Because the fund still gets 5% interest on the whole value of the municipal bond - plus
the additional yield from leverage - and only has to pay 3% on the short-term notes,
industry returns are between 10% and 12%, says Williams.
This compares with annual returns of 5.99% in 2004 and 5.60% in 2005 for Chicagobased
Hedge Fund Research's Fixed Income Arbitrage Index, which incorporates a
variety of arbitrage strategies in fixed-income instruments.
All returns are net of fees. Rockwater declined to disclose specific fees, but fund-ofhedge-
funds managers typically charge annual management fees of between 1% and 2%
and an incentive, or performance, fee of 20%. In addition, investors pay similar fees to
the underlying hedge-fund managers.
Municipal bond arbitrage's still early territory for hedge funds, and while lack of
competition has been good for returns, Williams isn't concerned about new players
entering the field.
"With 55,000 state, county and city government issuers across the U.S.
and unlikely to pull back any time soon, there will be plenty of municipal bonds
available," he says.
At the same time, demand for very short-term municipal paper is high because the
bonds are typically issued for long terms - anything from 20 to 40 years, he says.
The yield curve for these bonds is probably to remain steep even as the Federal Reserve
has raised short-term interest rates, which it did most latterly March 28.
"While the Fed's actions might put pressure on the municipal yield curve to flatten,
historically this hasn't happened and the municipal yield curve has maintained its positive
slope," says Williams.
Once the company builds a track record over a couple of years, Rockwater Hedge plans
on attracting institutional investors interested in this type of instrument, namely casualty
and property insurers, who currently make up the 30% balance of the direct municipal
bond market.
Williams declined to comment on the size of his fund or its performance citing
regulatory concerns and because, at the moment, investment is only by private
placement to high-net-worth every individuals and is not accessible directly to the public.
(Marietta Cauchi covers hedge funds, private equity and mergers and acquisitions for
Dow Jones Newswires.)
Dow Jones Tip Sheet: Rockwater Hedge Reckons Municipal Bonds Are Hot-2
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