One Hedge Fund Strategy That's Working

Stephen Harris

29 June 2005

Investor interest is growing among hedge funds in a trade in US municipal bonds called muni arbitrage. Investors have seen tax-free gains of more than 3 per cent so far this year, and more than 8 per cent over the past 12 months. Hedge funds investors are buying up longer-term municipal bonds, which lately have yielded about 4.1 per cent for 20-year notes. Then they set up a trust structure to convert the bonds into tax-free, short-term munis, known as tender-option bonds, which they sell to investors. These bonds pay a floating interest rate, which has recently fluctuated around 2.4 per cent. This huge spread is amplified by hedge fund gearing and compares extremely well with the flat results delivered by most other hedge fund strategies this year. The nature of the yield curve is of course that long-term Treasuries, corporates and other kinds of bonds also usually have higher yields than shorter-term bonds. The difference usually is much greater in the muni market, at present around 2 per cent compared with 1.2 per cent. This is in part due to greater demand for short-term munis as tax-free mutual funds focus on these investments and drive down yields on these bonds. In addition, since US cities and states prefer to borrow for long periods, there is an abundance of long-term muni bonds in the market keeping the yields on these bonds high.