The nearly $4 trillion muni bond market could be in for some big changes if hedge funds have their way. Traditionally, a retail-focused market, hedgies are showing keen interest in fixed income securities that are issued by public entities such as states and cities. Notwithstanding the negative headlines about bankruptcy filings in Detroit and elsewhere, some alternative fund portfolio managers see promising returns ahead if issuers can recover.

School is still out about whether the presence of hedge fund investors in the muni bond market is a good thing or not. According to “Muni Watchers View Hedge Fund Presence, Liquidity Favorably” by James Ramage (The Bond Buyer, November 13, 2013), these new entrants could add “liquidity at a time when traditional providers have pulled back”…expand the “base of tax-exempt investors” and reduce market inefficiencies. A broader set of investors has the potential to help stabilize the muni bond market and lower “dependence on tax exemption as a main driver of demand.” Hedge funds could be a significant source of new bids if the cost of regulations such as the Dodd-Frank Wall Street Reform and Consumer Protection Act reduces the perceived advantages of muni bonds for broker-dealers and banks.

Others are not so sure, asserting that an activist hedge fund could push for onerous terms at a time of distress when issuers may ask instead need some slack if they are ever to be in a position to repay principal and interest. Traders that seek a quick exit when trouble brews could induce short-term volatility and possibly harm those investors that choose to wait out the storm.

Several topics that will likely gain more attention as hedge funds gravitate to muni bonds include tax treatment, disclosure and valuation. The current tax-exempt advantages of purchasing a municipal fixed income security relate in part to one’s tax bracket, domicile and the locale of the issuer. Then there is the question of market growth or contraction should the U.S. government seek to rescind some of the current exemption rules as a way to close the gigantic U.S. budgetary gap. Earlier this year, a suggestion to cap how much muni bond investors could “save” in taxes raised eyebrows. See “Obama proposes municipal bond tax exemption cap, again” (Reuters, April 10, 2013).

Disclosure remains a hot button issue with the regulators. For the first time ever, the U.S. Securities and Exchange Commission (“SEC”) brought charges against a municipal issuer on the basis of misleading investors. According to its November 5, 2013 press release, the Greater Wenatchee Regional Events Center Public Facilities District will settle with this federal regulator after “withholding negative information from its primary offering document and giving investors a false picture of the future performance” of an ice skating rink that was financed with $41.77 million in bond anticipation notes. Issued in 2008, a default on principal payments occurred in December 2011. In addition, the SEC charged the underwriter, Piper Jaffray & Co. and “its lead investment banker,” Jane Towery, as well as Allison Williams, an employee of the issuer who certified that the official report was accurate. Besides fees, various parties are being asked to engage outsider consultants to assist with the development of an independent vetting of due diligence policies and procedures. See “SEC Charges Municipal Issuer in Washington’s Wenatchee Valley Region for Misleading Investors.”

Valuation methodology choice and getting an independent third party review of a model and input data is yet another aspect of investing in muni bonds. This includes the assessment of collateral that does not trade in an active secondary market and/or depends on numerous projections about future earnings. For example, debt obligations issued for American Airlines are backed by an economic interest in “airport terminals and maintenance facilities.” The good news for investors is that these bonds are rebounding. See “American Airlines municipal bonds take flight for U.S. mutual funds” by Tim McLaughlin (Reuters, November 13, 2013). The bad news for any bond buyer occurs when there are questions about how much underlying collateral is worth and debt service is late or absent altogether. An interesting discussion of “the importance of rigourous valuation analysis in bankruptcy litigation” can be found by visiting “Terminal Valuation: Will the Seventh Circuit Decision on Valuation of United Airlines Bond Collateral Bring Closure to Recharacterization Litigation” by George w. Shuster, Jr., Philip D. Anker, Craig Goldblatt and John D. Sigel, Wilmer Hale, May 12, 2009.

Main Street and Wall Street have a lot at stake in making sure that things run smoothly. No doubt there will be more attention paid to the nature and economic health of the U.S. debt market for municipalities.