Hedge Fund Losses Roil Muni Bond Market
Kurt Brouwer March 3rd, 2008
In this topsy turvy market, the historic relationship between muni bond yields and taxable yields is upside down. This article from the Wall Street Journal [emphasis added] points to hedge funds as the primary culprits for the turmoil in the municipal or tax-exempt bond market. Typically, muni bonds yields are lower than taxable bonds because they are exempt from Federal income taxes and, in some cases, from state income taxes:
Hedge Funds’ Fire Sales Send Muni Bond Yields To Historic High Levels (Wall Street Journal, March 1, 2008, Michael Aneiro, Tom Lauricella and Liz Rappaport)
“Months of turmoil in the municipal-bond market, long a placid haven for individual investors, reached a boiling point Friday — as hedge funds were forced to unwind complicated bets and in the process dump billions of dollars of the securities.
As a result of that surprising forced selling, yields on debt from municipalities and other tax-exempt issuers jumped to their highest levels in history, when compared with safe debt issued by the U.S. government. The average AAA-rated, 30-year municipal bond yielded 5.14% Friday afternoon, compared with 4.42% on a U.S. Treasury 30-year bond.
In normal times, municipal-bond yields are much lower than Treasurys, because investors don’t have to pay taxes on municipal bonds…
We previously wrote about this imbalance in the muni bond markets (see Tax-Free Muni Bond Yields Now Above Taxable Treasury Yields). Muni bonds yields have bounced above taxable bond yields a couple of times since 1990, but the situation did not last long. If history is any guide, the situation will not last that long this time either because, as we are seeing, bargain hunters are coming into the market.
“The muni market is at relative values that I have not seen in my career before,” said Evan Rourke, municipal-bond portfolio manager at MD Sass in New York. At current valuations, he said, investors can earn 5% or more on tax-exempt municipal bonds, roughly equivalent to an 8% taxable yield. “At this point, you’re approaching long-term [stock] returns.”
Brokerage firms issued all-points bulletins to their sales forces Friday suggesting they send clients into municipal bonds. One Morgan Stanley strategist described it as “the dislocation of a lifetime.” Bill Gross, managing director of Allianz SE’s Pacific Investment Management Co., or Pimco, said Friday the bond titan is moving out of Treasurys and corporate debt into the muni market…
This last part about Pimco and Bill Gross is quite interesting because it appears they are buying municipal securities in accounts for tax-exempt investors such as endowments and retirement plans. Normally, you would not do this because these entities cannot take advantage of the tax-exempt yield because these entities do not pay taxes. However, the folks at Pimco are well-known as bargain hunters and opportunistic investors (see PIMCO Buys Citigroup Bonds). So, for those investors who pay income taxes and are seeking income, this really does appear to be a buying opportunity.
…Typically, municipal bonds are the domain of the retail investors who are attracted by their tax-exempt status. But in recent years, hedge funds and foreign investors have become ever-bigger participants in the municipal-bond market.
Several factors are behind the market’s current dislocation. Some of these securities are backed by bond insurers — meaning the insurers guarantee to investors repayment of principal and interest. But the bond insurers — firms including Ambac Financial Group Inc. and MBIA Inc. — have been hit by insurance written on subprime-mortgage debt, reducing investors’ faith in other debt the insurers back.
Hedge funds are a new source of trouble. Many hedge funds made bad bets on the direction of U.S. Treasury bonds in recent weeks. Treasury bonds have rallied because of economic worries, and some hedge funds expected them to sink because of inflation. With the hedge-fund trades going wrong, lenders to the hedge funds demanded capital — something called a margin call — forcing the hedge funds to dump municipal bonds to raise money.
A number of hedge funds reached the breaking point on Wednesday and Thursday, when U.S. Treasurys moved sharply higher in price and muni bonds plunged.
“What they own is going down, and what they were [betting against] is going up,” says Joseph Deane, who helps oversee $38 billion for Legg Mason Inc.’s Western Asset Management. “It’s a financial hand grenade.”
I suppose we can thank hedge funds for this buying opportunity. I doubt if the investors in the hedge funds that have been hurt by this are very happy, but this is another example of how many hedge funds operated under riskier investment strategies than their investors realized.
And, the problem of liquidity in risky hedge funds may get worse for a while because investors in hedge funds that do poorly tend to pull money out quite quickly and those redemptions lead to even greater selling pressure on the hedge fund’s assets (see Hedge Fund Losses Lead To Redemptions).
Via: Rita Lee
- Hedge Funds , Investing , Money , Mutual Funds , Personal Finance
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I also found that story very interesting when I first read it the other day, although I think the hedge funds aren’t fully to blame.
It seems to me that the problems with the muni market began when it became clear that the monoline bond insurers were having problems and their backing of the securities could be worthless. Investors tried to unload many muni bonds before the possible downgrades and ahead of accounts that can’t hold lower rated bonds. While the market is large, it is spread among many issues, some of which rarely trade.
The panic and illiquidity played havoc with the yields and opened the door for the hedge funds. However, the market still didn’t return to normal and then they in turn became forced sellers, creating additional opportunity for the next set of buyers.
As a side note, hedge funds have great leeway to halt redemptions if there’s a run on the fund and rapid liquidation is not in the best interest of the limited partners. (It’s boilerplate language in all the offering memorandums.) However, the selling could be forced by lenders if they’re heavily leveraged.