With Subprime Fears, Market Activity Slows

Municipal market activity has slowed over the past two weeks as traders, fund managers, and dealers are not as active in the market. Lack of liquidity is nothing new for muni traders who make their living in a market where nearly half the buyers are households that rarely trade, according to Federal Reserve data. However, it appears many participants are “keeping their heads down more than usual,” as one New York-based dealer put it, for fear that the subprime mortgage crisis is grabbing hold of the muni market. The result is clear — trading desks are quieter than usual. “There has been a lack of liquidity over the past two weeks,” said Gavin Peter, portfolio manager for the international Rand Merchant Bank municipal arbitrage fund. “Our view is that this is due to the repricing of risk in general, which is evident in the muni market in both bond spreads and ratios.” Illustrating illiquidity is difficult as the muni market is decentralized. However, looking at Municipal Market Data statistics for trading activity yesterday begins to paint a picture. As of 4:26 p.m. yesterday, the par value volume of trading activity was 21.4 billion as reported by MMD. This number, when compared to the average volume the past five days, is down 13%. In terms of block trades, meaning at a par value of $1 million or more, trading is down 14%. When data on yesterday’s trading activity is compared to the average of the last month, which had higher liquidity for the most part, the trend is more pronounced. For the number of trades, the percentage decrease is 18%. For block trades, there is a decrease of 19%. High volatility, driven by rising rates in the Treasury market in reaction to the subprime mortgage crisis, keeps many owners of tax-exempt debt out of the market. Robert Nelson, managing analyst at MMD, said that events are affecting the number of transactions in the municipal market. “We see the bid/ask spreads widen and there aren’t many bids-wanted lists floating around,” he said. “Obviously this reflects a market that really doesn’t have much liquidity.” A risk reassessment began to permeate the municipal market at the end of July. While not spurred by any one event, the subprime mortgage default is prompting muni participants to reexamine the risk in their portfolios, and perhaps to steer clear for now. Subprime mortgage defaults do not directly affect municipal bonds. However, many munimarket participants have exposure to the mortgage market in other parts of their business. These include financial guaranty insurance companies that may also insure subprime mortgages or asset-backed securities that package them. Also, large investment banks that own large portions of subprime debt also act as dealers and hold a lot of tax-exempt debt. If defaults expand, these large players could have problems. The result has been that many muni credits have devalued. For example, prepaid gas bonds, where investment banks act as guarantors on the gas delivery, have experienced a yield jump in recent weeks. Tobacco bonds, acting in correlation to gas and other credits, have undergone the same process. Also, bonds insured by companies that also have considerable exposure to subprime mortgages have seen spreads open up. The market response to these credit issues is two-fold. In the primary market, sales have been postponed, such as the $2.6 billion Tennergy Corp. sale and $240 million Puerto Rico tobacco bond sale. Fewer bonds in the market means less liquidity. In the secondary muni market, many bond holders sit on the sidelines waiting to see where the dust settles. While other markets will see a rapid repricing of credit, it is a slower process for munis, as the fractured market makes it more difficult to get an accurate price on bonds during periods of transition, said Ross Berger, vice president at Wells Fargo proprietary portfolio. Thus, many participants sit it out and volume declines. “You just aren’t seeing a lot of trading,” Berger said. “You look at the equities market and it constantly reprices every second. In munis, it doesn’t happen that way, you need someone to trade to see where the market’s at, and right now everyone is waiting until the overall market volatility quiets down before jumping back in.” Prices have already gapped out considerably, but if and when you see large bid-wanted lists, then the market could sell off quickly. As the summer wears on, fixed-income markets are digesting these events and that makes for more volatility. Tax-exempt markets take a cue from where the Treasury and corporate markets are headed.On July 6, the benchmark 10-year U.S. Treasury bond yielded 5.19%. The 10-year stayed above the 5% yield until the market closed on July 20, when it yielded 4.96%. From there the market rallied and prices reach a pinnacle on Aug. 3, as yields which move in the opposite direction, fell to 4.70%, a drop of six basis points from the day before. This week yields moved up, closing at 4.85% on Wednesday. With Treasuries in mind, the benchmark 30-year triple-A general obligation MMD yield scale moved around as well. Starting August at 4.74%, the scale read 4.93% on Wednesday. Arbitrage accounts and cross-over buyers that take advantage of price discrepancies in different markets are also bowing out of the muni market to some extent. With the movement in municipals, the relationship between tax-exempt rates and the 30-year London Interbank Offered Rate swap has changed drastically. Many of these funds use Libor swaps as a hedging vehicle for their investments.From early February of this year through July 30, the 30-year MMD triple-A scale as a percentage of 30-year Libor swap ranged between 75.0% and 76.9%. From July 31 to Aug. 8, this percentage went to 78.9% from 76.7%, a jump of about 22 basis points. The higher this percentage, the closer the relationship between the two curves are. The closer the relationship, the poorer the performance of the hedge. The swap market moves in the opposite direction of bonds, so as the relationship between swaps and bond changes the hedge becomes less effective and actually quite costly.