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Many retired investors own portfolios of municipal bonds in order to generate tax-free income. They are usually not overly concerned about interest rate risk, since they plan to hold the bond until maturity. Of course, higher inflation is a concern, especially with long-term bonds which will have less purchasing power when they mature. But recently, more investors are worrying about default risk, rather than interest rate or inflation risk.

It is not easy to hedge default risk for municipal bonds. I am not aware of any inverse ETFs available to do this. But I’ve listed a few possibilities that at least may be useful as a partial hedge.

1) Sell short Muni Bond ETFs or Closed-end Funds

Both ETFs and closed-end funds trade on exchanges like stocks and in theory, you can sell them short in margin accounts. But finding shares to borrow and sell is not always easy. There is also a risk of being “bought in” at an inopportune time. Another drawback is that the short seller must pay the dividends to the long holders.

2) Rating Agency stocks: sell short, buy puts or use bearish option spreads.

Moody‘s (NYSE:MCO) and Standard & Poor’s, owned by McGraw Hill (MHP), are both exposed if a lot of investment grade municipal bonds start defaulting. These stocks can be sold short and there are put and call options available.

3) Bond Insurers: Sell short, buy puts or use bearish option spreads

If municipal defaults rise dramatically, the insurance companies that guarantee interest will obviously be hurt. Ambac has already declared bankruptcy. But MBIA(ticker:MBI) and Assured Guaranty(ticker:AGO) are other players in this group, and both companies have put and call options available for hedging purposes. Berkshire Hathaway has also insured a small number of municipal bonds, but this is only a miniscule part of their business.

4) Municipal Credit Default Swaps

Hedge funds and other big investors use credit default swaps which are basically insurance that pays off when a bond defaults. These were heavily used to short sub-prime mortgages. The muni version is the Markit MCDX index which contains 50 credit default swaps from major muni issuers.

5) Municipal Bond Owners: Sell short, buy puts or bearish option spreads

Commercial lenders like Citigroup (NYSE:C), US Bancorp (NYSE:USB) and State Street Corp (NYSE:STT) own over $200 billion in muni bond holdings. The banks use zero cost money from the Fed to fund these muni bond purchases. Insurance companies have also traditionally been large holders of muni bonds and own over $400 billion. Two of the biggest muni bond holders are American Intl Group (NYSE:AIG) and Travelers Insurance (NYSE:TRV). Both of these companies are liquid and have put and call options available.

6) Municipal Bond Underwriters: Sell short, buy puts or bearish option spreads

Some active muni bond underwriters are Citigroup, Bank of America (NYSE:BAC), Barclay’s (NYSE:BCS) and Goldman Sachs (NYSE:GS). Regions Financial (NYSE:RF) also have high exposure to this business.

Full Disclosure: Long positions in BRKA and C (unrelated to muni hedging).

Source: Six Ways to Hedge a Muni Bond Portfolio