The result is a long-term investment with minimized short-term exposure. For example, the hedge fund might get a 5 percent return from the very long-dated municipal debt that it owns, while, at the short end, it might pay out just 3 percent on the floating-rate notes that it sold to money market funds. That leaves a 2 percent profit, which is leveraged by putting the trade in place using borrowed money.

McGuirk gives a real-money example: "Today they’ll get 3 percent for the short-term paper issued to money market funds, so that is their cost of funds. Then they buy long-term munis at 4.8 percent. Then they take out the interest rate risk using a combination of Libor or BMA swaps [those based on the Bond Market Association’s BMA index] to take the duration of the portfolio down to as close to zero as they can get it. And then they leverage it up to 10 times."

The strategy has grown so prevalent that it is having repercussions throughout the muni market. "For someone like me, who doesn’t use that type of strategy, it affects the types of bonds I buy or sell, because I’m competing with large, leveraged hedge funds for the same names," says Abner Herrman’s Klein. "With the amount of control that they have at the moment, they’re actually moving the market in ways that my portfolio could never move it."

Not So Fast
Of course, investors do not achieve double-digit annual returns without shouldering some risk. The hedge funds employing muni-arb strategies are typically investing in very high quality, often AAA-rated, municipal debt—some of the safest fixed income instruments available. But as hedge fund investments, they carry the risks peculiar to those vehicles, such as a lack of trading history or accurate returns data, liquidity constraints due to lock-in periods and operational risk issues. And, as with any hedge fund investment, due diligence must be done on prospective managers. Indeed, because these particular trades are so specialized, it is vital that investors make sure the manager has extensive experience with the muni-arb strategy.

The strategy itself contains inherent risks. For example, the success of the strategy is wholly dependent on tax advantages that could, in theory, close. "That would collapse the trade," Williams says. "The good news is that the threat of [tax law changes] helps keep the curve steep, and the steeper the curve, the more income that can come out of it." Most would classify a full repeal of the muni tax advantage as an unlikely tail risk. However, the possibility of the tax situation simply being modified, resulting in diminished profitability for the trade, is higher. A simple reduction in corporate tax rates could, for example, lower the incentive to hold tax-free securities, which could also damage the profitability of the trade. (Click image to enlarge)

Another factor to consider is that the high degree of specialized skill required to execute this arbitrage opportunity may result in some unwelcome tactical rigidity. One of the big draws of hedge funds is the flexibility of the managers and the mandates they follow. If the opportunities to generate outsize returns dry up in one market, they can often reinvent themselves as a different type of manager employing a different approach. But this trade is so idiosyncratic that the manager may not be able to shift strategies quickly. "I think you need to be a muni bond specialist to be successful in this trade, and that means you’re probably going to be limited in your other options," McGuirk says.

John Ferry is an Edinburgh, UK-based financial journalist and a senior correspondent for Worth.

Photograph by John Webster.

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