By the end of July, investors had poured $6.8 billion into the high-yield tax-free funds. This is a record amount since just before 2008 when the funds received $8.2 billion of investors’ attention. This also places them on par with emerging markets funds as the income producer of choice.
 
The high returns fly in the face of the municipal bankruptcies that have increasingly occurred. The reason is that high yield municipal bonds are generally removed from the problems municipalities have that put pressure on higher quality bonds like government obligation bonds.
 
The high yield market finances different projects than government obligation bonds. These include nursing homes, infrastructure projects, or housing for the disabled, among others. The money generated from these projects is used to pay the coupon rates on the bonds.
 
These bonds are much more dependent on the economy than on municipalities’ fiscal health. It wouldn’t a big economic turn for the worse to cause the high yield market to fall out of bed. In 2008, the funds dropped an average of 40% more than the S&P 500.
 
They also were down an average 25% for that year compared to only a negative 3% for the Barclays Aggregate Bond Index.
 
Such swings are more than many conservative investors—those who typically invest in bond funds—can handle. This is where knowing your client, especially from the behavioral finance perspective—will make you a much more trusted advisor.

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