Lawrence Carrel
Investment banks have been using this strategy for at least 20 years, but it has become more popular over the last seven years or so, making hedge funds increasingly important players in muni bonds. Earlier this year, before the tender-option-bond programs started backfiring, investors using this strategy accounted for about 8% of the $2.4 trillion market, according to Municipal Market Advisors, an independent research and strategy firm.
When the subprime mortgage crisis picked up steam last month, hedge funds, banks and other investors found few buyers for the repackaged collateralized debt obligations, or CDOs, they had bought from mortgage lenders. With prices falling and no buyers, they found themselves in a liquidity crunch when the margin calls came. Because they couldn't sell what they wanted, they sold what they could, sparking the stock market's August swoon. But it wasn't just stocks, they also sold munis. Adding to their troubles, a common strategy for hedging their exposure to munis backfired. Hedge funds that are "long" muni bonds typically offset this exposure by going short, or betting on declines, in Treasuries, since the two asset classes often move in tandem. But a funny thing happened, the hedge didn't work. As stocks and munis fell, investors flew to safety by purchasing Treasury bonds. Instead of falling with the munis, Treasury prices rose. The hedge not only didn't protect them, it made things worse, forcing them to sell more munis.
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