Muni Bonds predicted the last market crash, and now they are saying this...

Bad things happen when people misprice risk. 

From the credit crisis of 2008, to the tech bubble of 2000, to the panic of 1873, all are the product of human misjudgement regarding risk.

Below, I present evidence of a current mispricing in one corner of the credit market. This same phenomena preceded nearly every equity market correction over the past thirty years.

I used to work in Municipal Bonds, both buyside (mutual fund shop) and sell-side (bank trading desk). I now follow muni bonds as an allocator at a family office.

High yield munis have a greater yield than investment grade munis. 

How much more yield? Glad you asked...

High yield muni bond funds have been around for a long time. MFS Municipal High Income (MMHYX) has been around since 1984. We can compare the yield on this fund to an investment grade fund, Vanguard Long-Term Tax-Exempt (VWLTX), to get a sense for "How Much More Yield".

Over the past 30 years, high yield munis have yielded 124% of investment grade muni bonds, on average. This ratio is illustrated below. The lower the line, the less investors are being paid to take on high yield credit risk. 

What is the current yield ratio?
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115% and dropping, compared to a long term average of 124%.

Relative to investment grade munis, high yield is very, very expensive. Mispriced risk, illustrated.

Perhaps something has changed over the past few years to make high yield muni credit fundamentally less risky than it has been in the past, but I doubt it. In fact, with the reduced role of municipal bond insurers since the credit crisis, muni bonds are likely more risky.
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You may be thinking... so what if high yield munis are overvalued, just don't buy them. 

Yes, but notice what happens to the equity markets when the yield ratio gets to 115% or lower.

​1987:

1990:

1998:

2007:

2016?

So muni bond yield ratios predict stock market corrections? Not really. I would say that over-reaching for yield tends to happen before inflection points in the market. Investors stop respecting risk, and then they pay.

Right now, if high yield muni investors are over-reaching, you can bet some other investors are too. If you want to learn more about high yield municipal bond,I recommend this book.
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The obvious answer: buy gold and bury it in your backyard.

In all seriousness, make sure you are being compensated for the risks you are taking... check your asset allocation, it might be time for a rebalance.

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I am my own worst critic, so here are a few critiques of the above analysis:

• MFS Municipal High Income (MMHYX)  is not a perfect proxy for the Muni HY market. It's actively managed, so that brings some bias into it. ​ However, no HY Muni index funds go back to the mid 80's. If you used an index fund, it would tell the same story, but with shorter time frame.
• TTM yields are not the best measurement of yield.  Yield to worst would be better, but I don't have that historical data. 
• Ideally MMHYX and VWLTX would be very similar except credit quality. They are not, and that  brings in some bias. For example, MMHYX currently has an effective duration of 7.43, while VWLTX has a duration of 6.38. There are likely numerous examples one could find that show this is not an perfect apples-to-apple comparison.