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.