Last month, a risky, new deal hit the municipal-bond market. It came from a small borrower in Colorado that was looking to finance the construction of 1,200 luxury homes in the foothills of the Rocky Mountains.

It was an odd time for such a project. Denver’s decade-long housing boom was beginning to show signs of cooling and, moreover, rival developers had already raised record sums to turn vast tracts of land into new communities. “There’s no houses to see,” said Nicholas Foley, a municipal-bond fund manager at Segall Bryant & Hamill in Denver. “It’s just dirt.”

No matter. The buy orders poured in anyways and, in the end, about $20 million worth of bonds had been sold for yields as low as 4.75% on 30-year maturities -- similar to the rates that investors once only reserved for relatively risk-free market behemoths like California or New York.

The Federal Reserve’s decision to lower benchmark borrowing costs is keeping the U.S. awash in cheap credit. That has fueled a surge in corporate borrowing, bankrolled takeovers of debt-laden companies and, increasingly, sparked concern that some of those leveraged loans have become too risky. That angst has also seeped into the $3.8 trillion market for municipal bonds, a corner of the financial world that traditionally has served as a refuge for individual investors seeking steady, low-risk returns.

With the steep drop in yields wiping out the tax advantages of some tax-exempt securities, investors are hunting for higher payouts. That’s driven yields on the riskiest tax-exempt securities down to about 4%, the lowest since at least 2003, and in turn spurred an increase in sales from the most default-prone segments of the market. Shopping malls, centers for novel health-care treatments, factories seeking to turn trash into fuel and speculative real-estate developments like the one outside of Denver -- all have recently sold tax-exempt debt through local government agencies.

At the same time, investors are receiving less return for the risk, with the gap between yields on top-rated and junk-grade debt holding near where they stood at the end of 2007.

“There is so much money coming in -- even if 90% of the market rejects it, if 10% wants to buy, they are able to get it done,” said Dan Solender, a partner at Lord, Abbett & Co.

The municipal-debt market remains one of the world’s safest, with only 0.16% of those rated by Moody’s Investors Service defaulting between 2009 and 2018, compared with 6% of corporate bonds. Yet many of the riskiest deals aren’t rated and could leave investors -- including those with stakes in mutual funds -- exposed to potential losses if the economy stalls.

During the 2008 credit crisis set off by the last recession, the municipal junk-bond market was roiled as the slowdown rippled through the economy. More than $8 billion of debt issued through state and local government agencies defaulted that year, the most for any year dating back to 1980, according to Richard Lehmann & Associates. When funds unloaded the riskiest securities, high-yield municipal bonds tumbled, saddling investors with a loss of 27% until the market rebounded in 2009.

The lowest-rated municipal securities have rallied this year, delivering gains of nearly 10%, as plunging yields worldwide leave investors hunting for ways to get higher returns. Mutual funds focused on high-yield tax-exempt debt have pulled in cash every week since early January, with about $384 million added in the week ended Aug. 14, according to Refinitiv’s Lipper US Fund Flows data.

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