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Derivatives

Muni Market Coughs Up Yield Surprises In Lazy Summer

Record steepening in the 20-30 year end of the municipal bond yield curve, combined with the gapping out of spreads between muni bonds and Bond Market Association (BMA) swap rate, which track muni rates, last week sent hedge funds scrambling to exploit the moves.

Record steepening in the 20-30 year end of the municipal bond yield curve, combined with the gapping out of spreads between muni bonds and Bond Market Association (BMA) swap rate, which track muni rates, last week sent hedge funds scrambling to exploit the moves. As a result, hedge funds have been trying to snap up 30 year muni bonds, noted Yingchen Li, director at Merrill Lynch in New York.

The coincidence of the steep yield curve with a wide spread between BMA swaps and the muni cash market makes the trade more attractive. "It's a unique opportunity," said Li. The spread between muni bonds and BMA swap rate last week widened as far as 56bps, out from 30bps in April and compared to an average of 40bps for the past year.

Many participants purchase bonds and hedge the interest-rate risk of the bonds by entering into BMA swaps, in which they pay a fixed rate and receive the floating-rate BMA Index. If spreads between cash rates and the BMA swap rate narrows, as most anticipate they will, the hedge fund will generate a return of the difference in the two rates.

One hurdle to executing the trades, however, is the lack of long-term munis up for sale. Robert Gay, head of fixed income strategy at Commerzbank Securities in New York, noted that many U.S. states have fixed budgetary problems and as such are not issuing as much debt. This and the relative illiquidity of the muni secondary market has resulted in a lot of hedge funds aggressively chasing down what opportunities exist, agreed Li.

The hesitance of retail investors, who comprise half the buyers of muni bonds, to take long positions in a rising rate environment has contributed to the steepness of the yield curve. Unlike the muni curve, the U.S. Treasuries curve is inverted at the 20- and 30-year marks, Li noted.

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