Municipal Bond Hedging In A Post-detroit Bankruptcy World

Open Access
Author:
Hoffman, Matthew Jean
Area of Honors:
Finance
Degree:
Bachelor of Science
Document Type:
Thesis
Thesis Supervisors:
  • Joel Matthew Vanden, Thesis Supervisor
  • James Alan Miles, Honors Advisor
  • James Alan Miles, Faculty Reader
Keywords:
  • Municipal
  • Bonds
  • Default
  • Detroit
  • Bankruptcy
  • Cross Hedging
  • Fixed-Income Securities
Abstract:
Municipal bonds are customarily regarded as illiquid, long-only securities. As a result of a limited secondary market and the dearth of a deep futures market on underlying municipal securities, dealers and bond investors have encountered roadblocks when attempting to hedge municipal credit exposure. Historically, yields on municipal bonds and United States treasuries were intertwined. Traditional trade strategies rely in some fashion on shorting spot or future treasury rates to hedge municipal exposure. After the unprecedented bankruptcy filing from the City of Detroit on July 18th, 2013, the highly correlative relationship between municipals and treasuries seemingly decoupled. The Detroit Bankruptcy filing, along with the adverse actions taken by the Federal Reserve regarding “tapering” , and U.S. government shutdown, all contributed to a volatile environment for the U.S. bond market during the second half of 2013. Amidst this overwhelming volatility, the municipal bond market was turned upside down causing systematic hedging models and strategies to collapse. Municipal ETFs, which cover the broad scope of the municipal market, experienced an average annualized return of -10.23% for the analyzed time period. Outflows in the third quarter of 2013 amounted to $32 billion, which exceeded outflows of any entire year on record dating back to 1992. Owners of municipal debt have rebalanced and repositioned portfolios in an effort to prevent further losses in the bear market. However, with the drop in correlation between municipals and treasuries, traditional bond management strategies (e.g. shorting treasuries and treasury futures) have been rendered virtually inept, forcing investors to pursue other means to suitably hedge their municipal holdings. An analysis of the data for the prior year shows that a widening of municipal yield spreads to those of treasuries and other fixed-income instruments has ultimately eliminated the effectiveness of single-asset interest rate volatility hedging. Following this former trade strategy resulted in losses across the board on both municipal inventory, as well as the treasury hedge. Dealers and investors alike were scrambling during the hectic period to prevent municipal portfolios from repeatedly hemorrhaging money. The objective of this paper is to study, test and measure effectiveness of traditional and unconventional municipal bond hedge strategies over an allotted six-month period, and to determine which asset class, if any, offers the highest potential outlook. Remarkably, there has been no major study on municipal cross hedging published since 1985, which pre-dates the market disrupting events of 2013. This paper will review the quantitative analysis of four single-asset hedge portfolios: treasury, corporates, agencies, and futures. These portfolios were constructed using methodologies set forth by Frank Fabozzi’s publication “Bond Portfolio Management”, as well as optimization analytics from Bloomberg. All of the portfolios aim to counterbalance the change in cash flows from the initial long municipal portfolio. Test statistics that are incorporated into the analysis were derived from Finnerty and Grant’s publication titled “Testing Hedge Effectiveness”. The three main tests examined in this paper are described in greater detail in Chapter 4. All of these tests were incorporated into the analysis through rigorous simulation experiments and Bloomberg back-testing tasks, to arrive at statistics that could be evaluated in a distinct manner. After a thorough investigation into the ideal municipal hedge, the actual results proved inconclusive as the hedge portfolios returned contradictory statistics. Lastly, any discoveries or findings from this thesis may serve as a foundation for further research into developing functional municipal hedging techniques involving multi-asset approaches.