Proponents of the technique, called a structural municipal arbitrage, trumpet its success. "These hedge funds have emerged over the last six years, and they are creating good track records by generating 8 to 10 percent annual after-tax returns," says Bryan Williams, managing principal with Rockwater Hedge, a Newport Beach, Calif., fund of funds company that specializes in muni-arb hedge funds.

Proprietary bond traders at investment banks started executing these structural trades in the 1990s. When they left to run their own hedge funds around 2000, they made the muni-arb strategy available to individual investors. Now, with investors increasingly seeking alternative investments that are not correlated with traditional asset markets, the muni-arb strategy is becoming more popular. "It’s gaining momentum," says Neil Klein, senior portfolio manager with Abner, Herrman and Brock Asset Management in Jersey City, N.J.

While the returns these funds generate are indeed impressive, they have some unique risks. Beyond the usual liquidity issues associated with hedge funds, the success of the muni-arb technique is dependent on certain tax advantages, and changes in the tax laws could slam shut the door of this particular opportunity. For now, however, the returns are tax-free and substantial. "Anecdotally, I continue to hear from hedge funds that [use this strategy] that their tax-free returns are anywhere from 7 to 12 percent annually," says Hugh McGuirk, head of municipal bonds at T. Rowe Price in Baltimore.

Like Falling Off a Log

"These hedge funds have emerged over the last six years, and they are creating good track records by generating 8 to 10 percent annual after-tax returns."

The arbitrage concept is relatively simple and involves taking advantage of the fact that the yield curve—the usually upward-sloping graph depicting the relationship between yield and maturity—for municipal debt is fundamentally different from the yield curve for regular bonds. "By design, the muni curve is steeper than the taxable curve, and it’s always going to be steeper for three reasons," Williams says. "First is the imbalance between supply and demand. There is a lot of demand for tax-exempt money market funds, but the supply of short-dated municipal debt is very small because issuers prefer to float longer-dated bonds. But demand for longer-dated paper is less robust, and that creates a need for issuers to give a yield premium, or sell at a discount, at the long end to induce people to come up the curve."

Second, Williams says, is the uncertainty that individuals have about their future tax liability. A 55-year-old investor may not be sure what tax bracket he will fall into 20 years down the line, so he is uncertain as to whether a tax-exempt investment will actually be worthwhile. "That uncertainty has to be paid for, and it’s paid for by the municipality issuing the bond. The issuer has to discount the bond or have a yield premium at the long end to give you an incentive for taking longer-term risk," he says.

Finally, another type of uncertainty creeps in at the long end, which also forces the cost of that tax-free debt to be discounted, and that is uncertainty over the tax laws. If Congress were to take away the tax advantage afforded municipals, then their issues would have to trade in line with similarly rated taxable debt. This risk, Williams says, is also priced in at the long end of the muni curve.

As a result of these factors, municipal bond yields are similar to their equivalent taxable counterparts only at the short end of the yield curve. Short-term municipal bond yields are around 66 percent of equivalent corporate bond yields, while the long-term municipal yield is more like 80 percent of those on comparable corporate debt. That difference in yield is what the hedge funds seek to capture, and then to leverage. To do this, the hedge funds have to invest in long-term municipal bonds and fund those investments at short-term municipal bond rates.

Transformational Trade

TOP VIEW: In the last six years, hedge funds employing an idiosyncratic municipal bond strategy have delivered impressive after-tax returns to investors. These funds utilize an arbitrage technique known as a "structural" trade, which involves taking apart an instrument to sell its component pieces. While consistent 8 to 10 percent returns are enticing, because of inherent risks and the sheer complexity of the trades involved, investors should choose their fund managers very carefully.

Municipalities typically issue long-maturity debt, anywhere from 10 to 40 years. "They don’t issue a lot of seven-day paper, so there is an issue of supply and demand imbalance," Williams explains. Arbitrageurs cannot fund their long-term investments at short-term rates without short-term paper. Investment banks noticed this imbalance some years ago and saw an opportunity to act as an intermediary, filling the gap in short-term demand. They created a product called a "tender option bond program," an arrangement whereby the bank holds a fixed-rate, long-dated bond in trust and splits the underlying economic components into two distinct parts: a floating rate municipal security and a residual long-dated investment certificate. Hedge funds buy these, retain the long certificate and sell the floating-rate part to money market funds. The funds are then left with some interest rate risk, which they hedge using interest rate swaps. "With the swap, you’re making it duration [the measurement of a bond’s price sensitivity to changes in interest rates] neutral," Williams says.

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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