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The Handbook of Municipal Bonds by FRANK J. FABOZZI, SYLVAN G. FELDSTEIN

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CHAPTER 38
The Role of Hedge Funds in the Municipal Market
Jonathan A. Fiebach Cofounder Duration Capital
 
 
 
The attraction of the municipal bond market for hedge funds can best be defined by the lure of a fundamentally inefficient relationship between supply and demand. Issuers tend to sell long-term debt to finance assets designed for very long-term use such as schools, roads, and utility systems. Investors in municipal bonds prefer to keep the terms of their loans very short, predominately through investments in liquid tax-exempt money market funds. Hedge funds bridge the gap. In this chapter, I explain how arbitrageurs take advantage of this basic supply and demand inefficiency and why it can be a profitable, yet risky, enterprise.
The arbitrage relationship between hedge fund and issuer begins with the relationship of each entity to tax rates. Municipalities are tax exempt; an issuer does not pay taxes so it is indifferent to tax rates. Most issuers have the choice of issuing municipal bonds to finance operations and projects or borrowing money from a bank directly in the form of a mortgage or a loan. Normally, the rate will be lower in the bond market as the interest paid from the issuer to the lender is exempt from federal taxation (tax advantaged). The fair value of a municipal bond for an issuer is
Interest rate < 100% of LIBOR swap rates
Interest received by the lender from a municipal bond investment is generally expected to be exempt from federal income taxes. Therefore, ...

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