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Even as Build America Bonds continue to transform municipal finance, one thing stays constant: hedging a portfolio of muni securities remains very difficult.
The BAB program has opened the market to new types of investors and traders, and potentially to greater liquidity and transparency.
That's small solace so far to dealers, traders, and brokers of state and local government debt, who have found that hedging the credit risk in taxable municipal securities is just as elusive as it is in the tax-exempt space.
"For the most part, neither tax-exempts or Build America Bonds are that easy to hedge," said Jeff Bosland, head of tax-exempt capital markets and public finance at JPMorgan. "It's a long-only market, and it's not super-liquid, with a limited ability to hedge spread risk."
Whether in the taxable or tax-free municipal debt markets, the impracticability of hedging comes down to one thing: fully shielding an inventory of municipal bonds requires shorting municipal credit, and nobody has figured out a good way to do that yet.
In a sense, any decline in the value of a muni bond is attributable to one of two things: either the benchmark interest rate rises, or the spread of the bond's yield over that benchmark interest rate widens.
Many market participants agree that hedging the former risk - which is known as duration - is not so tough.
Because U.S. Treasury debt provides the benchmark rate for just about all bonds denominated in dollars, and because Treasuries are among the most liquid and continuously traded instruments in the world, a trader stuck with a municipal position can hedge duration risk by shorting a Treasury.
Market participants say duration risk has also been hedged using Treasury futures or options, or short positions on the London Interbank Offered Rate.
That way, if prevailing interest rates spike and clobber the value of a dealer's municipal bonds, he will recoup his losses with gains on his short position on Treasuries or Libor.
The risk of a widening in a bond's spread over the Treasury rate is a different story altogether. A reliable method for positioning oneself to benefit from a municipal bond's spread swelling out has yet to emerge.
Take the story of Fred Yosca, who trades both tax-exempt and...