(The Bond Buyer) – Even as Build America Bonds continue to transform municipal finance, one thing stays constant: hedging a portfolio of muni securities remains very difficult.

The BAB program has opened the market to new types of ­investors and traders, and potentially to greater liquidity and transparency.

That’s small solace so far to dealers, traders, and brokers of state and local government debt, who have found that hedging the credit risk in taxable municipal securities is just as elusive as it is in the tax-exempt space.

“For the most part, neither tax-exempts or Build America Bonds are that easy to hedge,” said a capital markets veteran. “It’s a long-only market, and it’s not super-liquid, with a limited ability to hedge spread risk.”

Whether in the taxable or tax-free municipal debt markets, the impracticability of hedging comes down to one thing: fully shielding an inventory of municipal bonds requires shorting municipal credit, and nobody has figured out a good way to do that yet.

In a sense, any decline in the value of a muni bond is attributable to one of two things: either the benchmark interest rate rises, or the spread of the bond’s yield over that benchmark interest rate widens.

Many market participants agree that hedging the former risk — which is known as duration — is not so tough.

Because U.S. Treasury debt provides the benchmark rate for just about all bonds denominated in dollars, and because Treasuries are among the most liquid and continuously traded instruments in the world, a trader stuck with a municipal position can hedge duration risk by shorting a Treasury.

Market participants say duration risk has also been hedged using Treasury futures or options, or short positions on the London Interbank Offered Rate.

That way, if prevailing interest rates spike and clobber the value of a dealer’s municipal bonds, he will recoup his losses with gains on his short position on Treasuries or Libor.

The risk of a widening in a bond’s spread over the Treasury rate is a different story altogether. A reliable method for positioning oneself to benefit from a municipal bond’s spread swelling out has yet to emerge.

Take the story of Fred Yosca, who trades both tax-exempt and taxable ­municipal bonds at Bank of New York Mellon. Yosca began trading BABs at the beginning of this year, and like many traders hedged his exposure by shorting Treasuries.

“My model was to hedge them fully based on duration, with the appropriate cash Treasury,” Yosca said. “That worked like a charm until May.”

From January through April, the nominal spread of the average BAB yield indicated by a Wells Fargo index tracking the sector over the 30-year Treasury rate compressed 40 basis points.

The long-BABs short-Treasuries model worked fine as BABs outperformed Treasuries during that period.

Then, in May, public sector workers in Greece rioted. The markets fretted over sovereign debt defaults and fat-fingered traders and double-dip recessions. ­People worried about the swelling supply of ­taxable municipal bonds in the primary market, or about federal subsidy withholdings — or whatever else you want to attribute the widening of BABs spreads to.

The BAB spread over the 30-year Treasury jumped 17 basis points in May.

Yosca was slammed with a short position on Treasuries, which strengthened 30 basis points in May, and a long position on BABs, which strengthened fewer than 15 basis points.

“I got killed,” he said.

Yosca’s lament: hedging duration risk does not address a shift in spreads.

The long-BAB short-Treasury hedge has since completely fallen apart, as the nominal spread has distended an additional 40 basis points since the end of May to about 200 basis points.

“There’s duration to hedge, and then there’s spread,” said one public finance banker. By shorting Treasuries, this ­ banker said, “you’d really only be hedging duration — you haven’t hedged that spread risk.”

This is not so foreboding a problem in the investment-grade corporate bond market, where traders have long had access to futures on a number of credit indexes that would decline should corporate spreads bleed out. That offers corporate traders a way to hedge duration using Treasuries, and hedge spread risk using indexes.

Municipal traders have no such index

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