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High-Yield Municipal Debt and Its Inherent Risks

High-yield municipal debt has become an increasingly attractive investment vehicle for fixed-income investors – and with good reason. For the three years ending Oct. 31, funds in that sector returned an average of 9.1% a year, according to Morningstar.

The positive returns do not come without their share of risks, however. And, all too often, investors may be unaware of those potential risks. As reported Nov. 5 by the Wall Street Journal, some of the risks associated with high-yield municipal debt include liquidity issues.

The size of the high-yield muni market is $65 billion, which represents only a small portion of the total municipal market. Moreover, many individual issues are small. “It can be difficult to buy in or sell out,” said James Colby, a senior municipal strategist, in the Wall Street Journal article.

Default rates are another issue facing investors of high-yield municipal debt. Since 1970, the cumulative default rate for high-yield muni debt has been 7.94%. By comparison, Moody’s says the cumulative default rate for investment-grade muni debt - i.e. issues with credit ratings from triple-A to triple-B – is 0.08%.

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