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

The Impact of Bond Evaluations

One can make a solid investment case for high yield municipals from an index performance standpoint. Capturing that performance in the real world may not be quite so simple. One of the “dirty little secrets” of the municipal market is how dependent market participants are to bond evaluations provided by third-party pricing services such as J.J. Kenny (a subsidiary of Standard & Poor’s); Interactive Data; and, more recently, Thomson Reuters and Bloomberg. Because of its relatively infrequent trading flows and sensitivity to even the slightest change in creditworthiness, the high yield sector is particularly vulnerable to potential mispricing.

This phenomenon is not all that surprising when one considers the following characteristics of the municipal sector:

• It is, after all, an over-the-counter market with limited liquidity, where only a fraction of the two million or so distinct CUSIPs trade on any given day. Because of the relative scarcity of daily trade posts, market participants are forced to use third-party evaluations as a starting point for price discovery.
• It is dominated by retail investors and their proxies, the mutual funds. The latter promise their shareholders daily liquidity and, as a result, have to price all their holdings at the end of every trading day in order to determine their net asset value. With very little trading data to go by, daily pricing on any particular security is effectively based on the evaluators’ best guess until ...