The size of the municipal credit default swap market has more than quadrupled in size in the past year, in tandem with the credit risk reassessment occurring in the market because of the subprime mortgage default crisis.
More and more investors in the market are seeking credit default swaps on municipalities as a way to supplement credits already insured by a monoline insurance company, or more recently, entering into a CDS contract in lieu of buying insurance, market participants said.
Others are simply expressing views on where the price of CDS will go and buying with the intention of selling the contracts later at a higher price in the secondary market. Many also are selling protection with the expectation that the contrACTS will never be called on, as insurance companies regain more stable footing.
The muni CDS market, which is small when compared to its corporate cousin, has been steadily growing since spring. It experienced a jolt in late July as credit concerns arose t, but is now seeing significant growth. The muni CDS market was only a few billion dollars at the beginning of 2006. It grew to about $20 billion by the end of last year, and now has developed into an $85 billion market, sources say.
News of large holdings of structured investment vehicles — and subsequently bond insurers’ mark-to-market losses and broker-dealers’ write-offs — continues to have an impact. As a result, confidence in some triple-A insurance companies has dwindled.
The corporate CDS rates on the insurance companies demonstrates the market’s jitters. According to Bloomberg, the bid on MBIA Inc. CDS was 491.5 basis points on Nov. 12, more than double the quote on Oct. 19, when it was 202.6. The cost of CDS on Ambac Assurance Corp. was 421.3 basis points for on Nov. 12., up from 207.9 on Oct. 19.
Similarly, the price for muni CDS has jumped in the past month, as demand has increased.
CDS on a California general obligation bond had a bid of 12 basis points for 10 years of protection on July 31. It was quoted on Nov. 6 at 40 basis points for the same credit, more than triple the earlier level. A New York City GO bid for 10 years was nine basis points in July and on Nov. 6 was 35 basis points. The source for both quotes is a Lehman Brothers monthly report.
Peter DeGroot, Lehman’s municipal bond strategist, noted in the report that “municipal CDS proved itself a popular investment vehicle to express views on credit spread movement in the municipal market and global credit market.”
“If you believe in efficient market theory, then the market is saying that the default risk of Ambac is many multiples of a state GO,” said Ross Berger, vice president of the Wells Fargo proprietary portfolio. “If you do not want to rely on a monoline but want default protection, then you can go buy uninsured bonds and muni CDS for a lot less cost and less effective relative risk.”
Berger also said holders of bonds that are already backed by monoline insurance companies are seeking muni CDS for extra protection.Jon Schotz, chief investment officer at Saybrook Capital in California, also said there are many funds that are involved in the CDS market to express views on where they think the cost of the swaps are going.
“It is a combination of people expressing a point of view on the monoline bond insurers and the potential result of a downgrade on their credit and what the value of the insurance is,” Schotz said. “And the other part of it is someone choosing, for example, a New York City CDS and they are expressing a view as to whether credit spreads will widen generally in the muni market.”
As the muni CDS market has become more accepted, a variety of buyers are using the product.
“All sorts of folks are buying CDS now, people who are seeking protection with a macro hedge on the current subprime blowout, those looking to make a directional bet and play on the recent volatility, those looking to hedge current exposure, insurance companies looking for statutory capital relief, to name some,” Berger said. “The spreads to buy muni CDS have increased as a result, with more demand on the short side [seeking protection] than long [offering protection], but relative spreads are very cheap when you look at CDS compared to the monoline insurers.”
Brad Winges, head of public finance underwriting and trading at Piper Jaffray & Co., agreed. “We’ve seen CDS on state GO’s widen out quite a bit in the past month, and we are attributing it to increased demand. I can’t imagine that people are really that much more worried about states actually defaulting right now.”
For those who don’t believe that states will default, or that the woes of the monoline insurance companies are overplayed, then selling CDS can be a profitable venture.
“On the flip side are those that are writing the protection, they think things will either stay the same or narrow if you are looking at the spread side, or they think that the bond insurers are fine, and that this is a lot of talk about nothing,” Schotz said.
HOW IT WORKSA 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 the International Swaps and Derivatives Association, 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, a CDS usually lasts either five or 10 years.
If during the specified 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.
For example, the bid price of a 10-year CDS on a California GOs on Jan. 17 this year was five basis points, according to quotes in a Lehman 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 the 10-year period, if California defaults or is forced to restructure, the investor will deliver these bonds to Lehman and be made whole.
Large mutual fund families such as Nuveen Investments Inc. and OppenheimerFunds told The Bond Buyer that they do not participate in the CDS market because any income earned is taxable. While this is the case, companies like Delaware Investments recently altered their muni fund prospectuses to allow managers to buy muni CDS as a precaution. A spokeswoman for Delaware said last month that the company had not bought any yet.
