The spread between MCDX's Series 22 and Series 21 presents investors with another way to short Puerto Rico and the Puerto Rico Electric Power Authority bonds.
The index's Series 22 has replaced its Puerto Rico and PREPA constituents with the City of Chicago and the City of Philadelphia, Pa. The composite price spread for the five-year between Series 22 and Series 21, which still contains the junk bonds, has widened by 13 basis points since Series 22 was rolled out on April 3, according to the latest data a MCDX spokesman provided.
"[We expect to see substantial demand from] hedgers, intending to short Series 21 versus Series 22, so they can get exposure to credits dropping out of the index," Citigroup said in a strategy report about MCDX released on April 1.
The spread was 1.5 on Monday, at the beginning of the four-day week leading into Passover and Easter. The spread reached up to 1.6 on April 9, 23 basis points above the 1.37 it was when Series 22 was first created.
The MCDX is a Markit owned credit index that contains 50 municipal single-name credit default swaps. Bond buyers can use a CDS to insure the principle they pay on the bonds, because if the bond seller defaults, the CDS seller is obligated to pay the buyer back the premium. A CDS can also be used as a hedging tool because investors can buy a CDS on a bond they have not purchased, shorting the bond collecting the premium value if the bond defaults.
Shahzeb Rao, director of Markit fixed income, said in an interview with The Bond Buyer that MCDX constituents must have $250 million in debt outstanding and an investment grade credit rating of BBB-minus or higher. MCDX also targets liquid names, with the goal of enhancing liquidity in the single name CDS market, according to MCDX's website.
"The index includes both revenue-only and GO bonds," Rao said. "We tried to make an index that's indicative of the muni space."
MCDX releases a new roll every six months in April and October of each year. Series 22 is the first roll where the composition of the index has changed.
"Before the April 3rd 2014 roll of the MCDX, none of the names had failed the criteria," Rao said. "Before this index roll, no names had come out of the index, because they had always met the criteria."
Rao said that when Puerto Rico and PREPA's ratings were downgraded below BBB-minus they were no longer eligible for the index.
Citi said that based on spreads of legacy index series they assumed the index curve is worth about 10 basis points for the five-year tenor and about four basis point for the 10-year tenor.
"We arrive at fair values of the index roll for both five-year and 10-year maturities on the order of minus 15 basis points," Citi said.
Series 22 has outperformed Series 21 since April 3, with its composite price ranging from 100.78 to 101.3 in comparison to Series 21's price that remained between 99.47 and 99.68.
Series 21's composite price jumped 22 basis points to 99.47 on April 3 from the previous day.
"Series 22 should outperform Series 21 going forward, and the spread differential between the two index series is likely to start trading substantially lower compared to its fair value after the roll," Citi said in the report.
Rao said that if Puerto Rico and PREPA credit ratings are upgraded from junk and if they have substantial liquidity, they are eligible to re-enter the index.
Yields for Puerto Rico general obligation bonds have been rising since April 11, after the Puerto Rico Supreme Court declared that certain parts of the commonwealth's teachers' pension reform plan were unconstitutional.
Yields on the GO 8s of 2035 jumped up to 9.39% on Wednesday morning, according to data provided by Bloomberg. That's the highest level yields have reached since the bonds were issued on March 11.
