Investing in the High Yield Municipal Market: How to Profit from the Current Municipal Credit Crisis and Earn Attractive Tax-Exempt Interest Income

CHAPTER 3

The Investment Case for High Yield Municipals

Given the explosive growth of the high yield tax-exempt universe over the past three decades, have high yield municipals been a worthwhile investment? The answer is a resounding “yes,” but with some major caveats. Over the last 10 years, high yield municipals have exhibited attractive risk/return characteristics and have held their own against other competing asset classes, including corporates and equities. This is quite a remarkable record, achieved in spite of the unprecedented market volatility of the last three years. For many fixed-income buyers, the prospect of earning upwards of 6 percent on a tax-exempt basis (the equivalent of an eye-popping 9.23 percent taxable yield for someone in the 35 percent tax bracket) would be reason enough to consider high yield munis. However, because of the potential risks involved (as discussed in Chapter 1), investors need to actively manage their investment for after-tax total return, instead of passively investing for income. Managing for liquidity is especially important, as shown by the classic cautionary tale of the Heartland high yield funds.

With those important caveats in mind, the best time to have maximum exposure to high yield is when the economy is coming out of recession and credit spreads are at their widest. As the business cycle gets in full swing and rates start to rise, credit spreads will tend to narrow to a point where higher quality paper becomes a better relative ...