Hedge fund dumps bonds, hurting munis

Bank of America fund offers $250-$300 million of tax-free bonds for sale due to the subprime crisis.

NEW YORK -- A Bank of America hedge fund Thursday offered $250-$300 million of municipal bonds for sale, pushing secondary market prices lower, according to sources familiar with the list.

The tax-free bonds were part of a tender-option-bond program that likely was closing out positions because the subprime meltdown has made it unprofitable, according to the sources, who declined to be named.

A bank spokeswoman was not immediately available to comment on the so-called bid-wanted list. Sources said the list, the biggest seen this week, was the hardest evidence so far that tender-option-bond programs were suffering due to the market's sharply reduced appetite for risk.
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Tender-option-bond programs typically sell lower-yielding short-term notes and invest in higher-yielding long-term bonds, pocketing the difference. Hedge funds and banks run these often highly leveraged programs, and the sector is important due to its size, some $200 billion.

The selling pressured municipal bond prices, especially for longer-term maturities, with yields rising as much as 7 to 10 basis points by some measures.

Tender-option-bond programs, which often total several billion dollars, have become a growing concern in the $2.4 trillion tax-free market because they pose a two-fold threat.

Demand from the fast-growing sector helped drive municipal bonds prices higher over the past few years. But because the pace of new programs has slowed, the tax-free sector has lost some of its biggest buyers, leaving it with its traditional players - wealthy individuals, insurers and mutual funds.

A far bigger worry is the risk that tender-option-bond programs now will unwind their positions, financial analysts say. This could damage muni bond prices because the programs are so large and because they all tend to act in unison.

Tender-option-bond programs were often fat money-makers until the summer subprime mortgage debacle forced a brutal reassessment of risk and sent investors scurrying to Treasurys.
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But municipal bonds, like many other fixed-income investments, have not captured most of the safe-haven buying that has propelled a historic rally in Treasurys. As a result, some tender-option-bond programs are losing money on their cash hedges.

Tax-free bonds are becoming much cheaper compared with taxable Treasurys. Munis that mature in 10 years now yield around 88 percent of Treasurys, up 5 percentage points from just two weeks ago, a muni trader calculated.

"There is point where you cannot take the pain any more. If you hedge a long municipal position with Treasurys and Treasurys are up a point while munis are going down, you are losing on both sides, " a New York trader said. Top of page