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Sell Side

Turning Down the Volume

When hedge funds bailed from the municipal market beginning in late February and sold heavily, it pushed secondary trading volume to one of its highest levels ever. But now as the market continues to deal with the fallout from the credit crisis, trading volume has dropped to its lowest levels in years.

While daily average trading volume hit highs of $29.2 billion in February and $25.8 billion in March, it dropped off slightly in April when it fell to $22 billion. Volume then tumbled to $17 billion in May and $19.3 billion in June, according to Municipal Securities Rulemaking Board data.

This decline is more than just the usual summer doldrums, according to market participants. Daily average trading volumes in May and June dropped 35.83% and 37.40%, respectively, year-over-year. The daily averages for both months represent the lowest in any month since October 2005.

Indeed, the five-day moving average of par-value trading volume of fixed-rate municipal securities by institutional investors peaked at $15.2 billion March 7, about three times its normal level since last July, according to Merrill Lynch & Co. Two days earlier, the five-day moving average of all trading volume had hit $36.503 billion, its all-time high, according to the MSRBPAR index.

"That's the hedge fund blow-up," said Philip Fischer, municipal strategist at Merrill Lynch, referring to the peak in trading. "[Fixed-institutional trading] spiked to three times its usual volume. That explains the distortion; it takes a long time to fix that."

The late spring slowdown put a halt to what had been exploding trading volumes over the past few years. For example, the daily average trading volume in 2005 was $16.9 billion and grew to $25 billion in 2007. In June 2007, trading peaked at a daily average of $30.7 billion for the month.

But beginning last October when daily average trading volume was $ 21.2 billion, trading began to slow. For the first time since May 2005, a month's daily average trading volume had decreased year-over-year. That trend has continued in every month since, except for February and March. And daily average trading volume was down 12.38% over the first half of 2008.

A large portion of the volume decrease is attributable to a dramatic decline in the trading of short-term variable-rate debt, which includes auction-rate securities and variable-rate demand obligations. In January, short-term variable-rate securities with par value of $382 billion were traded, compared to just $211 billion in May. In all of May, just $406.9 billion of municipal securities were traded.

In addition to the dramatic slowing of the auction-rate market, participants have cited a number of other potential factors flowing from the credit crunch for the trading slowdown. The exit of hedge funds from the municipal market, dealers reining in their balance sheets, and downgrades of bond insurers have all played a part, they say.

Trading volume decreased as hedge funds, once an accelerator of secondary volume growth in the market, ended their active trading. Many of these hedge funds had previously executed carry arbitrage trades, in which they would essentially buy long-term, fixed-rate debt and sell short-term, floating-rate debt - hedged by another instrument - hoping to pick up the difference between the spread of the short-term and long-term rates. This added liquidity to the market and narrowed bid-ask spreads.

"The MSRB data has increased as the size of hedge funds increased," Fischer said.

But in late February their hedges failed. Treasury yields fell while municipal yields rose, forcing the highly leveraged funds to close their positions to meet margin calls.

Lower volume "is probably a symptom of deleveraging in the market," said George Strickland, co-portfolio manager at Thornburg Investment Management. "There's less trades where people were arbing this or that for a few basis points. These funds had their wings clipped."

Heavy selling flooded the market with paper, sending yields soaring further. Between Feb. 5 and Feb. 29, the yield on the triple-A rated general obligation bond scale rose to 5.14% from 4.25%, according to Municipal Market Data. In addition, municipals cheapened sharply as a percentage of Treasuries. The ratio of triple-A rated, 30-year general obligation paper and 30-year Treasuries reached above 117% March 20, according to MMD.

While hedge funds were selling, others were buying. News reports indicated that investor Wilbur Ross and fund Pacific Investment Management Co. had bought $2.5 billion in bonds during the first week of March, helping push yields back down below 5%.

Along with tightened risk management in general, the threat of another dislocation from typical hedging instruments such as Treasuries has prevented traders from holding large inventories at all times, participants said.

"People had a lot more confidence in hedges and credit ability, so letting inventory positions balloon up was not as big a concern," Strickland said.

This desire of the Street to keep bonds off its books means increased pressure to price new issues for a smooth sale.

"A lot of paper is currently being priced to sell on the new deals because the street doesn't want to own it," said George Friedlander, managing director and fixed-income strategist at Citi.

Before March, paper would have moved around the market a bit before settling with an owner, adding to secondary trading volume. Today it's more likely it's ending up directly in the hands of retail buyers and funds, who tend to take a long-term outlook on the market.

"There's more paper going into the retail sector, which doesn't come back," Friedlander said. "The willingness of the street to function as an intermediary is down sharply, and that means less trading."

The downgrades of bond insurers have also hurt trading volumes, participants said. In the past, issues wrapped by triple-A-rated insurers traded almost like "commodities," Friedlander said.

Now old paper wrapped by downgraded insurers trades based on its underlying rating, sometimes with a negative value added because of the insurance. Many more new issues have come to the market uninsured. Through June, the total volume of insured deals fell to $53.7 billion from $122.5 billion at that time last year, according to Thomson Reuters data.

This forces traders to analyze each bond more carefully before making a deal and accordingly slows down the trading process.

"A vastly lower portion of the market is insured, so easy trades aren't bounced around as much based on its value as an insured credit," Friedlander said. "Bond insurance was an important lubricant for the secondary market."

Finally, layoffs resulting from the financial turmoil have compounded all these issues, participants say. UBS Securities LLC, for instance, officially closed its public finance department in June - although its still bids for competitive deals- and the size of JPMorgan's tax-exempt capital markets group has been reduced 10% since its acquisition of Bear Stearns. The reduced size of trading desks has left fewer people to do what market conditions have made more difficult work.

"Each trade is harder to execute, and there's fewer people to execute them," said Matt Fabian, director of Municipal Market Advisors. "It's sort of a double whammy."

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