GEM Capital, LLC, a Registered Investment Advisor, was formed in 1997 and was the first to offer a municipal bond arbitrage fund of funds, which launched in 2005. The fund remains the largest of its kind.
Since 2001, GEM has focused its alternative investment efforts solely on municipal bonds and municipal bond arbitrage, offering investment opportunities to investors looking to receive tax-advantaged income with a long-term risk/reward profile superior to that of traditional municipal bonds, high-yield munis and taxable junk bonds.
As the first mover in municipal arbitrage, GEM and its affiliate have exceeded their goals, generating over 1% per month in tax-advantaged income since 2001. Credit risk is primarily AAA with some AA bonds in the portfolios; interest rate risk is hedged to a target net duration near zero. Total return in the municipal arbitrage portfolios has been negatively correlated with long-term bonds and has demonstrated significant, but mean-reverting volatility.
Municipal Bond Arbitrage:
Because longer maturity municipal bonds tend to offer significantly higher after-tax yields than corporate bonds with the same credit rating and maturity (i.e., they yield "too much"), investors in higher tax brackets may be motivated to invest in a relative value situation, pairing municipal bonds against corporate bonds. This strategy is called municipal bond arbitrage.
With municipal bond arbitrage, there is no material increase in credit risk and likely less interest rate risk versus a traditional municipal portfolio. Municipal bond arbitrage also offers a significantly higher yield. For long-term investors, the strategy has been negatively correlated to long-term bonds; so, when municipal arbitrage is included in a portfolio along with municipal bonds, the portfolio has demonstrated less overall volatility than a municipal bond portfolio on its own.
For long-term investors, municipal bond arbitrage is expected to outperform traditional municipal bond investments in both yield and total return in all investment scenarios.
The Opportunity:
Fund managers who engage in municipal bond relative value arbitrage exploit the fundamental pricing inefficiency that persists across the maturity spectrum of the tax-exempt municipal bond market. The graphical presentation of this inefficiency is a municipal yield curve that is steeper than a taxable yield curve of similar credit rating (see chart below).
The relative steepness (the mispricing) of the muni yield curve creates an arbitrage opportunity between the tax-exempt and taxable fixed-income markets. To capitalize on this opportunity, the funds are economically long tax-exempt muni bonds and short the equivalent of taxable corporate bonds, with matched maturities, market values and leverage.
This trade has been in practice on proprietary trading desks for 20 years, but has only been available to the public since 2001 when the first municipal bond arbitrage fund was launched. Investors in GEM Capital’s fund of funds have earned tax free income of >9%, along with range bound, but mean reverting principal volatility.
GEM Capital, LLC | 83 Beach Road, Belvedere, CA 94920 | (415) 563-3844 | info@gemcapital.com
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