Abstract
This study analyzes the risks and returns of low-grade municipal bonds funds by examining the financial performance of low-grade municipal bond funds over the study period. The analysis focuses on the effect of embedded options on low- and high-grade municipal bonds. After controlling for the effect of interest-rate call and put periods, I found that low-grade municipal bond funds have periods during which their returns are statistically greater than those of high-grade funds. Contingent claims analysis risky-debt pricing models which do not incorporate interest rate risk cannot explain the principal results of the study.
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