At this writing, the municipal market continues to benefit from powerful technical factors, including massive re-investment flows for the June-July period and virtually non-existent new high yield supply. Yields on long-dated AAA munis set a new record low last week at 2.90%. Against that backdrop, it’s not surprising that the high yield sector has also caught fire, as investors reach down the credit curve to capture more income.

According to the Bond Buyer on July 19. 2012, “high-yield muni funds saw their heftiest inflows since March 7. Flows have been positive for 17 consecutive weeks, and 31 of the previous 32 weeks.  High-yield funds that report weekly saw $288 million in inflows, Lipper said. The previous week, they reported $173 million in inflows.  Assets for high-yield funds that report their flows weekly increased to $42.09 billion, up from $41.57 billion the previous week”.

Since muni funds are basically just proxies for retail investors,  anyone with a bit of a contrarian mindset may want to take a step back and consider if the high yield tax-exempt sector has now become fully valued or even over-valued. For that, we turn to data provided by our friends at Barclay’s Capital, the premier source of muni market statistics. Barclay’s data as of 6/30/12 is displayed in the attached document:

BAA Municipal Index Spread to AAA Municipal Index

First, let’s take a look at where BBB-rated paper is trading. As of 6/30/12, the “spread” (or yield differential) between Barclay’s BAA Muni Index and  their AAA Muni Index has contracted to 215 basis points (2.15%), after reaching a record high of 413 basis points during the 2008 crisis. A year ago, that spread was 288. Thus, not only has the BBB sector participated in the general muni rally of the last 12 months, it has even outperformed high grade munis by a whopping 73 basis points!

All of this rather makes sense since BBB-rated paper is where all muni funds (high grade and high yield) go to capture those few extra basis points in yield while nominally staying in the investment grade arena.

For example, one of the most “liquid” (relatively speaking) high yield issues in the market, the St John The Baptist Parish, LA bonds backed by Marathon Oil (cusip 79020FAM) traded at a new record low yield-to-worst of 3.95%, a mere +102 basis points higher than AAA paper.

One can argue that the current spread still looks wide relative to the last 10 year’s average spread of 121 basis points. However, that average includes the extended period of ridiculously tight spreads from the bond insurance era, so it may not be all that relevant going forward.  One has to conclude there is little value left in BBB munis at this time. Note also that Puerto Rico paper accounts for a significant portion of the BBB supply and that’s another potential credit problem into itself (more on this later).

At least the true high yield paper, the stuff rated below investment grade or not rated at all, still looks reasonably attractive from a spread standpoint. The second chart in the attachment shows that, as of 6/30/12, the spread between Barclay’s High Yield Municipal Index and their Investment Grade Muni Index stood at +357 basis points, after reaching an eye-popping 638 basis points in the depths of the financial crisis.

We conclude with a note of caution: although spreads matter, investors also have to take into account where absolute yield levels are. Buying into a market where both absolute yield levels and spreads are unattractive is a surefire recipe for disaster.