Getting down to brass tacks, what are the key risks involved in a high yield tax-free investment?
Before all else, a high yield municipal bond is still a fixed-income instrument and, as such, is affected by changes in the general level of interest rates. Bond fundamentals dictate that as rates go up, the value of a fixed coupon bond must go down, and vice versa. Most investors tend to think of their interest rate exposure in terms of maturity, that is, how long the exposure will last. It makes sense that the longer the maturity of your bond holdings, the more exposed you are to interest rate fluctuations and the more extra yield you need to be paid for the additional risk (that’s why the yield curve is normally positively sloped, except under exceptional economic circumstances). If you are bullish on rates (i.e., you expect rates to decline), you would want to extend out on the curve and, conversely, if you’re bearish you should aim for shorter-term maturities.
Fixed-income professionals have found maturity to be too crude a yardstick since it fails to take into account the time value of the coupon income and other cash flows you may receive before the final maturity. As a result, they have devised a couple of more sophisticated ways to gauge the potential interest rate volatility of a single bond or a bond portfolio, namely duration and convexity.
Duration, or more precisely Macaulay duration, is expressed in years and can be thought of as the ...