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Leveraged Municipal Bond Arbitrage: What Went Wrong?

Published in The Journal of Alternative Investments, Spring 2012, Vol. 14, No. 4: pp. 69-78.

2010-10-25

In this article, we explain that, while marketed as an arbitrage strategy, the leveraged municipal bond strategy was simply an opaque high-cost, highly leveraged bet on the value of call options, interest rates and liquidity and credit risk. Brokerage firms misrepresented the strategy by comparing the yields on callable municipal bonds with the yields on non-callable Treasury securities without adjusting the yields on municipal bonds for their embedded call features and by ignoring 30 years of published literature which demonstrates the remaining difference in after-tax yields is compensation for liquidity and credit risk. We also show that much of the losses suffered by investors were suffered during a period of relatively routine interest rates and not during an unprecedented interest rate environment.

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By Geng Deng and Craig McCann

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Craig J. McCann
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