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

A Few Preliminary Considerations

The municipal bond market typically is a fragmented over-the-counter marketplace. Disclosure has gotten better in recent years but still leaves a lot to be desired, even for industry professionals. This problem can be more pronounced in the high yield market and in particular for smaller issuers that frequently populate this sector. If you are trading in small lots (less than $500,000 par amount), fragmentation can be even greater. What does this mean for an individual investor?

First, there is no central marketplace to execute secondary market trades. Each trade is executed directly with a dealer, either by phone or through the dealer’s electronic platform. If you have not done a great deal of homework on the sector and on the specific bond you want to buy or sell, even if your investment idea is sound, you may be tripped up by poor trade execution due to wide bid/ask spreads, translating into high implied trading costs. Furthermore, bear in mind that dealer markups may be much higher for retail trades than for institutional trades. Ideally, you should strive to buy bonds at so-called “retail odd lot” prices and, conversely, to sell bonds at “institutional” levels, but that is easier said than done. For this reason, investors buying smaller lots should view these investments as illiquid, to be bought and held to maturity until there is a specific reason to sell (such as a perceived significant deterioration in creditworthiness or any other credit ...