The number of hedge funds using the muni arbitrage strategy is still relatively small - about two dozen -- but some bond practitioners worry that HF involvement could create a big headache for them and their clients. According to Investment News, the presence of hedge funds flattens the municipal bond curve, and it’s when the curve is steep that managers make more because of the increased risk. In addition, says David Baldt of Schroders, since HFs use leverage to boost returns, it could be “disastrous for the market” if some financial crisis comes along that will “turn some of these arbitrages upside down.” What’s more, muni investors can get burned when hedge funds jump from the market, thus causing a steeper yield curve (which the managers like), thus forcing down bond prices - which can translate into heavy losses for those who bought higher-risk bonds. Despite the fact that HF demand for munis is forcing down yields, financial advisers aren’t too concerned, says Investment News. The fact that the bonds are tax-exempt is considered enough of an attraction to make them popular among wealthy clients. Besides, even with low yields, Richard Schroeder, executive v.p. of Schroeder Braxton & Vogt told IN, they still perform better than taxable bonds. He could do better by putting money into riskier fare, but he’s not eager to take that chance. “We’re happy with the returns we’re getting,” Schroeder says.
