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Navigating an Inefficient Market


...the opaque world of bonds can offer more opportunity than one might think.

We are all taught in college how 'efficient' markets are supposed to be. Once you spend some time actually trading with real money or managing OPM (other people's money), you quickly realize that markets are not nearly as efficient as advertised in textbooks or in the media. Sometimes options are mis-priced due to a particular investor's need to put on a particular position. Eventually, the inefficiencies are noticed by astute investors who look to exploit those inefficiencies.

These inefficiencies of which I speak can be due to seasonal factors, investor sentiment (fear and greed), taxes, or just plain foolishness. I have spent the majority of my career trying to find these little gifts from the investing public and then reverse the position once the relationship returns to 'normal.' The case I will make today is for high-quality long-term municipal bonds.

As a primer, municipal bonds trade in the marketplace 'as a percentage of Treasury bonds.' In other words, the higher the percentage, the 'cheaper' they are on a relative basis, resulting in a good risk/reward scenario relative to Treasurys. When the spread is tight, the risk/reward retreats closer to risk as the tax-equivalent yield is lower and the bonds lose their appeal. There are hedge funds and arbitragers that do nothing but study this relationship and try to exploit the inefficiencies as they arise. While we are not hedge fund managers, we will place particular emphasis on municipals when the percentage is high and avoid them when they seem too tight compared to Treasurys.

To give you some perspective; since 1950, 20-year municipal bonds have traded at a mean rate of 84.9% of Treasurys. The ratios move for obvious reasons. For example, back in the 1970's and early 1980's, when income tax rates were much higher, the percentages relative to Treasurys were at an extreme low of about 70%. Rarely, if ever, do high quality tax-free instruments trade above their taxable counterparts. It is most certainly counter-intuitive and makes a mockery of the efficient market theory. Nonetheless, with 30 year Treasury bonds trading at 4.70% as I write this, I have been purchasing high quality municipal bonds of similar maturities at yields in the 4.8-4.9% range (a tax equivalent yield of around 7.5%). Our belief is that the spreads will tighten, possibly quickly, as arbs and hedge funds buy the munis and simultaneously short Treasurys. Also, December and January are two of the best months of the year from a seasonal perspective as there are many maturities and coupon payments and issuance slows around the holidays.

While not advice, it is our goal to bring to your attention that the opaque world of bonds can offer more opportunity than one might think. We hope to bring these inefficiencies to your attention on a regular basis as they present themselves. Your feedback or questions are welcome at

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Positions in various long-term municipal bonds

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