SLCG released today 'Leveraged Municipal Bond Arbitrage: What Went Wrong?'. Leveraged municipal bond arbitrage is a strategy employed by fixed income hedge funds. This strategy buys long term municipal bonds and sells or shorts long term Treasury bonds while hedging with interest rate swaps. The strategy would seek to profit from the difference in the rates it receives from the municipal bonds and the rates it pays on the Treasury bonds and interest rate swaps.
Brokers marketed hedge funds that employed this strategy as an alternative to traditional municipal bond funds and claimed that such a strategy offered higher returns with little to no additional risks. Prompted by substantial losses in multi-billion dollar fixed income hedge funds during the crises of 2008, we wrote a paper explaining what leveraged municipal bond arbitrage strategy was not, what it really was and its underlying risks.
We argue that, while brokers and hedge funds claimed that the higher yields in municipal bonds were a result of the excessive supply of municipal bonds pressing down prices and pushing up rates, the higher yields came from the embedded call option and the liquidity and credit risks of municipal bonds.
We conclude that leveraged municipal bond arbitrage was not an arbitrage, but a bet on short call options and interest rates. Furthermore, we conduct simulations to show that such a portfolio was much riskier than a traditional municipal bond portfolio.
