High-Yield Municipals Look Set to Rise

While some investors compare high-yield municipals to corporate bonds, the two groups are very different. The typical junk corporate bond depends on revenue from a business. During recessions, the number of corporate bankruptcies can climb sharply. In contrast, many tax-free bonds are backed by municipalities, which rarely go bankrupt and almost never disappear.

On average, about 4% of all corporate junk bonds default every year. But municipal default rates tend to be much lower. Studying the performance of municipal bonds over a 22-year period, Standard & Poor's found that of bonds rated BB -- one rung below investment grade -- the number of defaults amounted to only 1.47% of total issues.

High-yield corporate funds are also significantly different than their muni counterparts. Shakier bonds pay higher yields, and many corporate funds reach down for lower-quality credits. Typical corporate high-yield funds emphasize bonds rated B, two steps down the credit ladder from investment grade. Many muni funds take a more cautious approach, holding some stakes in bonds rated BBB, the lowest investment-grade rating.

Partly because of the more conservative stance, high-yield muni funds tend to be less volatile than their corporate competitors as measured by standard deviation, an indication of how much investments bounce up and down.

Despite their relative stability, muni bonds suffered badly as the credit crisis unfolded. Much of the trouble had its roots in trading by hedge funds and other big players last year. In a popular leveraged trade, a hedge fund would buy long-term municipal bonds yielding 4.5%. To finance the transaction, the fund would sell short-term debt, yielding 1.5%, to money market funds. To attract money markets, hedge funds bought coverage for the short-term debt from insurance companies such as Ambac(ABK Quote) and MBIA(MBI Quote).