Hedge Funds & Muni Bonds

Municipal bonds (“munis”) are often called the second safest invest in the world, with US Treasurys being the safest. Many munis are backed by cities, counties, states, etc., that have the ability to raise taxes to service their debt. Yes, municipalities are also suffering in this downturn, but default rates remain extremely low. I have heard various muni bond mutual fund managers claim that even in the Great Depression default rates were under 2%.

So, it is puzzling to many why munis are down so much this year, in many cases down as much as the stock market. One explanation I have heard has to do with forced selling by hedge funds, life insurance and annuity companies, and various other institutional investors.

The story is that these investors knowingly took on risk by investing in the hot items of the day like collateralized debt obligations (CDOs) and credit default swaps (CDSs). To hedge that risk they also invested in “safe” securities, often munis. Now they are being forced to sell large holdings of their safe investments to cover losses and redemptions. These forced liquidations are driving down prices.

This would be a simple case of supply and demand. Forced selling creates more supply than demand, driving prices lower than would be the case if markets were operating normally. Today’s Wall Street Journal has an article titled, Hedge Fund Liquidations Soar, which would support this reasoning.

If this is the reason that munis are down so dramatically, it is further evidence of the unusual opportunity this market represents for buyers at this moment. Prices are down, driving up yields, potentially delivering an unusual income stream and opportunity for total return down the road. You need to be cautious about duration and the threat of inflation longer term, but there seems to be a glowing needle in this haystack right now.

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