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Editorial See other Editorial Articles Title: Muni hedge funds liquidating to meet margin calls, Pimco says (2008 Is Really Going To Suck) Muni hedge funds liquidating to meet margin calls, Pimco says By Alistair Barr Last Updated: 2/29/2008 3:37:00 PM SAN FRANCISCO (MarketWatch) -- Hedge funds that trade municipal bonds have been hit by margin calls in recent days and some are having to sell positions to meet those obligations, according to a leading investor in the market. Problems with bond insurers and other disruptions from the global credit crunch have pushed yields on muni bonds close to, or above, those of comparable Treasury bonds. That's hurt hedge funds that try to make money from the difference, or spread, between those yields. Muni bonds usually yield less than Treasurys, partly because they are tax-exempt. The disruptions have encouraged banks and brokers that lend money to muni hedge funds to pullback and impose more margin calls. (Margin calls happen when securities bought with borrowed money lose value. If they drop too far, brokers require that more cash be deposited in an investor's account to support the position. Otherwise they must sell some of the assets.) "The market is in further disarray the last two days as a number of muni hedge funds are being forced to liquidate to meet margin calls," Mark McCray, head of muni bonds at Pimco, said. "The widening of munis versus Treasurys has been a negative and broker dealers have upped their margin requirements for hedge funds," he explained. "As such these funds are trying to liquidate into this illiquidity." Hedge funds that focus on muni arbitrage try to take advantage of differences between muni bonds and other types of debt such as Treasurys and corporate bonds. Blue River Asset Management and 1861 Capital Management are among firms that focus on this strategy. "I don't have any comment, but you can imagine that I'm very busy right now," Robert Bigelow, an executive at Blue River, said on Friday. John Lee, a co-founder of 1861 Capital, wasn't immediately available to comment on Friday afternoon, a representative of that firm said. Long-term bonds usually pay higher interest rates than short-term debt. That's called the yield curve. In the muni-bond market, that curve is usually steeper than for Treasury bonds or corporate debt. That's partly because cities and states like to borrow money for long periods, while mutual funds prefer to buy shorter-term muni bonds. That means there's lots of supply of longer-term muni bonds, so issuers have to offer higher yields to sell them. Muni arbitrage hedge funds buy the higher yielding, long-term muni bonds. They then chop up the bonds into short-term munis called tender option bonds (TOB) and sell those to other investors. Those short-term bonds have lower yields, so the hedge funds end up making money on the difference between long-term and short-term muni yields. The growing popularity of this strategy began to bring the yield on longer-term muni bonds down, flattening the muni yield curve. See full story. But the subprime-fueled credit crunch began to reverse that trend in August, pushing long-term muni yields back up, especially in comparison to Treasury yields. Problems with bond insurers have exacerbated these problems in recent weeks.
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