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

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Credit Setbacks

Unfortunately, next to the credit success stories, the high yield funds also suffered some very significant credit debacles. The first wave of defaults could be traced back to the Tax Reform Act of 1986, which sought, among other things, to curtail many of the abusive municipal conduit financings mentioned above. The act restricted the use of tax-exempt financing to public-purpose activities and specific private activities. The latter became subject to volume caps and to alternative minimum taxation. Predictably, many issuers rushed to issue bonds before the act took effect and the market was flooded with many questionable high yield deals. A great number of these pre-1986 Tax Reform Act issues, including an infamous racetrack issue for Polk County, Iowa, ultimately ended up in default two or three years later. Ironically, even though the Tax Reform Act of 1986 did reduce the marginal tax bracket for high-income earners to 31 percent, it did eliminate many other tax shelters and further cemented the status of municipal bonds as the only “liquid,” tax-advantaged vehicle available to the average investor.

As mentioned earlier, the relentless pressure to generate tax-exempt income had forced many of the funds to invest in illiquid, nonrated, stand-alone project financings. In hindsight, the two major areas where the funds stumbled badly were real estate risk and commodity risk. No wonder the biggest credit setbacks (in dollar terms) suffered by the high yield funds ...

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