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

CHAPTER 7

Investing in Distressed Bonds

Within the high yield municipal market, no strategy holds as much promise of outsize returns as distressed investing. Here, total return is the name of the game, and tax efficiency is only a secondary consideration. Assuming you are armed with the requisite due diligence and valuation tools, the ability to buy bonds at only a fraction of face value (sometimes as low as 10 to 20 cents on the dollar) may limit your downside while allowing for greater potential upside. As we saw in Chapter 3, purchasing bonds at a significant discount is inherently desirable as it allows you to align your cost basis more closely with the potential recovery value in a post-default scenario.

Before the high yield credit crisis of the late 1990s (discussed in Chapter 2), the high yield muni funds themselves were the leading participants in distressed opportunities. With their large credit research staff, the funds acted as the buyers of last resort for many troubled credits. Steady asset growth allowed them to “grow” out of any potential credit problem. However, as growth started to level off and credit losses mounted circa 1998 (even though such losses were concentrated in only a couple of particularly disastrous sectors such as de-inking projects), many of the funds were forced by their respective senior management to retrench and adopt a much more conservative posture. Over time, the funds went from being opportunistic buyers to being net sellers (or at least ...