The rapid deterioration of the municipal bond market in the past month has its roots in the sell-off of all markets in the aftermath of the Lehman Brothers collapse.  From an already cheap level versus US Treasuries, the Bond Buyer 40 (a long-maturity index of investment-grade tax-free bonds) soared to yields much higher than 6%, versus long-maturity US Treasuries at 4.25% or less.  This is unprecedented.  Recently, several forces have pushed muni yields higher:

• The selling of all asset classes by individuals stocks, bonds, equity mutual funds, municipal bond funds, etc. – following the Lehman bankruptcy.  Municipal bond funds are included here and have been selling to meet a high level of redemptions.  This has sent longer municipal bond yields from 5% to 5.5%.

• Aggravated selling by municipal bond hedge funds.  These funds make money on the difference between short-term municipal bond rates and longer-maturity bond rates.  With short-term rates heading higher (selling in money market funds) and the high degree of leverage (25:1 to 40:1 or higher), this liquidation has been much more damaging than that of individuals and has sent municipal bond yields even higher – from 5.5% to well over 6%.

• There is much less liquidity in the markets than even last year.  Bear Stearns: gone.  Lehman Brothers: gone.  Merrill: to be merged into Bank of America.  UBS: cut public finance.  Retail desks have been busy but can’t keep up with the deluge of supply from the hedge fund selling.  This has caused yields to spike up dramatically.

Cumberland is looking to take advantage of this anomaly by starting a program which emphasizes long high-quality tax-free bonds in combination with two ETFs (exchange-traded funds) that provide two times the inverse performance of long-term Treasuries.  We are doing this on both the ten-year range (cheap) and the longer-term munis (really cheap).  The idea is that 2/3 munis, 1/3 inverse Treasury ETFs should provide very positive returns when the tax-free bond market returns to a more normal relationship with US Treasuries – that is, with tax-free bonds yielding LESS than US Treasuries.  Clearly there are times when this relationship moves adversely –  the last two months have been a perfect example, as investors have sought the safety of Treasuries at very low yields (in the case of short-term T-bills, effectively zero).  As the credit markets slowly unfreeze – given the level of interaction on the parts of the Federal Reserve and the US Treasury – we should see tax-free yields move down and Treasury yields move higher.  This would be an environment where this muni/Treasury strategy will provide ample total return.