Hedge Funds Are Buying More Muni Bonds

A spike in yields and a desire to diversify portfolios is prompting some unusual investors to jump into the municipal bond market, say traders and analysts.

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In recent weeks, traders from Moore Capital Management, the large New York hedge fund that manages some $15 billion, and from Oak Hill Advisors, the New York fund with nearly $13 billion in capital, have been snapping up municipal bonds, say people familiar with the matter.

The attraction: a combination of high yields and a relatively low long-term risk of default. States aren’t permitted to file for bankruptcy, and municipalities, which have access to Chapter 9 of the bankruptcy code, only rarely do.

“Non-traditional buyers who could buy anything are buying munis,” says Matt Fabian, senior analyst for Municipal Market Advisors, which provides independent research on munis.

The municipal-bond market, where cities, states, and public authorities go to raise cash for projects and general needs, has long been dominated by mom-and-pop retail investors, who own between two-thirds and three-quarters of all the debt issued.

But with many states and municipalities now struggling to close budget gaps and, in some cases, falling behind on debt payments, the perceived risk associated with muni bonds is rising sharply.

Along with it, so are yields—which in some cases are reaching 10 percent or more on an after-tax basis, say traders and analysts.

There are also technical factors that are pulling muni prices down. Retail investors, responding to the bad press these bonds have been getting, are pulling out of muni mutual funds, forcing redemptions, say analysts.

The mutual funds have to dump their bonds to raise the cash to pay off shareholders. These fire sales are creating “the buying opportunity of a generation,” says David Kotok, co-founder of the money management firm Cumberland Advisors.

These conditions appear to be paving the way for a new crowd of savvy institutional investors.

Hedge funds and other sophisticated investors are making “opportunistic trades,” he added. “They’re not buying the whole market. They’re buying particular bonds, looking for big-win situations.”

A big win for these investors, Fabian said, would be a bond that generated outsize returns for a short period of time, like a few months or a year—rather than a bond that provided slow and steady gains over years or even decades.

Spokespeople for Moore and Oak Hill declined to comment.

Other muni market participants noted that muni bonds could provide a useful diversification tool for hedge funds, since they aren’t subject to the same market factors as, say, a Treasury or a stock.

Watch special coverage of the municipal bond crisis,"Muni Maze," all day Monday, February 14 on CNBC.