Friday, July 8, 2011

A Smoking June for Hedge Funds

A Smoking June for Hedge Funds


For some investors in the municipal-bond market, June added insult to injury.

In an otherwise bleak month for many investments, tobacco bonds were star performers, rising an average of 10%. Some jumped more than 60%.

But many municipal-bond funds missed out on the gains. They had been forced to sell the bonds months earlier, often at a big loss, after a credit-rating downgrade made them noninvestment grade.

Instead, the big beneficiaries were hedge funds that scooped up the bonds at pennies on the dollar. Municipal bonds overall returned 0.35% in June, according to Barclays Capital's municipal-bond index.

Tobacco bonds have been part of the municipal-bond market for about a decade. They are sold by states and backed by payments from cigarette manufacturers that flow from a legal settlement in the late 1990s. The downgrade of many of the bonds by Standard & Poor's in November caused forced selling by municipal-bond funds that aren't able to hold noninvestment-grade debt.

The exodus helped trigger a broader wave of selling across the market.

Big hedge funds like Brigade Capital and GoldenTree Asset Management snapped up the debt on the cheap, according to people familiar with the matter. Smaller firms such as Venor Capital Management and Foxhill Capital Partners also jumped in.

"We started off looking at the muni market early this year because it was selling off so much from concerns about the states, and the bonds that were selling off most were tobacco bonds," says Michael Wartell, co-founder of Venor, in New York.

..Mr. Wartell says he put a small piece of his $700 million fund in tobacco bonds this spring, buying them for as little as 1.5 cents on the dollar. The bonds offer a so-called asymmetric investment, Mr. Wartell says, meaning they have little downside but have a chance of producing outsize gains.

Some of the bonds that Venor bought rose more than 60%.

The rebound in the bonds, most of which jumped in the second half of June, came at a fortuitous time for the hedge funds that bought them.

Worries about U.S. economic weakness and Greece's debt restructuring roiled financial markets and drove the average hedge fund to a loss of 0.72% in May and 1.36% in June, according to a weighted index maintained by Hedge Fund Research.

The sudden bond rally was fueled by news of a tentative settlement among states and tobacco companies, including Phillip Morris USA, a unit of Altria Group Inc.; Reynolds American Inc. and Lorillard Inc., which would open the way for as much as $5 billion to flow to bondholders.

"This [recent settlement] is the first good news tobacco buyers have had in some years and recently hedge funds have legged into positions that have benefited," says Peter Bartlett, co-head of municipal capital markets at Citigroup.

To be sure, municipal bondholders that aren't restricted to investment-grade debt still hold some tobacco bonds.

Citigroup has handled about $3 billion in sales of tobacco bonds this year, many of them from traditional tax-exempt-bond investors to hedge funds, according to the bank.

Citigroup estimates that it handled about 60% of all transactions in the market. About $54 billion of tobacco bonds are outstanding.

Since the bonds are sold by state governments, they have the tax-exempt status of municipal bonds.

Hedge-fund managers like Mr. Wartell started looking at the debt in late 2010, after signs that a prolonged decline in cigarette consumption was moderating.

For example, one 30-year bond sold by New Jersey was yielding about 8.5% in March, compared with an average 7% for a taxable junk bond.

The gamble paid off in June, when news of the settlement broke.

The 30-year New Jersey bond jumped to 68 cents on the dollar after the settlement news, up from 61 cents in May, a gain of 11.5%.

The state's zero-coupon bonds, which don't pay interest until they mature, jumped to 4 cents at the end of June from 2.5 cents in May, a gain of about 60%.

Foxhill, which has had net gains of 20% this year, bought some zero-coupon tobacco bonds in March and April.

While the $50 million fund still suffered overall losses of 1.5% in June, it would have been down more without the tobacco-bond windfall.

"It definitely made a positive impact," says Neil Weiner, Foxhill's founder.

—David Kesmodel contributed to this article.
Write to Matt Wirz at

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