Two Muni Funds Pay the Price for Extreme Credit Risk

A recent crisis involving a couple of small high-yield municipal bond mutual funds hammers home the eternal lesson about extreme credit risk : It works, until it doesn't work.

Bond investors take credit risk when they buy speculative-grade bonds -- bonds issued by financially fragile entities, making it conceivable that they will fail to pay interest and repay principal in full and on time. The enticement for taking credit risk is that these junk bonds have high yields. As long as the issuers don't default, high-yield bonds can outperform investment-grade bonds, which don't yield as much.

The problem is that issuers sometimes do default. And when they do, not only do investors lose the payments from those bonds, they may also lose the ability to sell those bonds, even at extremely low prices. Meanwhile, the prospect of additional defaults may make it tough to find buyers for other extremely risky bonds. ...