Investors in high tax brackets flock to municipal bonds to earn tax-free income. Like any other fixed-rate debt, municipal bonds have prices that fall when interest rates rise. If you aren't going to hold your bonds until they mature, you may want to hedge against falling prices. You also might want insurance against municipal bond defaults.
Shorting Municipal Bonds
Traders use short selling to hedge price risk. However, it’s almost impossible to short individual municipal bonds. To short a bond, you must borrow it from a broker and then sell it in the bond market. You hope to buy the bond back later at a lower price and pocket the difference. The problem is that brokers won’t lend out tax-free municipals, because the lender collects tax-free rates but pays the short seller taxable interest. Without the ability to short municipals directly, some traders hedge munis by short selling Treasury bonds. However, the two don’t always move in unison, defeating the usefulness of the hedge.
Shorting Muni ETFs
A municipal bond exchange-traded fund, or ETF, sells shares backed by a basket of municipal bonds. ETF shares trade on the stock exchange and are readily available for shorting. In a January 2012 article, "Forbes" magazine recommended shorting muni bond ETFs from iShares, Market Vectors and Pimco. These funds are all highly liquid, meaning it’s easy to buy and sell shares without causing prices to move. If you hedge individual bonds with an ETF, you run the risk that two might not move in lockstep. Also, you may have to hedge bonds from your state with an ETF containing bonds from other states, creating further potential mismatches. Inverse ETFs, which use futures and options to short indexes, are not available for municipal bonds.
Hedging Default Risks
You can limit your muni portfolio to insured bonds. However, insurers have, and do, go bankrupt. This has left few muni bond insurers standing in late 2013; only about 5 percent of new munis are insured. An alternative is to buy municipal bond credit default swaps, or CDS. These instruments pay off when the underlying bond’s rating drops or the bond defaults. Unfortunately, issuers of these instruments collapsed during the mortgage meltdown of 2007-2008, and the market remains risky. According to a June 2010 JP Morgan report, the CDS market is very thin, and most professional traders don’t use CDS.
You might be able to indirectly hedge default risk by shorting the shares of agencies that rate municipal bonds, such as Standard & Poor’s. The thinking is that if a highly rated muni bond defaults, the rating agency will draw a lot of criticism and probably some lawsuits. This is bound to depress the agency’s shares. If you want to hedge against rising interest rates but don’t want to short Treasury bonds, you can buy futures and options on interest indexes such as the London Interbank Offered Rate or the Federal Funds Rate. This avoids the “flight to quality” effect that can prevent Treasury bond prices from falling when economic surprises occur, thereby defeating a short Treasury bond hedge.
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