Monday, February 14, 2011

Hedge Funds Buying Munis In Extremely Stupid Move

Stupidity isn't the exclusive provenance of people with low IQs.  Ostensibly well-educated people do dumb things too.  Hedge funds run by investment professionals who are supposed to be intelligent are jumping into muni bonds:

A spike in yields and a desire to diversify portfolios is prompting some unusual investors to jump into the municipal bond market, say traders and analysts.

This comes in the face of warnings of massive deficits facing municipal governments and unfunded pension liabilities that will now affect states' credit ratings.  Hedge funds buying New Jersey's bonds hoping for bargains may get more than they bargain for thanks to rating cuts driven by pension costs

The pension fund managers whose liabilities are contributing to muni bond haircuts are just as stupid as hedge funds.  CalPERS can't resist the siren call of higher returns from less liquid investments, which is exactly why it cannot solve its funding shortfalls. 

There's nothing wrong with buying munis for their triple tax free cash flow and ability to stabilize a diverse portfolio.  Buying munis from solvent governments or even insolvent governments that are prohibited from declaring bankruptcy (like California) makes sense if the bonds are held to maturity.  Unfortunately, that's not the typical hedge fund's approach.  Hedgies place their client's money at risk by using algorithms to play a guessing game with interest rates and credit ratings.  Due diligence and credit quality probably play a minor role.  That's what makes this latest hedge fund craze sound so stupid. 

Full disclosure:  The author has a small position in California state municipal bonds at this time.