WASHINGTON - The cost of protection against muni credit defaults has dramatically increased and is more than double its six-month average. But market participants say the jump may be more of a sign that speculators are trying to profit from issuers' budget troubles than an indication of the health of the tax-exempt bond market.
The municipal credit default swap market is estimated to be about $250 billion, a mere sliver of the $58 trillion corporate CDS market.
The MCDX index, which measures the cost of credit default protection, was created in May to give investors exposure to a basket of muni CDS rather than a CDS on a single issuer. The index tracks a pool of 50 municipal issuers and it increased 60% this month through Friday, as the spread between buying and selling credit protection widened, according to data from Markit Group Ltd. The index jumped 288% from its six-month average and increased 600% since its inception.
The jump indicates that the municipal market is being priced seven times riskier than it was in May, market participants said.
The wider spread means the cost of default protection is greater. Buying protection on $10 million of the bonds in the MCDX index rose to 292.75 basis points or about $300,000 on Friday, compared to the $89,020 average cost through November.
"Much higher MCDX readings are adding another level of tension to the muni bond market," Matt Fabian, a managing director at Municipal Market Advisors, told clients in MMA's Weekly Outlook on Monday. The rising cost of default protection has helped "unnerve some investors already skittish over rating and default risk," he wrote.
But trading in the muni CDS market is mostly conducted by speculators who want to bet on the health of the tax-exempt bond market without actually owning any muni bonds.
"The movement in MCDX may not represent an increasing caution among large bondholders," Fabian wrote. CDS traders may be "playing the news" and taking opportunistic positions to profit as reports show state and local governments are increasingly worried about their budgets, he said.
Other factors also could be contributing to the MCDX jump, according to Fabian and other market participants.
The MCDX may be rising as traders that used the index to hedge their muni portfolios sell their bonds. In an effort to offset a hedge that he or she does not need anymore, a trader could sell the credit protection to a counterparty. The trader can potentially recoup what was paid for in the initial hedge and neutralize the loss.
"You don't unwind your trade, you sell protection in an offsetting amount," Fabian said in an interview. But selling protection into an illiquid market such as the muni CDS market is costly. Sellers "are depreciating the value of that asset. They're charging more and more to write protection against it," he said. As more CDS sellers enter the market, they drive down the price of the protection being offered. The MCDX spread widens as a result.
Jon Schotz, chief investment officer at Saybrook Capital LLC, said traders may use muni CDS "as a proxy for the muni market" to gain exposure to the muni market as credit spreads widen. Muni CDS trading is "very thin" where a trade in excess of $10 million "is going to move the market."
"Does that mean you should be paying 300 basis points per year for credit protection on [California] GOs?" Schotz said. Traders may speculate on municipal health, but their bets may not correlate well with the strength of the issuers, he said.
