The demand for contracts used to bet on municipal defaults may soon grow larger with the creation of an index which will be used to track the market for municipal credit protection.
Markit Group said earlier this week that it will create and manage the MCDX index - scheduled to launch May 6 - to track the growing municipal credit default swap market, used by investors to bet on the creditworthiness of municipal issuers. Investors and the seven dealers who have signed up so far to trade the index - Citi, Goldman, Sachs & Co., JPMorgan, Lehman Brothers, Merrill Lynch & Co., Morgan Stanley, and UBS Securities LLC - hope the index will bring added liquidity and consistency to the market.
"The creation of these indices quite often deepens liquidity and broadens the market for the underlying single names," said Nishul Saperia, head of U.S. credit indices for Markit.
CDS, designed to allow investors to buy and sell credit protection, have been in existence in the municipal market since before 2004, the year the International Swaps and Derivatives Association Inc. first standardized the trading documentation. Since then, trading in single-name muni CDS has grown steadily. The current market may be as large as $200 billion, according to sources, but as an over-the-counter market, the exact scope is unknown.
In the past, CDS have been used to supplement the insurance provided by one of the bond insurers on municipal bonds, and more recently, in lieu of buying the insurance entirely. As the market has taken shape, additional investors, many of them not traditional muni buyers, have taken an interest.
"This index will likely attract additional players to the credit market for municipal securities," said Peter DeGroot, muni bond strategist at Lehman Brothers. "[Investors] making broad market plays will have a diversified representation of credit risk in the muni bond market."
With the bond insurers facing capital constraints and added uncertainty, the CDS market has taken on an even bigger role for investors looking to protect themselves against credit risk. Through the four months of this year, bond insurance penetration is about 26%, according to data from Thomson Reuters. This is about half of what it had been in recent years. Between 2002 and 2007 the use of credit enhancement was above 50%.
"[The index] should open up liquidity in general for the CDS market and in a post-insurance world, CDS liquidity is going to become more important," said Matt Fabian, managing director at Municipal Market Advisors.
According to Markit, the index will be made up of CDS contracts written on the general obligation, revenue, and full faith and credit bonds for 50 municipal issuers. Ratings must be above BBB-minus or Baa3 and not on negative watch. All of the issuers must have $250 million of uninsured bonds outstanding, while tobacco bonds and health care issues will be excluded, Markit said.
Contracts will be tied to two credit events, a failure to pay and a restructuring, and will provide protection against those events for three, five, or 10 years, Markit said in a press release.
CDS have been used by investors to hedge their exposure to credit risk in the muni market and as recent upheaval and worries about future revenues for issuers have caused investors to more closely examine municipal credit risk. As the yields and perceived risks on municipal bonds becomes more stratified, those who hold CDS could profit as other investors feel the need to buy protection for their bonds.
However, market participants have raised some concerns about the index, and dealers are actively working with Markit to address some of the biggest reservations. Currently, the bid-to-ask spread on a triple-A rated CDS name, for a 10-year contract, is four to six basis points, according to one quote.
A chief concern among market participants is the potential for a large amount of capital, held by large macroeconomic players like hedge funds, to come into the market and manipulate the index. If a large amount of capital were to flood the market, those participants could drive the valuation of the index regardless of the credit factors of the underlying securities, naysayers claim.
To put it in perspective, some analysts earlier this year estimated the corporate CDS market to be as large as $46 trillion, and while the current muni CDS market is much smaller, a large capital influx could potentially move the index.
Complaints have surfaced in the structured finance market, where some investors used indices to short subprime mortgage exposure. This made index spreads widen out dramatically. The fear is that something similar could happen with the MCDX, a point disputed by Markit's Saperia.
"If people start shorting the market using this index and the spreads start widening out, I think there is a lot more comfort in the fundamentals of this market versus, say, the structured finance market," Saperia said. "In the muni market, I would think people would be much more comfortable in terms of having a strong opinion of where the index should be, and would see people coming in and take positions the other way."
One concern relates to the fact that while the MCDX is made up of a basket of CDS contracts on 50 municipal issuers, only a handful of those trade with any regularity. CDS tied to California state GO credits, New York Cityand New York State credits, and Florida state bonds are the most liquid, and while a handful of others also trade, they do so far less often.
Markit's experience with other indices shows that creating an index initially composed of illiquid credits eventually brings liquidity to those same names, Saperia said. He said the LCDX, an index of loan credit default swaps, was originally composed of 100 names, and only about 50 of those were liquid at the time, in May 2007. On the morning of the launch, dealers were offering lists with all 100 names.
One hope is that the creation of the index will give dealers an incentive to trade the same list of credits, said Paul Ferrarese, managing director with Merrill Lynch's municipal capital markets group, on a conference call Tuesday. Currently, all dealers do not trade or quote the same credits, though there is a fair amount of overlap. Saperia said he knows at least one dealer offering more than 100 names.
"We think that when creating new indexes, especially in nascent markets like this, the addition of names in the index that are not liquid themselves will help create liquidity in those names," Saperia said.
Another concern expressed by investors is the inherent riskiness of the exposure to banks on the other side of the transaction. At 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. In many cases, Wall Street's largest brokers provide the protection.
As those banks have written down billions of dollars in subprime-related exposures, the risk that these banks could not uphold their obligations has increased.
"You also have to question the state of the dealer community given the counter-party risk," said Jon Schotz, chief investment officer at Saybrook Capital. "Are people going to want to take the dealer counter-party risk?"
And another sticking point among dealers is how to deal with the settlement of the contracts in an event of default.
In the corporate CDS market, a provision called "cheapest to deliver" exists where, when a default occurs, one side of the contract can present to the other side the cheapest option, which could be a bond with a significantly lower coupon. In the tax-exempt market, this takes even greater importance with the existence of de minimis tax rules and other provisions that affect the value of bonds, and a "cheapest to deliver" option could mean a bond with a vastly different value from the bond being protected by the CDS is delivered as payment.
In addition, when a company defaults on its debt or files for bankruptcy, all of the obligations can be accelerated to pay the CDS holders quickly. In the municipal market, many official statements specify that the government pay only what is due in an event of default, without the right to accelerate.
Many questions need to be sorted out before the true impact, either positive or negative, of the index is felt. In the meantime, many investors have taken a 'wait and see' attitude.
"No one knows how it will perform," Schotz said. "We'll have to see how wide the spreads are."