Buy Side

CDS Have Edge on Taxables

Anyone considering buying a taxable municipal bond might want to get a quote on some municipal credit-default swaps first.

Chances are, the CDS is a ­higher-yielding way to play the municipal market.

Consider Illinois. According to Bloomberg LP, it costs 290 basis points a year through a CDS contract to insure the state’s five-year debt, which itself yields 2.85%.

This is in flagrant violation of the “law of one price,” which states that the same cash-flow streams with the same risk should cost the same in different markets.

An investor with $10,000 could buy a five-year Illinois taxable bond yielding 2.85%. Or, he could buy a $10,000 five-year Treasury note yielding 1.53% and sell a CDS on Illinois yielding 291 basis points, collecting 4.44% for the same investment and the same theoretical risk as Illinois’ cash bonds.

Maybe that is why more people are starting to pay attention to muni CDS, which offer investors exposure to municipal credit, often at higher yields than municipal bonds themselves.

“I’d say starting late summer and fall I started seeing more activity in the space,” said Mikhail Foux, an analyst at Citigroup. “Spreads are extremely attractive, and more and more investors sort of noticed it. ... With the last couple of months, we saw substantially more interest, and spreads did come in.”

There are 966 contracts outstanding on Markit’s MCDX indexes, a standard index for muni credit swaps, according to the Depository Trust & Clearing Corp. A year ago, there were 492 contracts.

Gross notional contracts outstanding on MCDX indexes total $13.4 billion, compared with $9.5 billion a year ago.

The five-year MCDX index composite spread has tightened 75 basis points since the end of June.

Foux expects 2011 to be a big year for municipal credit-default swaps. Yield is hard to find, especially low-risk yield. As a result, in a “grab-for-yield” environment, he expects more investors to get involved with muni CDS.

If you want to go long on municipal credit, Foux said, the best way to do it is not to buy bonds but to sell the MCDX.

Credit default swaps are essentially insurance contracts. The buyer must pay the seller an annual premium, in exchange for which the seller promises to cover any losses sustained on the insured bond.

The CDS annual premiums theoretically should be comparable to the credit spreads on the reference issuer’s bonds.

An investor should be indifferent between owning a taxable municipal bond or synthetically replicating that bond by holding a short position in the CDS complemented by a Treasury bond with the same maturity. Therefore, arbitrage should compel CDS spreads and bond spreads to move toward each other.

But it is not working that way. Municipal CDS spreads are mostly higher than taxable municipal bond spreads, in some cases drastically so.

Ohio’s five-year taxable spread over Treasury yields is 109 basis points, compared with a CDS spread of 121 basis points. California’s 10-year yield spread is 192 basis points, while its 10-year CDS trades at a spread of 290 basis points.

In both cases, an investor could collect more yield at the same theoretical risk by buying a Treasury bond and selling CDS protection than by buying the taxable municipal bond.

The arbitrage argument admittedly overlooks some risks that come with CDS. The credit-default swap market is not very liquid, and investors could understandably demand a higher yield for illiquidity. Plus, it assumes an investor could unwind a position to pay off the CDS in the event of default, which might sometimes impose a haircut.

But Foux said illiquidity alone does not justify the differential in spreads. There is enough activity that investors can get out of trades if they need to, he said, and even allowing for illiquidity the CDS sector offers “decent risk-adjusted yields.”

“We have noticed an uptick in volumes,” said Otis Casey, an analyst at Markit. “This is something that makes the ­municipal markets interesting. Institutional investors are increasingly concerned about the state of affairs in the municipal debt market.”

Theory Versus Reality

In theory, it’s hard to justify municipal CDS spreads at such high levels. Foux calculates the probability of default implied by the MCDX indexes is 35%, based on an assumed 80% recovery rate from the bond.

He doubts many investors are seriously contemplating a default rate that high.

The average municipal CDS spread is higher than the average spreads for corporations in the U.S. pharmaceuticals, consumer, industrial, oil, tobacco, health insurance, restaurant, chemicals, and telecommunications industries, according to Bloomberg.

Yet municipalities historically exhibit lower default rates than corporations in every rating category, and have a higher recovery rate in the event of default.

And muni CDS contracts mostly refer to states or big, investment-grade, well-known names like New York City or the Los Angeles Unified School District — not smaller issuers like Harrisburg, Pa., or Vallejo, Calif., which are currently among the most troubled credits in the market.

The MCDX index refers to 50 municipal credits, all equally weighted. About half the bonds are secured by full-faith-and-credit pledges, while the other half are revenue bonds, mostly water or power utilities or toll roads. And while the MCDX contracts assume an 80% recovery in the event of default, corporate CDS contracts typically assume a 40% recovery.

Casey says he is not aware of any municipal defaults that have triggered payouts on credit-default swap contracts.

The reality of the municipal CDS market is that spreads have taken their cues from the corporate and sovereign markets, not from the municipal bond market.

In May 2010, something curious happened with California’s CDS contracts. Bond markets were in turmoil over Greece’s inability to finance its deficit, and a flight to safety sent lower-risk bond yields tumbling.

California’s 10-year taxable bond yield plunged an eye-popping 140 basis points from the end of April to the end of May.

Meanwhile, its CDS spread leaped 62 basis points.

California’s credit-default swap contracts were following blast-outs in Greece, Ireland, Italy, and Spain.

“For most of this year, MCDX spreads have been very sensitive to oscillations of CDS spreads of Euro sovereigns, given fears that state governments could face a similar dire fate as European ­counterparts,” JPMorgan analysts Chris ­Holmes and Alex Roever wrote in a report last week.

The rolling 30-day correlation between changes in California’s CDS spread and Greece’s has been high — more than 0.4 for most of 2010. The correlation with Ireland has been even higher, topping 0.8 for most of the year.

Even though Holmes and Roever believe U.S. states are much more healthy than the peripheral European sovereign credits, they expect municipal CDS spreads to continue to obey these correlations.

They recommend scaling back positions in the MCDX.

“The tightening momentum in MCDX slowed this week as investors grew ­cautious of the waning backdrop in Europe,” they wrote. “We see little benefit of fighting this trend.”

“If Europe has a real bad day, it prompts investors to reflect more closely on the municipal market than they did the day ­before,” Casey said. “They move in the same direction in response to the same forces.”


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