Strategies reborn and lessons learnt – hopefully

By John Dizard

Published: October 9 2007 06:28 | Last updated: October 9 2007 06:28

A number of “strategies” that failed in the most recent credit crisis have been given traditional Viking funerals, with the bodies of portfolio managers’ careers going up in flames on their long ships, or long positions. By now, for example, the securitising of subprime mortgages is reviled from central Asian yurts to the floors of European parliaments.

However, some are coming back. Take the US municipal bond carry game. The American muni market was for the longest time the most mom-and-pop end of the investing business: tax-advantaged interest income from conservative issuers to pay for the retirements of the country’s savers. Flows in this market had the consistency of road tar. Because the interest rates were low – in recent years about 85 per cent of the US Treasury curve – they did not have the appeal of high returns to offset the low liquidity.

Then the speculative world took notice of some appealing features. European banks realised that under the Basel capital adequacy rules, US munis did not put much strain on balance sheets.

The market is pretty big: currently about $2,200bn. The general automating of the bond market meant that transaction costs, even in the expensive muni market, had declined dramatically.

Furthermore, the muni bond curve invariably has a positive carry, even when the US Treasury curve or the curve for private issuers inverts. That means you should be able to lock in a spread, leveraging it up by some double-digit multiple, and not be concerned about negative cash flow.

That is thanks to the demographics of the underlying demand for munis. The on-the-run buyer of a muni bond is a relatively unsophisticated 65- or 75-year-old person who does not see the point to buying a 30-year bond, since the actuarial tables tell her she will be dead at its maturity. Yes, she could sell it before then, but older retail investors are reluctant to ride up or down the yield curve.

On the side of the issuers, also conservative people, in this case state and local civil servants, the requirement was for long-dated paper. After all, the reasoning went, the physical facilities being financed, such as roads, water plants and hospitals, were long-term assets.

This mismatch between buyers and sellers’ desires has meant there was always a tendency to a positive yield curve that went beyond that of the rest of the market. So the Tender Option Bond was born.

The TOB programme is a trust that borrows short-term money to buy US municipal bonds. The people setting it up, such as a US hedge fund or an Irish bank’s prop trading desk, buy long-dated US munis with money borrowed at Libor. After paying for a hedge against a rise in Libor, they might net 30 to 50 basis points, but they can lever that trust up perhaps 12 to 14 times. Also, the short-term muni rate is below Libor, remember, due to the tax advantage. Those older savers, or the mutual funds they buy, want short-term tax-free income. They are paid the short-term muni rate by the TOB trust. The hedge fund in New York or prop desk in Dublin collects the difference between the long muni rate and the short-term rate, all teetering on the Libor borrowings. What made this acceptable to the risk managers was the “tender option” part. The managers have the option of liquidating the trust in case things go against them in some way, or if they decide they want to wind up the business.

What they had not counted on was, of course, what happened. In the summer crunch, Libor blew out as banks became suspicious of each other. At the same time, like all non-sovereign bonds, US munis came under suspicion.

Jamie Iselin, a senior vice-president of Lehman Brothers Asset Management and muni expert, says: “There is no perfect hedge with munis. In August, the non-traditional buyers (read: hedgies and prop traders) were unwinding their positions at a time when people were flocking to Treasuries. There was a very limited bid out there, since the retail investor was on the sidelines.” So they had expensive funding of cheapening bonds.

By late August the US muni bond index was up to 98 per cent of Treasuries, far above the 86.8 per cent mean for the previous 12 months. At that point, though, some cash heavy retail money, insurance companies and speculators who had dry powder started buying, on the assumption that the muni curve would mean-revert back to that mid-80s point.

It has been working, slowly. The muni curve is about 92 per cent of Treasuries. Mr Iselin says: “As we move later into the year, when supply typically comes down, it should continue to revert to the mean.”

And just a couple of months after the near end of credit-spec life as we know it, there are brave souls looking to set up some more muni bond hedge funds. However, as one of them says: “We’re spending a lot of time studying the lessons to be learned from July and August.” Such as, say, less leverage. More hedging. More fear. Less greed.