(Bloomberg) -- James Pruskowski learned the intricacies of the municipal bond market in his 30 years at BlackRock Inc., before exiting the world’s largest asset manager in 2023. He brought that expertise to another arcane part of Wall Street, the hedge fund industry, and produced market-beating results.
His muni hedge fund at 16Rock Asset Management has generated a more than 20% return in the past 12 months, according to Pruskowski, crushing the market’s benchmark by 16 percentage points and a broad hedge fund index by about 11 percentage points.
The $7 million 16Rock Municipal Opportunities Fund, which charges a 1% management fee and a 20% levy on profits generated beyond a certain threshold, plans to close on $100 million in investments by the end of the year, the 52-year-old money manager said.
“The opportunity in municipals is often overlooked and misunderstood,” Pruskowski, 16Rock’s chief investment officer and former head of BlackRock’s institutional and wealth management team for municipal bonds, said in an interview. “Investors can take advantage of market dislocations because of supply, demand, and public policy while the asset class’s stable credit quality and low volatility provide recurring real return potential.”
Arbitrage Opportunities
Like other managers, he employs leverage and hedging through short positions and derivatives and quickly exploits price differences between securities. But Pruskowski is one of the relatively few among thousands of US hedge fund managers who does so by seeking arbitrage gains between tax-exempt and taxable munis, not stock activity, merger transactions or other corporate events.
“They’ll toggle back and forth between taxable and tax-exempt munis, wherever the opportunity set is,” said Joe Marren, chief executive officer of KStone Partners, an investor in muni hedge funds in discussing the two dozen or so hedge funds dedicated to municipal bond investments. “They’re not driven by trying to generate tax exempt income.”
Companies in the lightly regulated hedge fund industry that focus on municipal debt are typically run by traders who formerly worked on Wall Street proprietary trading desks, according to Marren.
Those that center on investment grade debt, such as 16Rock, Whitehaven Asset Management, Spring Lake Asset Management and Old Orchard Capital Management, target gains of 8% to 12%, with low volatility.
Rosemawr Management and Foundation Credit invest in riskier securities, such as some sold for charter schools or distressed bonds like those of bankrupt Puerto Rico. MacKay Shields, which provides municipal bond mutual funds and exchange-traded funds, also offers muni hedge funds to clients, said Marren.
Quirky Market
The fragmented nature of the $4 trillion muni arena provides opportunities, said Pruskowski. Price transparency is more difficult than in other markets because securities come from tens of thousands of issuers, many aren’t actively traded, and the bonds have diverse security structures.
Seasonable patterns of supply and demand and domination by retail investors — who are quick to sell if their perception of safety is undermined — present investment possibilities. A retrenchment from the market by dealers, such as the departure last year of Citigroup Inc. from the business, leaves more room for hedge funds.
“The market has an opportunity set to deliver 10-plus, 20-plus percent returns because of all these dynamics,” Pruskowski said.
The former BlackRock manager took advantage of a market quirk in August, 2023, for example. At the time, several Texas school districts — rated AAA because of a state sovereign wealth fund guaranty — sold a deluge of bonds.
The heavy issuance spurred the districts to price their bonds cheaper than usual to attract demand, allowing Pruskowski to pick up some securities with spreads as wide as 0.70 percentage point to top-rated bonds with comparable maturities. Spreads later narrowed to 0.4 percentage point, he said.
“It was about buying into that weakness,” the fund manager said. “And positioning Texas because of its favorable migration trends and robust economy.”
Lower coupon, longer maturity bonds contributed greatly to the fund’s performance in the past year, and Pruskowski now says the recent turmoil in financial markets on whether a US recession is coming has him favoring state debt over bonds from localities. He likes defensive sectors, such as water and sewer bonds, in AAA rated states like Virginia and North Carolina.
Hedging Priority
For muni hedge fund managers, the way to outperform the pack is often in how well they hedge their portfolios, Marren of KStone Partners said.
Unlike corporate bonds, munis are hard to hedge. Selling munis short to generate profits from a price decline can be almost impossible.
After all, it’s a buy-and-hold market, with scant supply of securities to borrow and then buy back. Also, Internal Revenue Service rules related to tax-exempt interest makes shorting expensive.
And getting protection against credit and interest-rate risks is also difficult, partly because a muni credit default swap market never took off. To guard against rate risk, most investors short US Treasuries — an imperfect hedge because the markets can diverge — or use derivative contracts like futures or options.
Hedging munis is “part art, part science,” said Pruskowski, who spends his time away from the market in athletic pursuits like surfing and triathlons.
He uses Treasury options and futures, and options on the biggest muni bond ETF, the iShares National Muni Bond ETF, to hedge. But Pruskowski also hedges credit risk with taxable munis.
Some state and local government debt, plus securities from large hospitals and universities, can be easier to borrow than other munis, he said.
For example, Harvard University, New York Metropolitan Transportation Authority and Kaiser Permanente health system have structured some of their taxable bonds like corporate debt, with one or two large maturities, making them more available to cover short bets.
To be sure, Pruskowski said he isn’t wagering on a default by these issuers, but rather using short positions to bet on credit spreads and volatility.
“You would like to see some momentum to that volatility if you’re hedged appropriately and picking the right securities,” Pruskowski said. “There’s a strong ability to put up positive returns in a negative environment.”
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