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

Lessons from Historical Default Records

The extremely low aggregate default numbers often quoted in the press, while generally accurate for the tax-exempt market as a whole, may provide cold comfort to the high yield investor. First of all, the aggregate numbers benefited greatly from the virtual absence of default in the tax-backed sector, at least until the advent of the last recession. Yet the preponderance of high yield issues come from the revenue bond sector, particularly the private activity issues, which resemble corporate debt more than traditional municipal debt. (In fact, in contrast to most corporate borrowers, many of the small industrial development bond borrowers do not even have any capital structure: The bondholders represent the entire capital structure and thus function more like equity providers than creditors.) Furthermore, even within the high yield asset class, historical defaults are concentrated in only a handful of the riskiest sectors. The default record for those sectors should be of greatest relevance to high yield market participants. What conclusions can we draw from the historical default data presented above?

First, one can make the case that there is not one but two separate tax-exempt markets. On the one hand, there is the traditional municipal market with its extremely low default rate, buttressed by strong, time-tested legal protections (at least for now). On the other, there is the tax-exempt high yield market, which is municipal in name only ...