of the pie. For example, this year alone more than $250 billion of debt sold by state and local government borrowers has been earmarked solely for new infrastructure developments. That’s a 30% increase over last year, according to Bloomberg data and Goldman Sachs.

Looking at the total, roughly two-thirds of critical infrastructure (e.g., roads, power grids, water systems, etc.) rely on municipal bonds/funding to be built and maintained.

This is interesting for investors.

For one, many investors simply ignore the elephant in the room. Despite being just 28% of the $3.8 trillion municipal bonds market, general obligation bonds (GOs) are the most popular among retail investors and tend to be what we think of when we define municipal bonds. GO bonds are issued by state or local governments whose repayment is driven by these entities’ taxing authorities. Infrastructure-based revenue bonds are often overlooked.

And, that’s a real shame.

This is because revenue bonds could offer higher yields, better credit profiles and potentially inflation-proof cash flows.

As the name suggests, the cash flows of revenue bonds come from the revenues generated by the underlying project. For example, paying a toll for using a bridge or a fee on your water bill to cover sewer charges. These revenues are strictly tied to the project, not California’s or Texas’s ability to tax its citizens. These cash flows can fluctuate based on usage and how in demand the asset is. This gives them a lower credit rating than a GO bond, and that lower rating doesn’t necessarily increase risk.

Looking at credit ratings, 62% of all general government bonds, which includes GO bonds, are rated investment grade (Aa3 or higher), while only 41% of revenue bonds have that rating. As for defaults, GO bonds rarely go bust. Looking at all the municipal bond defaults from 1970 to 2020, less than 25% have been GO bonds. However, when they do default, they go big. GO bonds were responsible for over 75% of the dollar volume or value of all muni defaults. Meanwhile, recovery rates for many revenue bonds are higher than those for GO defaults. That’s because there is an actual asset that can be sold to recoup bond losses.

These factors make revenue bonds less risky on a dollar-issued basis than GOs. At the same time, they offer a higher yield, which can include inflation-protected additional charges for customers using the underlying asset.

With the need for greater infrastructure spending boosting the fortunes of municipal bonds and many revenue bonds offering strong yields and great risk/reward tenants, it makes sense to bet big on the sector.

There are two ETFs that directly bet on infrastructure-only revenue bonds: the Xtrackers Municipal Infrastructure Revenue Bond ETF (RVNU) and the Goldman Sachs Community Municipal Bonds ETF (GMUN). There is also a closed-end fund, the BNY Mellon Municipal Bond Infrastructure Fund (DMB).
All three funds are fine. However, assets and trading volume are low. A better bet may be one of the many high-yield muni bond ETFs out there. Again, the bulk of revenue bonds are for infrastructure projects. As such, the vast bulk of these fund’s holdings are infrastructure-based. And often, high-yield munis are absent from a portfolio, with many investors thinking the risks are high. However, as we showcased and stated, that’s not necessarily the case.

These funds were selected based on their exposure to the high-yield municipal bond market. They are sorted by their YTD total return, which ranges from 5% to 10.4%. They have assets under management between $80M and $3B and expenses between 0.32% to 1.98%. They are currently yielding between 3.1% and 5.6%.

Ultimately, infrastructure development and municipal bonds go hand-in-hand. And yet, they are often ignored by portfolios and investors. That’s a real shame, as these bonds can offer a lot for portfolios including high yields and lower default rates.

When it comes to raising capital for infrastructure, the municipal bond market is quickly becoming a go-to place for states and local governments. Trading in this market can offer substantial benefits for investors, including high yields, low default rates and strong interest payments based on cash flow.