The End Of The Muni Carry Trade?

Supply/Demand Imbalance
There has been steady growth in the assets held by Tax-Free Money Market funds since their inception. During the last 10 years the holdings of these funds have more than doubled in size as their assets increased by about 123%. Last year about $430 billion was invested in short-term Tax-Free funds. The chart above shows the “gap” between assets held by money market funds and the amount of issuance of short-term tax-free securities that are available for them to purchase. These securities have maturities of 13 months or less, or are longer maturities that have floating-rates and a put that gives short-term liquidity to the debt. Most of these floating rate securities are issued as Variable Rate Demand Notes. This money market supply gap has continued to widen over the last decade.

The Muni Yield Curve
The strong demand for short-term paper by money market funds causes munis to trade “richer” in the short-term part of the yield curve relative to U.S. Treasuries than in the longer part of the curve. This means that munis have a long history of having a positively shaped curve, even when treasuries are inverted by Fed induced tightening measures. The chart below shows the spread between a 1 year muni and a 30 year muni over the last 3 years. When the Fed was
in a tightening mode the curve flattened to a low of 40 bp’s on 2/27/2007. During that same period of time the Treasury curve was inverted. Since the muni yield curve has a history of having a positive slope even when money is tight, it works well for strategies that borrow short and lend long.

The Muni Carry Trade
Tender Option Bond programs (TOB’s) and leveraged Closed End muni funds both borrow short and lend long in the tax exempt marketplace. TOB strategies are funded by money market eligible instruments that allow the programs to purchase long muni bonds by employing leverage. The amount of leverage varies by the entity that is employing the strategy. The muni “carry trade” has become increasingly important over the last 10 year period. The chart below shows the holders of municipal debt as of 12/31/2007. Banks held about $193 billion at the end of last year and Closed End funds held about $92 billion of munis. During the last 3 years the growth in assets held by each category of investor can be seen below. Commercial Banks grew their holdings by about $50 billion since 2004. Much of this growth came from a few large banks that employed carry trade strategies in the muni bond market.


The chart below shows the increase in holdings by the 7 largest holders of muni debt by commercial banks over the last 3 years. The 5 largest holders were all significant purchasers of munis during this time period and accounted for about 50% of the growth in holdings by all the commercial banks. The addition of these large positions of muni debt in such a short time period can only be explained by the use of leveraged TOB strategies. In addition to the TOB’s issued by the commercial banks, there was considerable growth in the number of these strategies employed by hedge funds/arb accounts. It is estimated that Merrill Lynch’s TOB is about $40 billion. Many of these strategies were offered as Alternative Investments or as Fund of Funds strategies. Data on the size and number of these programs is not readily available, but the amount is impressive. Closed End muni funds had little impact and did not experience much growth during this time period. These funds are leveraged through the use of Auction Rate Preferred securities which are not money market eligible, because their liquidity is not guaranteed.

Filling The “Gap”
The leveraged strategies employed by TOB’s are primarily funded by the tax-free money market funds. For example, La Salle Bank would purchase a large block ($15-$50 million) of long muni bonds and deposit them into a trust. The trust splits these bonds into 2 different parts:
1. The short-term holder gets a weekly floating rate security that is money market eligible and can be put back to the marketing agent on 7 days notice.
2. The residual certificate holder (La Salle Bank) receives the difference between the rate paid on the short-term piece and the rate received on the long bonds that were purchased.
This is a “carry trade” for the Bank, because they borrow short and lend long. The steepness in the yield curve has made this a desirable trade for the Bank and the shortage of money market eligible paper has made it beneficial for the tax-free money market funds. The residual holder assumes the market risk of the bonds, and the short-term holder assumes the credit risk of the securities. The credit risk is minimized through the use of insurance or guarantees. The market risk for La Salle Bank is hedged with derivatives. Historically, this strategy has worked well for both money market funds and TOB programs. This type of funding has been useful in filling the “gap” between demand and available supply for the Money Market funds.

Auction Rate Securities
Closed-End funds and Municipalities both issue auction rate securities. The Closed End funds primarily fund their leverage through the issuance of Auction Rate Preferred (ARP’s)securities. These are high quality securities that are secured by the assets of the fund. These are not money market eligible securities, because their liquidity is not guaranteed by anyone. Instead, the rates and liquidity are set by an auction process. Auction Rate Preferred’s are purchased mostly by individuals and corporations. Municipalities issue Auction Rate securities (MAR’s) that are also not money market eligible for the same reason as the ARP’s. These securities are usually either credit enhanced by an insurer or bank, or are of very high quality.

Crisis In Confidence
The huge write downs by municipal insurers of CDO’s with sub-prime exposure has called the creditworthiness of the insurers into question. The rating agencies are imposing tougher rating standards and are calling for more capital from the insurers of municipal credits. Moody’s has downgraded FGIC from AAA to A-3 and Fitch lowered XLCA from AAA to A. This has led to serious disruptions in the short term muni markets. Money Market funds are only able to hold securities (Variable Rate Demand Notes) that are AA rated or better. These funds are not able to hold weaker underlying credits with an insurance wrap that might get downgraded below AA. This has caused Money funds to “put back” weaker credits whose insurers are likely to get downgraded.

In the Auction Rate market, many auctions have recently failed. This is due to liquidity concerns, rather than credit concerns. Dealers have been unable to provide enough liquidity for all of the auction rate securities. Roughly $10 billion of auctions failed during the last 2 weeks. The sudden lack of confidence in the auction process has led this market to unravel. This is causing financing costs to increase for issuers of these types of securities, because when an auction fails the holder of the security gets the maximum rate payable according to the original documents. These rates have been as high as 12-20%. This is causing issuers to look for alternative modes of financing instead of using the Auction Rate marketplace.

Recent Developments
We have noticed these developments due to the distortions in the short-term muni market:

1. There is extreme pressure on banks, dealers, and hedge fund TOB programs due to downgrades of securities that can no longer be funded in the short-term markets. There is constant fear that these programs will be or are unloading long munis to unwind trusts due to downgrades. There is also pressure caused by increased financing costs for these programs. Cheap funding in the money market arena has given way to much higher financing costs. This increase in costs has made the carry trade unprofitable for some hedge funds, which has led to liquidation of some of their long bond holdings. This has caused the long end of the market to underperform relative to Treasuries.
2. Issuers are searching for ways to lower soaring financing costs of Auction Rate securities. Some of these will be converted to VRDN’s and will be bought by the Money Market funds. Others will be reissued as long term debt. Since rates are low on an absolute basis, we expect many of these loans to be converted to long term bond deals.
3. There is now a severe shortage of acceptable money market eligible paper for the funds to purchase. This has led to short-term rates for quality paper falling rapidly to levels around 1%. This is below levels that are justified by current tax rates for taxable accounts. Money has continued to flow into Money funds during this recent scare. Assets are now up close to $500 billion.
4. The Auction Rate market has suffered a serious setback from the large number of failed auctions. Some investors, who are not concerned with liquidity, have been attracted by the high rates currently available in this market.
5. The muni yield curve has continued to steepen which will provide an incentive to investors to extend to pick up yield when the market returns to normalcy.

Conclusion
Guarantees of liquidity and credit are an integral part of the short term muni market. The current disruptions have been caused due to concern about the credit-worthiness and dependability of these guarantees. This has led to a contraction in the supply of capital as a funding mechanism for carry trades. We do not expect this shift in supply to be reversed any time soon. This will make it much more difficult for TOB’s to do carry trades in the future.