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Q&A: "I Have $400K+ in AMT Tax-Free CA Muni Bonds. What's a Good Way to Hedge Against a Rise in Interest Rates?"

Investment Tax

Question and background: 

I have $400K+ in AMT Tax Free CA Muni bonds. With the general expectations that interest rates will rise, what is one way to hedge this position? Or do you recommend some other investment which provides a good 4-6% after tax returns? The bonds have worked well for me over the past 5 years.

Answer: 

Since I'm not aware of your total financial picture, these are ideas for further consideration rather than specific recommendations:

  • Buy Put options on a municipal bond ETF to hedge both an increase in interest rates and a general decline in municipal bond prices

The beauty of this is that 1 option contract controls 100 shares of the underlying investment. You can deploy a relatively small portion of your overall capital for a magnified hedging impact. If what you're hedging doesn't come about, you've lost that premium you paid. But that's OK because you go into this approach with a "portfolio insurance" perspective.

My cursory review indicates the iShares National AMT-Free Muni Bond ETF (symbol: MUB) has options availability. What I don't like about it is they currently go out no further than November 2014. Most of us have been expecting interest rates to rise for about three years now and it hasn't happened. So I'd prefer to buy long-dated Puts (i.e. January 2016). But I don't see any of those available in the muni ETF space and nothing for California muni ETFs.

  • Buy Put options on a long-term Treasury bond ETF to hedge an increase in interest rates

The same interest rate increase that would harm municipal bonds will also harm Treasuries. And the longer-dated they are, the bigger the negative impact. Since interest rate hedging is the primary concern, it doesn't really matter that you're not also hedging specifically for municipal exposure. 

An example (not recommendation) is the iShares 20+ Year Treasury ETF (symbol: TLT). And the beauty of this vehicle is not only are the bonds long-dated, but you can currently buy options contracts out to January 2016.

  • Sell some of your current California municipal bonds and buy a "defined maturity" municipal bond ETF

First off, be aware that you may trigger capital gains in the liquidation. And if you trigger capital losses, be mindful of the 30-day "wash sale" rule.

I'm not an iShares "groupie" but, once again, they offer a number of national AMT-free municipal bond ETFs with defined maturities (i.e. 2016, 2017, and so forth). The potential advantage with these is the bonds will mature in the indicated year. So that potentially mitigates interest rate risk if you hold the fund to maturity vs. a standard muncipal bond ETF or mutual fund which will be frequently rotating their bond holdings. Credit risk of the underlying bonds will still be a consideration. And since these are national funds, you won't get the California tax benefit.

  • Forget hedging and simply reduce exposure at this time

Same potential capital gain issues as noted above. With this strategy, you'd simply bite the bullet and sell some (you decide the percentage) of your municipal bond portfolio. Then painfully sit in cash or very short-term bond funds earning hardly any interest and wait for interest rates to rise so you can buy back in at better prices.

As indicated above, some of us have been expecting some rise in interest rates for around three years now. If you moved too much to cash or short-term bonds and we have another three years of interest rates like the last three, you'll have "lost opportunity cost" in missing out on the bond yields you're currently enjoying. Of these four ideas, I favor #2 and then #4 (or some of both). 

Hope that helps.