Mortgage Crisis Spreads to Muni Bond Funds

The subprime mortgage crisis is spreading to an unlikely place -- municipal bonds.

Muni bonds, which are debt obligations issued by state or local governments, are the latest type of asset to get hit as investment banks and hedge funds holding nearly worthless mortgage bonds scramble to unload anything they can in order to raise cash.

Nearly every category of muni bond funds tracked by Morningstar fell in August, with the high-yield, or below-investment-grade, category tumbling the most, 3.16% as of Thursday's close. That wiped out all of the gains they had made this year, leaving them down 2.54% for the first eight months.

Among funds carrying investment-grade munis, those holding California and New York long-term muni bonds posted the biggest declines, 1.32% and 1.12%, respectively. For the year to date, they are down 0.94% and 0.64%, respectively.

Muni bond funds weren't the worst performing category last month -- that place was reserved for precious metals funds, which lost an average of 8.22%, leaving them down 3.61% for the year.

Muni bonds might seem like an unusually staid investment for high-flying hedge funds. They tend to yield less than comparably-rated corporates, but their tax-free status tends to appeal to wealthy retirees.

But these securities provide the foundation for a popular hedge-fund strategy called tender-option-bond programs: Hedge funds and the proprietary trading desks at investment banks buy long-term, higher-yielding muni bonds, paying 4.5% for example, and put them in a trust, where they are used as collateral to issue short-term commercial paper paying a much lower rate of interest, say 2.5%. These investors pocket the spread, or difference between the two rates. They can also boost profits by buying the muni bonds with leverage, or borrowed money.