Fixed Income Pair Trade: Long MLN, Short TLT

Includes: AGG, MLN, TLT
by: Benjamin Hacker

I certainly wouldn't consider myself an 'income' investor per se; I'm an equity or cash guy in most circumstances. However, I do own insurance companies that have large bond portfolios, and the general market does take some cues from the fixed income markets so in my opinion it is always good to pay attention to what is going on in the general credit markets.

Recent market action in the MBS, ABS, CDO, and SIV markets have received much coverage for good reason. The TED spread (difference between LIBOR and Fed Funds) is even getting some mainstream attention these days for its historically large deviation from the mean. However, just recently I was doing some (very frustrating) research on the bond insurers and I stumbled upon something absolutely bizarre to my eyes. (Click here for the Bloomberg interest rate summary)

It turns out that the current rates for 30yr AAA (insured) rated Municipal Revenue Bonds are ~4.50%. (Note that these Muni bonds are federally tax exempt for US taxpayers.)

At the same time, you can see that 30yr US Treasury Bonds have a YTM of <4.3%.

Now I have to admit that I am most certainly not a municipal bond market expert or even watcher (usually), but when Muni's yield more on a nominal basis than their maturity matched UST, I just can't help but thinking there is an inefficiency or pair trade that is waiting to be exploited.

At 4.5%, the taxable equivalent municipal yield (for a 35% marginal payer) is 6.9%.

While there is certainly some finite amount of extra default risk that you take on when purchasing a AAA insured Muni vs. a US Agency Bond, I believe is is immaterial. Over the last 30 years, there have been zero AAA rate muni bond defaults (even AA and A have been zero). The bigger risk here, and in my opinion this is what the market is freaking out about, is that there is a tremendous amount of liquidity risk with Munis. And as we all know right now, the market is valuing liquidity above all else. In fact, in the limited data I've been able to dig up, it appears that it has not been unprecedented to see Muni yields surpass treasuries in times of stress.... although historically the mean ratio is ~0.9 (Muni/UST); which would make sense given that the marginal pricing for Munis is probably set by tax paying investors. (In fact, I would have guessed that the ratio would be even lower...)

As an investor (or speculator) attempting to profit from this, it seems to be pretty straight forward: You can go long any number of leveraged or unlevered Muni-Bond CEFs and simultaneously short an equivalent of UST (maturity matched) bonds or funds.

An example of one simple way to approach this would be the following pair trade:

1) Long MLN (a new National Muni Bond ETF from Van Eck - Fact Sheet (pdf file))
Duration is 10yr, Maturity is 25yr, 90+% A rated or better, Weighted Average Yield - 4.7%

2) Short TLT (iShares 20+ Gov Bond fund - Fact Sheet)
Duration is 14yr, Maturity is 25yr, 100% Agency, Weighted Average Yield - 4.35%

A Tax paying investor would capture the spread (net of fees and factoring in expense ratios) between the two funds. The cost to pay the TLT interest would be tax deductible and the interest received on the MLN position would be federally tax free.

In addition assuming the spread narrows, there could be a good chance to pick up some capital gains here.

Overall, this smacks a bit of the Long Term Capital Management strategy of picking up nickels in front of the liquidity bulldozer, but the intellectual in me thinks that it would probably be a good trade for a small position of the portfolio, assuming you can keep fees in check and ignore any mark-to-market losses for several months at least.

I have no plans to deploy this trade at this time, but that may change in the future.

Disclosures: None.