I was reading about it in a buisness week issue a few weeks ago and had a little trouble understanding how it works. i dont have enough money for this type of investment vehicle, but it sounds interesting. the part i am confused about is when a hedge fund splits up the bonds into there own long term and short term securities do they sell both? and where does the money go after they sell?

I would like to see the calculations so i can try to follow each cashflow to clear up my understanding. the numbers in the magazine are:

hedge fund buys $100 million worth of 30 year AAA -muni bonds and puts them into a trust. then an ibank creates long term and short term securities using the muni bonds as collateral. Long term - 4% and short term is 3.2%. money market pays $100 million for the short term paper. (where does the money go?) then they buy a swap for $10 million. after that the article says it returns +8% tax free? how does that happen?

so the hedge fund gets the long term paper @ 4% + the difference between 4% and 3.2% to make 8%? is that right am i missing something?

 

Is there a link to the article, or is it only in the hard-copy magazine?

 

wow, i just checked the website and i found it for free

article

 

They use leverage (borrowing against the LT portion) to magnify the gains on the ST portion. The emphasis of how this works is between the demand of the muni (a LT security) and the demand for any ST tax free security.

Edited: Tax free, sorry!

 

huh? what does demand have to do with anything? i think u may be more confused than me. where did u get interest free security from?

 

Demand is important - read about how after 9/11, everybody wanted LTs, so the iR dropped, but STs rose, creating a negative spread for the "arbitragers".
Greater the demand for STs, the bigger the spread (pushes the iR down), creating more potential gain for the bankers behind it.

 

Demand has everything to do with it: when demand is high the price goes up. The key to this is the demand for short-term municipal bonds:

"The demand for the short-term munis is so great that the money-market funds will often pay for this sliver a price close to, or sometimes even equal to, what the whole bond cost."

Perhaps he meant "zero-coupon security", rather than "interest-free security".

 

ok i understand the inverse yield curve and how it can screw things up, and that is the reason why they buy the swap.

however i am still confused. so they split up 100 million worth of securites into lt and st. is that 50 mil worth of lt and 50 worht of st? or just 100 mill worht of lt, they keep it. and they have another 100 mil worht of st which they sell paying out 3.2%?? i am completely confused as to where the money goes between each transaction and how it all comes back together.

 

This link has a better explanation of what is going on:

http://www.worth.com/Editorial/Wealth-Mana...t-Arbitrage.asp

Splitting it up $50m or 100m is all the same, just more leverage than the other. The point is, as the hedge fund is receiving 5% (because of a steeper sloping yeild curve, less demand), they only pay out 3% (less steep yeild curve, more demand here) on the short-term component. They magnify the 2% spread through leverage of borrowed money.

1. Hedge fund buys munis
2. Ibank splits up muni into two components- ST and LT
3. Hedge fund retains LT and collects 5%
4. Hedge fund sell the ST and pay out 3% to the holders of the ST component
5. Hedge fund keeps the spread, 2%

Hope this helps!