Unique Risks of High-Yield Muni Bonds
In 2008, the typical high-yield municipal bond fund had a total return of > -25%; some of these funds lost > 40%. A large number of these bond offerings are from issuers too small to pay for a credit rating. This bond category is subject to large price swings.
Many of these high-yield bond issuers are from the private sector and are therefore subject to corporate credit risk. For example, a common holding in municipal debt is backed by airlines and used to secure construction at airports. When American Airlines filed for bankruptcy in 2011, a number of tax-free funds holding this debt took a big hit. The health care sector is another popular borrower who is able to use to municipal debt.
Probably the biggest risk with high-yield municipal bond funds is leverage—borrowing large amounts when short-term rates are moderately or substantially lower than long-term debt. When short-term rates rise, the funds that use this kind of leverage suffer. Two funds that do not use leverage in this category are Franklin and T. Rowe Price.