Leveraged Municipal Bond Arbitrage: What Went
Wrong?

Abstract

Substantial losses suffered by several multibillion dollar fixedincome hedge funds have brought attention to risks involved in what was advertised as a leveraged municipal bond arbitrage strategy. Brokerage firms marketed these hedge funds to investors as higher-yielding alternatives to conventional municipal bond portfolios with little, if any, additional risk. In this article, the authors explain what the strategy really was, why it was not an arbitrage, and why it failed. Sponsors of these hedge funds portrayed the failures as the result of unprecedented and unforeseeable market events operating on a fundamentally sound strategy. In contrast, the authors show the funds failed because of the confluence of flaws in the strategy:ineffective hedges, high leverage, poor incentives created by management fees, and leverage limits based on portfolio acquisition costs (not market values), and the mis measurement of within horizon risk, which differentiates strategies operated on proprietary trading desks and in retail hedge funds. Fundamentally, the strategy was simply a highly leveraged bet on the value of short call options, interest rates, and liquidity and credit risk. Events in late 2007 and early 2008 revealed the fundamental flaws in this hedge fund type that is now effectively extinct.

TOPICS: Real assets/alternative investments/private equity, fixed income and structured finance, derivatives, risk management