(Money Magazine) -- I'm a senior citizen with ample monthly income and have about $20,000 maturing in a CD. Would it be wise for me to put this extra money into a highly rated high-yield municipal bond fund to secure a little more tax-free interest than I'd get in a new CD? -- Joyce M., Seagoville, Texas
That depends on how comfortable you are taking on more risk with your 20 grand. Because that's exactly what you would be doing by moving it from CDs to a high-yield municipal bond fund in return for a shot at a higher return.
You see, CDs and muni bond funds, high-yield or not, aren't even close to being interchangeable. They're two entirely different types of assets with totally different levels of risk. When you invest in a CD, the interest rate is set in advance and fixed for the term by the bank.
As long as you don't incur an early withdrawal penalty by yanking out your money before the CD's term is up, you're sure what your rate of return will be, puny though it may be today. And assuming your CD is covered by FDIC deposit insurance, you also know that your principal and interest earnings are guaranteed.
But you don't have that sort of certainty and safety with a municipal bond fund. When you invest in a muni fund, you are buying into a portfolio of individual muni bonds issued by state and local governments.
And the rate of return you ultimately earn depends on two things: whether or not the bond issuers are able to make their payments and the market value of the bonds themselves.
That makes you subject to two risks. The first is credit risk, or the possibility that a bond issuer might default on its payment obligations. This risk is higher with high-yield muni bond funds than regular muni funds because high-yield funds focus on lower-quality bonds.
Those bonds pay higher yields not because the issuers are more generous. Their yields are higher because bond investors know these issues have a higher risk of default. So lower-rated bonds must pay more to attract money from investors.
The second risk you're taking on is interest rate risk. Interest rates and bond prices are like a seesaw. When interest rates go up, bond prices go down, and vice versa. Which means that even if all the bonds in a fund's portfolio pay interest on time, the fund could still lose money if interest rates start rising from their present relatively low levels.
All of which means that you don't have the same level of security investing in muni bonds as you do with CDs. And that's even more true for high-yield muni bonds.
To see that this is the case, you don't have to look very far. As concerns rose late last year and early this year about the ability of many states and municipalities to handle huge budget shortfalls, many investors began fleeing the muni bond market.
The combination of uncertainty about state and city finances and the exodus from munis combined to send both muni bond prices and muni bond returns tumbling.
Between the beginning of November and mid-January, when muni fears peaked, national intermediate-term muni bond funds suffered a 4.5% loss. Not surprisingly, high-yield muni funds got hit even harder, dropping 8.8%.
The fact that the high-yield muni fund you're considering is highly rated is, for the most part, irrelevant when it comes to assessing their security relative to other types of investments.
Assuming it's a Morningstar rating you're referring to, a high rating means that the fund has performed well on a risk and return basis vs. other bond funds in general or, in the case of Morningstar's category-specific ratings, vs. other high-yield muni funds.
But even highly rated high-yield muni funds (and regular muni funds) still face the risks that I outlined before. And their prices and returns will still fluctuate, just as the prices and returns of highly rated stock funds will (although bond funds in general aren't as volatile as stock funds, of course).
I don't want to give the impression that muni funds or even high-yield muni funds can't be an appropriate investment. Despite the recent turbulence in munis, muni bonds and muni bond funds can still be a core holding in investors' taxable accounts, especially for people looking for tax-free income in retirement (although I think high-yield muni funds should account for only a small portion of one's muni holdings).
In fact, as this story notes, munis may be even more attractively priced now that they're under a cloud. But you don't want to go into them thinking that they're CDs with higher returns.
If you do decide to put your $20,000 or some portion of it into muni bond funds, there are ways to mitigate (though not eliminate) the risks I talked about. For more on how to do that, click here.
Whatever you do, though, don't kid yourself that you can move 20 thou from CDs to a muni bond fund and skim off some extra income without taking on extra risk. The investment world doesn't work that way.
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