Hedge funds have been off loading massive tender option bond (TOBs) positions, a leveraged long bond position that is hedged by swaps, since the beginning of the year as fund managers have looked to reap the gains from a fall in U.S. Treasury prices. Ying Chen Li, v.p. in the fixed income strategy division at Merrill Lynch in New York, said since Jan. 2, when the U.S. 10-year Treasury note yield sat as low as 3.80%, hedge fund managers have been unwinding positions and making big profits. The 10-year Treasury note yield reached 4.09% last Wednesday, having gone as high as 4.18% on Jan. 9.
TOBs are leveraged trades that enable managers to borrow munis in the short-term floating rate market and buy long term muni bonds, which are then hedged with Bond Market Association or LIBOR swaps. Munis don't normally fall as much as Treasuries, thus allowing the position to make gains when Treasuries fall. Li estimates USD5060 billion resides in TOBs, although Li was unable to estimate how much of this has been sold off by hedge funds in recent weeks.
Meanwhile, BMA/LIBOR ratios are continuing to look high by historical levels, following movements happening toward the end of last year that saw the BMA index, an aggregate used in the muni swap market, trade close to 100% in the one-year BMA vs LIBOR ratios, a rate which was virtually unheard of before this time. Eric Hiller, chief rates strategist at Bank of America in Chicago, noted that last Wednesday one-year ratios stood at 91% of LIBOR vs BMA, having traded at close to 100% in December. Several states, including California and New York, are looking to raise capital through the issuance of municipal paper, and if demand for such issues doesn't meet increased supply, ratios will likely climb again with the front-end of the curve
