Wednesday, February 9, 2011

Hedge funds searching for ways to short munis

Munis - the name given to municipal bonds - are bonds sold by states and state agencies.   For years munis have been considered safe and boring.  But now, with many states facing severe budget crisis, investors (and in particular hedge funds) are paying close attention to munis.

If you are running a hedge fund, you might sense an opportunity here.  If you believe that the credit worthiness of states will continue to decline, then the price of munis should fall (and at the same time the yield on these bonds will increase).  The obvious strategy then is to go short munis.  The question then is how?

The Financial Times tackles this question.  First it turns out that shorting muni bonds is quite hard as most muni debt is held by buy and hold investors like pension funds who are not interested in lending the bonds out to short sellers.  Second, even though in theory you could buy credit default swaps, the market for muni CDS contracts is pretty thin and as a result there are liquidity issues.  Finally, you could just try and short a muni index, but you won't be able to target a specific state.

For students of finance, this is what we call a "limits to arbitrage" problem.  While in theory the smart money should try and short overpriced bonds, frictions in the market render such a strategy costly or unpractical.   It is important to note however, that this doesn't mean that markets are not efficient, just that they are not perfect.  There is a difference.