First of a 2-Part Series on Credit Default Swaps in the Muni MarketToday: When It Began & How It Works
Tomorrow: Who’s in the Market and WhyIt seemed for the last few years that the bankers trying to sell municipal credit default swaps were throwing a party that few buyers wanted to attend. That has changed this year, though, as hedge funds, European banks, and other outside-the-box investors have begun showing interest. While the muni CDS market represented only a few billion dollars in notional amounts at the beginning of 2006, it grew to about $20 billion by the end of last year and now has developed into a $75 billion market, sources say.“It is growing because people are figuring out how to use it and there is more liquidity in the CDS market, but not as much as its corporate counterpart” said Jon Schotz, chief investment officer at Saybrook Capital.Credit default swaps, designed to allow people to buy and sell credit protection, first hit the muni market in earnest following California’s 2001 energy crisis. Since then, however, muni CDS were slow to sell, even as the total market for CDS — including corporate CDS — has mushroomed to $34.4 trillion dollars, according to the International Swaps and Derivatives Association Inc.Municipal bonds simply were too secure to create the kind of credit volatility that draws buyers into CDS markets.From 1970 to 2006, only 41 municipal deals rated by Moody’s Investors Service defaulted, according to an updated study the rating agency published in March. Fitch Ratings and Standard & Poor’s have also published studies this year showing how infrequently state and local governments default.How It StartedIn the morass of a global credit and liquidity crisis in recent weeks, even the municipal market is seeing investors worried more about risk. Newly interested buyers, many of them from outside the traditional muni fold, have taken interest in the potential for CDS’ other use — betting on the widening and tightening of credit spreads.As the yields and perceived risks on municipal bonds becomes more stratified, those who hold CDS could stand to profit as other investors feel the need to buy protection for their bonds.Some said the trend started with hedge funds purchasing CDS on bond insurance companies as concern mounted over the insurers’ exposure to the souring subprime mortgage market. Quotes on the CDS for bond insurers rose dramatically this summer as the investment became more popular, and some investors looked for a way to buy other forms of related credit protection.Others said the hedge funds were simply taking a wider outlook on what they think will happen to credit in fixed-income markets around the world.“In the beginning, munis didn’t follow the credit spread change, so the hedge funds saw this happening in their other assets and took a bet that this would happen soon,” said Mark DeMitry, portfolio manager at OppenheimerFunds Inc.Along with hedge funds, European banks, crossover buyers, and insurance companies have shown warming interest in muni CDS. The foreign buyers also have shown interest in other municipal products, such as structured notes, that get them exposure to municipal credits.The result was dynamic growth for certain names in the muni CDS market, especially during the last two months, Schotz said, who also noted that his firm is a buyer of muni CDS.“Many investors, as a proxy for credit spreads widening, bought a number of [general obligation] credit default swaps and are now getting paid handsomely for it,” Schotz said.
The change in credit spreads can be seen in the differences in yields between high-grade municipal bonds and their lower-rated cousins.The difference between yields on low investment-grade bonds and those on high-grade municipals has increased noticeably since mid-July, according to Thomson Financial. While there were 36 basis points of spread between the 30-year maturities of these types of credits on July 20, that gap had widened to 45 basis points by Tuesday.Muni CDS also play to the interests of the market’s newer, non-traditional buyers, which often seek out the more complicated corners of the market.While getting this exposure is something that can also be done through buying standard cash municipal bonds and entering into a set of swaps, buying credit protection through a CDS is a more streamlined process for getting muni credit exposure, said Paul Ferrarese, a managing director in Merrill Lynch & Co.’s municipal capital markets group.“Managing that whole process for an entity that does not have a full-time muni staff is not such an easy thing to pull off,” he said. “Some don’t care to dedicate the infrastructure to having a full-scale municipal trading operation.” Ferrarese added that his firm has been active in the muni CDS market for nearly five years.How It WorksAt the most basic level, a muni CDS involves one party — the buyer — paying another party — the seller — to take on the risk that a state or local government will default on its bonds.The standard muni CDS contract, as laid out by ISDA, states that a credit protection buyer pays the seller a premium — or “spread” — for this protection during a given period of time. In the municipal market, CDS usually last either five or 10 years. If during this time the government in question fails to pay its debt service or has to restructure the debt, then the protection seller will make the buyer whole for the face value of the bonds. The seller, in turn, takes possession of the bonds and is responsible for pursuing them in court.Standard spreads paid for muni CDS are calculated as percentages of the total notional amount being protected.For example, the bid price of a 10-year CDS on a California general obligation bond on Jan. 17 this year was five basis points, according to quotes in a Lehman Brothers presentation. If an investor bought credit protection from Lehman at this bid price on $10 million of California GO bonds, that investor would pay $5,000 a year to Lehman. The payments are typically paid on a quarterly basis.During this 10-year period, if California defaults or is forced to restructure, the investor will deliver these bonds to Lehman and be made whole.The concept of selling credit protection through muni CDS started at a handful of Wall Street banks that are active in underwriting municipal bond deals. While some other shops were hesitant to quote markets for muni CDS at first, nearly all of the big banks are now involved.“Guys who didn’t quote at all six months ago are now quoting markets,” said a banker from a New York-based mainstay in the muni CDS market. “At this point, all the major muni underwriting firms and muni derivatives shops are quoting muni CDS.”Although Lehman is widely cited as one of the first to focus on muni CDS, the firm declined to comment on the record for this story.By and large, broker-dealers were reluctant to provide current quotes, saying their quotes were proprietary information.Ferrarese said, however, that the midpoint between the bid and ask quotes for a 10-year contract on triple-A state GO bonds is about 10 basis points right now. The midpoint for double-A state GO bonds is about 15 basis points.He said levels jump slightly for CDS on issuers that bring large bond sales to market, such as Puerto Rico and California, but that the quotes remained relatively even until recently.The bid price for CDS on Florida’s state GO bonds was about seven basis points two months ago, while the asking price was about 11 basis points. These levels had not changed much during the previous year, he said.But by Tuesday, the bid price had jumped to 16 and the asking price was at 21 — a good indication of how levels for all muni CDS have risen.The CDS market also has a secondary trade. This is one way that many funds have profited from the muni CDS market — as spreads widened, they looked to sell their protection at a higher price.But one director at a New York-based broker-dealer said his firm decided not to get into the market as a seller while the markets have been so volatile. This decision was a good one in retrospect, he said, because the widening spreads have made it tough for credit sellers to trade out of their positions as credit worries continue to worsen.“Who wants to step in front of a moving train, right?” he said. “Even though spreads are just now starting to go levels where they are really interesting, the banks are not really in a position that they are able to provide that much liquidity for the market.”
