Every investment has some degree of risk and, in exchange, the owner of the investment should be rewarded with a higher potential for gain. A Certificate of Deposit, for example, has a very low level of risk but offers very minimal gain in the form of a fixed interest rate. A technology stock, on the other hand, has much more risk but considerably more upside.

Typically, investors see municipal bonds as a relatively conservative investment with the purpose of distributing tax-free income until the bond matures. However, not all municipal bonds are created equal and there are various risks versus rewards for each bond.

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Municipal bonds are broken down into two categories: investment grade and high yield. To determine the risk of a particular bond issue, an investor should examine the bond’s credit ratings from various rating agencies. Investment-grade bonds are bonds that are rated BBB or higher by Standard & Poor’s or Baa or higher by Moody’s Investors Service.

Bonds that are rated BB or Ba are considered below investment grade and referred to as high yield or junk. With this lower rating, high-yield bonds typically have a much higher coupon payment than a comparable investment-grade bond of the same maturity. This is to compensate investors who are taking the extra risk in investing in a lower quality bond.

Let us consider an example to compare risk versus reward in investment terms. Vanguard offers both investment-grade and high-yield municipal bond funds. The Vanguard Long-Term Tax-Exempt Fund Investor Shares (VWLTX) has a stated average maturity of 16.8 years, an SEC yield of 2.76% and an A average credit rating. The Vanguard High-Yield Tax-Exempt Fund Investor Shares (VWAHX) has a stated average maturity of 17.8 years and an average credit quality of BBB. Although this is still considered the low-end of investment grade, the fund compensates its shareholders with a higher SEC yield of 3.15%. In this comparison, VWLTX has one step higher in credit quality but yields 0.39% less than VWAHX.

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Bonds are rated based on the revenue they generate to make principal and interest payments, and based on any assets pledged to secure the bond. As an investor, this is extremely important to understand how this works and how this could affect the principal value of the bond.

Most investment-grade municipal bonds tend to be general obligation bonds, which are backed by the credit and taxing power of the issuing jurisdiction. Revenue bonds, which are typically what most high-yield bonds consist of, are backed by the revenue stream from a given project. At the same time, if the project faces issues generating the minimum levels of revenue to support debt commitments, the bonds could inevitably default on interest payments. However, many high-yield bonds have security features like tax liens to help secure the revenue in the event of a default.

This is better understood with the help of a recent example.

Over the last few years, Puerto Rico was in the news because of its inability to cover interest payments on its municipal bonds. As a result, the outstanding issues were downgraded from BBB- to a junk rating. Ever since then, owners of Puerto Rican municipal bond debt have seen their bond’s value drop from the $100 par value to as low as $20.80, a decrease of nearly 80%. Although Puerto Rico has not yet officially defaulted, many of its debtholders have taken a loss by selling their municipal bonds or by continuing to wait in hopes of a recovery.

Essentially, a high-yield bond that defaults could see the principal value completely wiped out or go through time-consuming bankruptcy proceedings.

From a buyer’s perspective, high-yield bonds could provide a lot of upside potential. In the same scenario, investors were buying Puerto Rico bonds at $20.80 per bond and saw it increase to as much as $45 per bond, equal to more than a 100% gain. In this case, bond purchasers bought the bonds at an extreme discount and were hoping to either sell at an appreciated price or to collect the coupon payments that are very high in relation to the bond’s current value. Some Puerto Rican bonds are yielding more than 8%, much higher than any investment-grade bonds available in the marketplace.

As part of a diversified portfolio, municipal bonds should be bought in various sectors as well. High-yield munis tend to be consistent with a particular sector. For instance, the healthcare and tobacco sectors tend to have higher yields because they have a lower credit rating. However, healthcare could provide a lot of opportunity with the influx of Baby Boomers eventually needing to go into healthcare facilities and hospitals. Other high-yield sectors typically include tax-backed, education, transportation and toll roads, and industrial development.

Another opportunity for high-yield munis is that their volatility can be used to an investor’s advantage. This can be advantageous in taxable accounts for investors looking to capitalize on realized gains or losses while tax harvesting at year end. Typically, in times of extreme volatility, when municipal bond yields spike and bond prices drop, the bond recovers typically within 12 months. Speculative investors who are willing to wait 12 months could find muni bonds that are yielding new highs and benefit both with high interest payments and bond price appreciation.

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High-yield municipal bonds are attractive to income investors looking for higher yields. However, with that extra yield comes extra risk. Like any investment, high-yield muni bonds should be part of a larger portfolio that is well diversified across many asset classes and sectors. Investors who are interested in owning high-yield municipal bond funds should do their due diligence before purchase. For investors looking for exposure to that asset class, using a high-yield muni bond fund or ETF might be a more viable option, thus spreading out the risk over many different issues.

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