Municipal arbitrage funds did not fare well in 2007.
Funds using the investment strategy that analysts believe accounted for much of the trading activity in the municipal market were down an average of 20% to 40% for the year. Market participants said that as holders of municipal debt, these funds account for roughly $140 billion to $180 billion, or about half of what mutual funds do.
But with performance down and market conditions volatile, there are many questions about how this significant category of new muni market investors will behave in 2008.
First, all municipal market arbitrage investment strategies are not alike. One is the popular tender-option bond trust used primarily by large banks, and yet others are highly leveraged private funds.
But all muni arb investors have two things in common — borrowing money cheaply short-term and investing it in higher-yielding long-term investments and hedging that against market fluctuations.
THE ARB EFFECT
Understanding the strategy behind arbitrage investing in 2007 is important for anyone selling bonds, either in the primary or secondary market, because these buyers — by the volume and frequency of their trades — have the ability to change market dynamics.
Take, for example, the historically flat yield curve that emerged midway through 2006 and lasted into 2007. The monthly average basis point spread between the two-year triple-A general obligation yield scale and the 30-year scale was 42 basis points in February 2007, according to Municipal Market Data.
In February 2003, before many muni arb shops opened up, the same comparison shows a spread of 346 basis points between the short and long ends of the market.
Observers say arbitrageurs’ demand for large amounts of long-term debt has lowered yields on the long end. It should also be noted that during this time the U.S. Treasury market was also flat and in some parts even inverted.
The past year was the most difficult and volatile one for the municipal arbitrage strategy for two main reasons. First, the carry trade at the start of the year was less than historical averages, making the investment style less profitable during that time. In the second half of the year, the carry trade did become more profitable, but the hedging instruments the funds use did not work efficiently, making for bad performance in the second half of the year.
“While 2006 was the one of the best years in the last two decades for municipal arbitrage, 2007 will likely go down as the worst year,” said Jonathan Fiebach, co-founder of Duration Capital Management, an arbitrage fund. “Many hedge funds will see losses in 2007 that will wipe out their entire return from 2006.”
PERFORMANCE
As with other hedge funds, municipal market hedge funds, while falling into the statutory definition of an investment company, are exempt from much of the regulation to which mutual funds are subject. Hedge funds are specifically prohibited from marketing to the general public and can only sell to qualified investors. The rule also limits the performance information a hedge fund can legally release.
This makes it very difficult to obtain information on hedge fund performance, as it can only be sent to a fund’s investors. The Bond Buyer compiled the following performance data from a variety of sources, including investor performance documents and individuals within the municipal arbitrage industry. In the case where documentation was not available, we are reporting data we received from two sources that reported identical performance for the same time frame. In many cases, although not all, the number was confirmed by the fund itself.
The following numbers are all total return after fees in alphabetical order.
1861 Capital Management, for 2007 through the first week of December, was down 16% and down 11% for the months of August and November each.
Anchor Capital Group, a New York-focused muni arb account, was down 19% in 2007 through Dec. 1.
Aravali Partners LLC was down 12% in August and down 13% through the end of October.
Blackrock Inc. was down roughly 20% before November.
Blue River Asset Management was down 2% in 2007. Through November, the fund was down 11.9%. In August alone it was down 11.2%.
Citi’s TOB Capital year-to-date through Dec. 1 was down roughly 30%. It was down 23% in August alone.
Havell Capital Management LLC was down 11% in August and down 13% through the end of October.
PK4 Municipal Strategies was down roughly 40% through the end of November.
Rand Merchant Bank’s municipal arbitrage account based in Johannesburg and London ended the year through December at negative 14.7%.
Palio Capital Management closed its municipal arb fund but the company is still acting as an investment adviser, managing director Tina Hastings said in an e-mail on Friday. “We are still in the market but not actively raising capital,” her e-mail stated.
Fiebach estimated that losses on the year for arb funds were between 20% and 40% on average.
The year’s poor arb returns reflect the stresses that resulted in few muni mutual funds reporting negative results for the year, but the arb results were magnified by two features unique to them — the carry trade and the hedge.
THE CARRY
The cash flow of municipal arbitrage investing is a carry trade, or earning on the spread between being a long-term higher-yielding asset and borrowing at a short-term lower rate.
An investor buys a single bond or a portfolio of municipal securities with a fixed coupon. These bonds are deposited into the fund, or a trust if it is a TOB. The trust produces a floating-rate piece, which has a rate that is reset weekly and is sold to short-term investors as a seven-day put, and a “residual receipt” that retains the risk of the underlying bond and receives a return that is the difference between the bond yield and the floating rate.
In a generic example, a fund will purchase $100 million of long-term debt with a 4.50% yield. The fund will then sell $99.995 million as variable-rate debt, likely pegged to the weekly reset of the Securities Industries and Financial Market Association’s swap rate — say, 3.50%. The $5,000 is a residual certificate, which isn’t pertinent for the purposes of this example. Now the fund is earning interest on the muni investment with a 4.50% yield and are funding that purchase with the money invested by the money funds, who are earning 3.50%. The spread here is 100 basis points. The fund is earning $1 million each year on their initial investment of $100 million. In some cases, the funds are highly levered, investing up to 10 or 11 times their asset value in borrowed money. This strategy magnifies the upside, but it also, making the downside potential much bigger if the strategy proves wrong.
Market turmoil led by the growing subprime mortgage crisis resulted in higher long-term rates as 2007 progressed.
Starting in June, the market began to change as munis got cheaper and yield curves got steeper — a good thing for arbitrage as this created more spread between short- and long-term rates. In June, long-term yield jumped 23 basis points from the week of June 1 to the week of June 22, climbing to 4.52% from 4.29%. For the rest of the year, yields at the long end stayed above the early June levels, hitting a high of 4.78% for the week of Aug. 24 and ending up last week at 4.35%.
“Subprime issues, and then problems with the holdings of insurance companies, made it riskier to hold a large portfolio of long-dated bonds, so prices dropped,” said Ben Thompson, principal at Samson Capital Advisors, who manages a hedge fund along with other accounts. “This made for a better carry trade, so that was good, but along with that came the basis risk that greatly impacted hedges.”
A simple way to analyze the profitability of the carry trade for muni arb is to compare the MMD noncallable yield curve to the SIFMA swap rate.
On Dec. 21, 2005, the spread between the 30-year, noncallable 5% coupon MMD scale and the SIFMA weekly reset was 97 basis points, from 4.35% on the long end to 3.38% on the short term. On May 16, 2007, the spread had diminished to 30 basis points, 4.15% on the long end and 3.85% for the SIFMA reset.
The decrease in spread was in part a result of demand for long-term debt. But after May, the spread began to widen, as long-term debt cheapened as a result of subprime concerns. On Nov. 21, 2007, the same spread was 85 basis points between 4.43% on the long end and 3.58% on the short term.
“There is an inherent cash flow arbitrage to be earned by owning long-term municipal bonds and hedging out the interest risk in the taxable market. The current environment of a steeper yield curve and a cheaper muni-to-taxable ratio on the long end of the curve has resulted in the most favorable cash flow in a long time,” said Jed McCarthy, managing director at 1861 Capital Management. “Additionally, the current cheap muni-to-taxable ratios present an opportunity for mark-to-market capital gains going forward. These two factors add up to a very attractive entry point for the trade right now.”
While the carry was better at the end of the year, it was only half the story.
THE HEDGE
The hedge for an arbitrage account is the other key factor of the trade. A hedge is an investment aimed at reducing risk with a corresponding investment. In reducing interest-rate risk on a municipal investment, a party will enter into a swap with a negative correlation, or one that benefits the investor if rates move in the opposite direction of the initial investment.
The most common hedges used by muni arb accounts are based on the London Interbank Offered Rate, U.S. Treasuries, and the SIFMA swap curve.
Almost all arb trades are hedged so that a fund is paying a long rate and earning a short rate. Therefore, the overall net carry for hedged investors will be the sum of the carry of the long and short positions.
For example, a muni fund purchases a $100 million notional amount of 30-year, noncallable bonds on Sept. 10, when the 30-year MMD scale yielded 4.33%. The fund could then enter into a $50 million swap, which serves as the hedge for the initial $100 million investment. If hedging using Libor, the fund is likely to pay a 30-year Libor fixed-rate, which was at 5.25% on Sept. 10. The fund will then receive one-month Libor, which was 5.81% on Sept. 10.
Later that week on Sept. 13 the MMD 30-year yield has increased to 4.40%, up seven basis points. The investor owns bonds purchased at 4.33%. Now the value of the initial investment has decreased. This is where the mark-to-market value of the hedge should be in the investor’s favor.
The 30-year Libor that the fund is paying has increased to 5.37%, up 12 basis points. What happened is that the Libor swap moved 12 basis points, but the fund has used a hedge ratio of 50%, as it hedges $50 million of the $100 million investment. So, the hedge moved six basis points, while MMD moved seven basis points. Risk is minimized.
What happened in 2007 is a historical anomaly.
Hedging ratios, which are a measure of the performance of municipals to the corresponding hedge, skyrocketed and were increasingly volatile. When the ratio between the MMD curve and Libor increases, it means that munis are under-performing taxables, as the municipal yields are increasing faster then taxables, therefore the price of munis are decreasing faster.
“Ratios went way out of whack,” Samson’s Thompson said. “While people may have been earning on the carry trade, their hedge began to greatly hurt them.”
This is a bad thing for an arb account hedged in Libor because the mark-to-market value of their holdings are going down, while their Libor hedge is also paying less. According to MMD, on Dec. 28 the ratio of the triple-A yield curve for 30-year bonds to the 30-year Libor swap curve was 86.0%. The average for the past year is 79.2%. The higher the percentage, the cheaper munis are to taxables, and the worse the hedges perform.
Therefore, by the end of the year, the hedges were reducing the mark-to-market value of the funds in spite of the greater carry.
OUTLOOK
Views on 2008 are mixed. McCarthy pointed to the solid carry trade that now exists, and also noted that high hedging ratios are likely to come down in 2008.
“With high hedging ratios, the likelihood of them going down are more probable,” he said.
Others differ.
As for subprime issues, both Fiebach and Gavin Peter of Rand Merchant Bank believe problems will persist into the first quarter of 2008.
“The ratings issue of the monoline insurers should persist into the first quarter in our view,” Peter said. “Although we will see some further tiering with respect to insurer name, we do believe that the TOB trade will offer value in 2008, mostly in the better quality insurers and the solid AA and AAA issuers.”
Fiebach noted that “2008 is likely to start with continued under performance of tax-advantage versus taxable bonds as we wait to see how the rating agencies view the ongoing remedies of the municipal insurers. Unless the insurers are downgraded or taken off negative credit watch, the uncertainty will keep long-term investors on the sidelines.”
In a November report to investors, Blue River wrote that “we feel that once we get into 2008, some of this pressure will be released, although it will continue to be a factor well into 2008 and even into 2009 until this credit/liquidity crisis cleans itself up.”
To help the fund, Blue River was expecting to add Morgan Stanley as a new dealer to work with. Its larger fund has a $14 billion fixed-income portfolio with $1.8 billion of assets under management.
As for what these funds will look for in 2008, Fiebach said hedge fund investors will likely continue to target bonds in the five to 20 maturity range, and they will seek out noncallable bonds, which are the easiest to value and hedge.
“It is also easier to value and hedge callable bonds if the maturity date and the call date are within 10 years of each other,” he noted. He said short-term bonds are very difficult for hedge funds as it is not possible to leverage most securities that mature in four years or less.
Peter said RMB focuses on bonds between 10 and 30 years in maturity of a credit rating no lower that AA-minus. Fixed coupons between 5% and 5.5% are ideal, he said.
Arbitrage accounts differ in their approaches to munis and their outlook on the market for the upcoming year. To Fiebach, there is one certainty.
“Everyone has different views of what represents the best value,” Fiebach said. “Every investor and trader believes that the securities they are buying represent the absolute best value in the market at the time of purchase. The only certainty, though, is that not everyone can be right.”
