Pumping Up The Muni Advantage

Using financial engineering, hedge funds can hike returns to 8% or 9%

Here's the way you used to invest in municipal bonds: Buy $50,000 of 30-year Texas highway bonds with a 4% coupon and collect interest of $1,000 twice a year for 30 years. At the end, you get your $50,000 back.

Here's a new way, at least for high-net-worth investors: Give $1 million to a hedge fund. It will pool your money with others' to score $100 million of bonds, chop up the interest payments, buy a derivative instrument to protect the investment, and voilà, turn the 4% into 8% or 9%—that's still tax-free.

This juiced-up style of investing is called muni-bond arbitrage. Until several years ago, investment banks and corporations did it mainly for their own accounts. Then the muni traders heard the siren song of hedge funds, too, and set up their own shops. Now there are about 25 hedge funds with an estimated $3 billion in muni-bond arbitrage. At least three firms, gem Capital, Rockwater Hedge, and Fortigent, are repackaging their services in funds of funds, some of which allow investors in with as little as $100,000.

What has made this style of investing suddenly so popular is the return it offers: It has earned 8% to 12% annually over the past few years, tax-free, on an investment with an aaa credit rating. "This is a time of great popularity" for the approach, says Keith Pagan, president of gem Capital. "It is generating significant cash flow with infinitesimal credit risk." Still, that popularity is starting to squeeze the returns to investors.

The hedge funds start with aaa-rated long-term bond issues, now paying out around 4% a year. They take a good amount of that, often between $50 million and $100 million, and put the bonds in a specially created trust. Using the bonds as collateral, an investment bank creates two securities. The first, called the "A certificate" or "floater," is a money-market-like instrument on which the yield resets every seven days. The second part, the "B certificate," is held by the hedge fund and gets the 4% fixed rate. Today, the floaters generally pay interest of 3.2%. The hedge fund collects the difference between the 4.0% the municipality is paying and the 3.2% going to the money market fund.

This would be a terrible bet, of course, if the muni-bond yield curve ever "inverts"—in other words, if short-term rates were to exceed long-term, as rates on Treasury bonds do today. But it never has. That is because muni-bond investors, particularly money-market funds, want short-term securities, but cities and states issue mainly long-term debt because they use the proceeds to build long-lived assets such as roads and schools. The demand for the short-term munis is so great that the money-market funds will often pay for this sliver a price close to, or sometimes even equal to, what the whole bond cost.

Since the trust must make the interest payments on the short-term paper first, the hedge fund has to guard against rates going higher. To do that, the fund buys an interest-rate swap from an investment bank. Different funds do this in different ways, but it's typical for that to cost about 10% or less than the total value of the bonds—say, $10 million on $100 million in 30-year bonds. Even though the fund gets 4% on the bonds and pays 3.2% on the short-term securities, the leverage allows them to earn an 8%-plus return a year after fees.


the spread, or the difference between short-term and long-term rates, is what makes the arbitrage work. When the yield curve is steeper or when there's a bigger gap between long and short rates, these hedge fund deals are even more rewarding.

The problem with all kinds of arbitrage is that the more people who practice it the less profitable it becomes. And that is a concern now. Traders say the growing popularity of this strategy has contributed to the flattening of the muni yield curve. At one end the hedge fund demand for aaa-rated bonds allows issuers to lower the rates they pay. At the other end the funds risk flooding the money market with so much short-term paper that they have to pay higher rates to attract buyers.

Other factors could spoil these delicate deals. If the law were changed to lower tax rates, munis would become less attractive and their prices would fall. A complete loss of the tax exemption would have an even more devastating impact.

The worst time for muni-arb was right after September 11, when investors rushed to Treasury bonds in a flight to quality. Treasuries rose faster than munis, leaving the traders to pay more for their hedges. The arbs lost 15% in a month but soon recovered. You don't get 8% or 9% tax-free without a little risk.

By Nanette Byrnes

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