It's all relative in this market

February 01, 2010  

Hedge funds willing to take on the associated risks of arbitrage trading have reclaimed significant market share.

By Basil Williams

After more than a decade of competing directly with prop trading desks at large banks, hedge funds willing to take on the associated risks of arbitrage trading have reclaimed significant market share. At the heart of the opportunity set for relative value strategies are three important ingredients in evidence now that I expect will prevail for an extended period: volatility of spreads resulting from the interplay of financial and economic factors; structural imbalances owing to such factors as increased regulation, the increased level and frequency of new issuance, and differences in investment objectives among market participants; and an increased desire to maintain liquidity in portfolios.

Case in point is the municipal bond market, where the braided effects of a shift in market participants, structural imbalances and real liquidity can be clearly seen. Between 2002 and 2007, hedge funds and proprietary desks flooded into the muni space, employing a seemingly successful leveraged carry trade strategy. Positive carry was almost assured since spread volatility had shrunk to a few basis points a month, and increased leverage was used to enhance returns. In 2008, credit downgrades for municipalities, the near-bankruptcy of the muni bond insurers, rapid unwinding of muni positions caused by deleveraging, and the failure of the auction rate muni market combined to upend the entire muni sector. Muni carry trades imploded almost overnight.

Twelve months later, "healthy" volatility is back, with spread volatility averaging 10 to 20 bps per month. More significantly, trading capital committed to the muni space has fallen off a cliff, with hedge fund allocations down 70% and, as significantly, muni assets owned by hedge funds off by a whopping 90%, according to Citigroup internal estimates.

Despite the exodus of capital, the muni market remains very liquid, thanks to strong demand by mutual funds and retail investors seeking tax-exempt income. What volatility exists stems from idiosyncratic structural imbalances. Wealthy investors are looking to maximize tax-exempt income, while issuers are looking for funding for long-delayed projects and ways to plug spending gaps. Additionally, the unique element of cyclicality in the muni market causes predictable pricing changes that can be traded. Springtime, for example, typically sees demand abate as tax season saps investor cash at the same time municipal issuance seasonally increases. Summer often finds investors flush with cash seeking a reduced supply of bonds. Such patterns create good windows of opportunity for experienced investors.

On the supply side, issuance patterns in municipal debt are changing. High-quality issuers who have historically sold tax-exempt bonds now can choose between traditional tax-exempt bonds and taxable Build America Bonds, depending upon how the two markets price on a relative basis. The BABs program has brought new owners into the muni market: the traditional corporate bond buyers. We now have a new dimension to consider when assessing which bonds to buy and when to buy them. Changes in issuance patterns can dramatically affect the value of an ill-positioned municipal portfolio.

BABs have also served to reduce the supply of high-quality longer-maturity tax-exempt bonds. Less demand from knowledgeable municipal bond buyers and a more complicated supply picture make navigating this formerly simple market more challenging.

Looking out to 2010 across multiple asset classes, a few things are readily apparent. Fallout from the economic crisis will be lengthy and complicated. Volatility will be powered by economic headwinds. At the same time, regulatory pressures are likely to persist, which can be expected to keep global risk capital at bay. This will have the direct result of raising the return premium for those players remaining in the space, especially given that ample liquidity has returned to the market.

Against this backdrop, it appears certain that structural imbalances will prevail, driving the inefficiencies and mispricings that create a strong sustainable environment for relative value trading. The opportunity to generate absolute returns for such strategies is better now than it has been in years.

Basil Williams is chief executive officer of Concordia Advisors, an international multistrategy hedge fund based in New York.

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