It happens every time interest rates stay low for any sustained period of time:  people freak out and look for yield.  No longer satisfied with the returns of FDIC insured bank CDs. many people who have no business doing so decide to take on more risk by reaching for yield.  Well, let me rephrase that.  Many of them reach for yield not knowing the risks involved.  And thats a recipe for disaster.  And these are the same people who will lecture greedy bank CEOs about taking on too much risk

High Yield Municipal Bonds Are Riskier Than You Think

Many people consider municipal bonds. bonds issued by state and local governments to pay for public works projects, to be one step below U.S. Treasury Bonds in their safety.  And there may be some truth to this belief.  In a 2003 study on municipal bond default rates over the 1980-2002 period, Fitch Ratings found that municipal bonds issued before 1986 had a 1.5% default rate while municipal bonds issued after 1986 was 0.63%.  The decrease was attributed to the Tax Reform Act of 1986. which among other things restricted the issuance of poorly-performing tax-free industrial development bonds.

Still, a 1.5% default rate is significant.  High yield municipal bonds, being generally of lower quality than high-grade municipal bonds, have an even higher default rate, perhaps twice as high.  In fact in some segments the cumulative municipal bond default rate reached 17.02% (non-hospital health care bonds), 14.62% (Industrial revenue bonds), and 5.72% (multi-family housing bonds);  sectors high yield municipal bonds funds are more likely than average to own.

Some people cite the solid performance of Vanguards High Yield Tax Exempt bond fund (VWAHX ) as evidence of the safety high yield municipal bonds can offer.  What they dont seem to be aware of, though, is that the Vanguard fund keeps between 70-75% of its assets in high-grade municipal bonds, only dipping its toe in the higher-yielding but riskier lower credit tiers.  Though it has High Yield in the name, this fund is not really a high yield municipal bond fund.  Its more of a low-investment-grade fund.

Californias Debt Downgraded, Outlook Negative

Barely 3 weeks ago, Standard & Poors downgraded Californias credit rating to A-, just barely a step above the lowest investment-grade rung, in light of a $20 billion budget deficit.  The company also said it had a negative outlook on California debt, meaning theres a distinct possibility of further downgrades.  So yes, municipal bonds are backed by the taxing power of the issuing government and the best municipal bonds are probably more resilient than most corporate bonds.  Still, you can only raise taxes so much without choking off economic debt.

So while municipal bond default rates do tend to be lower than their corporate counterparts, defaults are also not unheard of.  If safety is your main criteria, you would do well to stick with an FDIC insured savings account like ING Direct or high yield CD .  Investors who reach for yield without considering the risk are often burned.  Dont be one of those investors.