@Morgan_03 HFs are the new liquidity providers and it don’t come cheap
— Guillermo (@groditi) November 12, 2013
There are plenty of stories about how hedge funds are being lured into buy Puerto Rico debt by big dealers. The Wall Street Journal wrote about hedge funds buying distressed debt. Bloomberg reported that Morgan Stanley, Citigroup and Lazard are holding information sessions for hedge funds to learn about Puerto Rico debt. A trader passed me the presentation from the Citi meeting. It was a detailed explanation of the seniority of Puerto Rico debt and the legal covenants and trading history of specific Puerto Rico issuers and authorities. I would guess Morgan Stanley and Lazard did an equally good job on the background for their clients.
Everyone in fixed income markets has been hunting for yield. It’s easy to see how Puerto Rico debt, with its hefty yields, could be attractive to alpha-searching hedge funds. Hedge funds can’t take advantage of the municipal bond tax exemption, so yields for them are not as high as they would be for a risk-loving retail investor. But hedge funds have the advantage of using leverage to buy assets. This leverage usually comes in the form of loans from the hedge funds’ prime broker. Prime brokers are the large dealer banks that provide financing, trading and back-office services to their hedge fund clients. Morgan Stanley is the second-largest prime broker in the U.S. and Citigroup is seventh largest, according to Hedge Fund Alert. These two dealer banks were prime brokers to about 1,800 hedge funds in the first quarter of 2013.
Hedge funds and other buyers that don’t to take advantage of the tax exemption are referred to as crossover buyers. The Federal Reserve does not track the holdings of hedge funds in its “Financial Accounts of the United States” report, (page 98) so we have no official data on how many hedge funds are buying municipal bonds.
There is historical data available from the MSRB and Sifma showing the most actively traded bonds. Puerto Rico captured 14 of the top 50 CUSIPs traded in the third quarter of 2012, and 8 of the top 50 a year later. Average trade size increased year over year from $133,747 in 2012 to $618,614.
In 3Q 2012, there were 26,930 Puerto Rico trades among the 50 most active CUSIPs (suggesting retail activity), versus 8,206 trades in 3Q 2013. Trade size quadrupled year over year to $633,000 (suggesting increased institutional trade activity).