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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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The Advent of Leverage

In the late 1990s, as a result of weak relative performance and the public’s growing fascination with the Internet, the high yield funds did experience a period of declining assets. However, asset growth soon resumed once the Internet bubble burst, and interest rate levels started their secular decline. During the first six years of the new century, the only notable source of credit volatility came from a relatively new structured financing sector: tobacco settlement bonds, which will be discussed in Chapter 11 (no pun intended). More importantly, over the same period, a new driving factor came to the fore in the muni market: That new factor was leverage.

With the proliferation of Tender Option Bond programs, or TOBs (described in more detail in Chapter 5), which allowed both broker-dealers and institutional buyers to leverage their purchases (i.e., buy on margin) without jeopardizing the tax-exempt status of the bonds, the muni industry discovered it could juice up tax-exempt income and total return without much of a stretch in credit quality. In fact, between 2002 and 2007, the widespread availability of leverage, combined with the record penetration by the bond insurers, had the effect of drawing into the muni market a whole generation of buyers who either ignored or were ill-equipped to handle credit nuances. Those buyers relied solely on official credit ratings, and as long as the ratings were sufficient to give them access to leverage, that was all ...

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