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High-Yield Muni Funds That Dive Into Unrated Waters

In their quest for higher yields, these funds add risk by investing at least a quarter of their portfolios in unrated bonds.

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As anyone who's ever participated in a holiday grab bag can tell you, it's awfully hard to judge the value of something just by looking at how it's wrapped. In the world of bond-fund investing, individual investors usually have a good sense not only of what kinds of bonds a fund invests in but--just as importantly--the quality of those holdings. Ratings agencies such as Standard & Poor's and  Moody's (MCO) rate bonds based on the credit quality of the issuer, and bond-fund managers might consider those ratings in assembling their portfolios.

But not all bonds are rated, and in fact those unrated bonds can add to a bond fund's risk profile. A recent study by the Federal Reserve Bank of New York found that the number of municipal defaults from 1970-2011 was actually much higher than previously thought, when unrated bonds are included in the count. Morningstar's Eric Jacobson recently discussed the dangers of investing in unrated bonds in this video.

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Adam Zoll does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.