Still in its infancy, the market for buying and selling protection against a default by a state or local issuer is tiny compared to the outstanding volume of credit default swaps on corporate names. But some dealers are betting that if they quote it, investors will come.
Dealers interviewed for this story estimated the notional principal outstanding volume of credit default swaps on municipal names to be around $5 billion to $6 billion. This is but a sliver of the $17.3 trillion in outstanding credit default swaps on single names, baskets and portfolios of credits, and index trades at the end of 2005, according to the International Swaps and Derivatives Association.
The ISDA does not break down the amount by the type of credit, but its figures show that the market for these over-the-counter agreements — under which one party assumes credit risk from another party in exchange for a premium — grew exponentially from the first half of 2001. At that time, the ISDA reported $631.5 billion in notional principal outstanding.
Now, some municipal bond dealers hope to see similar strong growth on the municipal side, and Lehman Brothers has been cited as one of the most active players in the market.
“It’s been over a year now that we’ve been actively quoting daily markets and it was really a conscious decision on our part that we want to take a leadership role,” said Richard Rein, a vice president at Lehman’s structured products group. “We think at this stage, you need someone to champion the market and the product. We are making markets to provide more liquidity in the interest of stimulating more activity.”
“It’s been around in various forms but it really emerged as a regular market with screens and regular quotes sometime last year,” said Philip Fischer, a municipal market strategist at Merrill Lynch & Co. Merrill also makes daily markets for credit default swaps on a number of large issuers.
Rein and his colleague, Michael Whang, said the firm sends to its clients on a daily basis bid-ask quotes for credit default swaps on 10 to 15 municipal names, although some days no trades take place. On the other hand, there are occasionally large transactions, some north of $2 billion, indicating that there is demand to offload municipal credit risk to free up capital.
“This is a real market. There is real money flowing in these instruments. It took off like a rocket on the taxable side — we would assume that the same factors that drove that growth would drive us,” Fischer said. “The muni market generally has the problem of having highly concentrated issuance. Institutions have limitations on concentrations of particular holdings, so they may get some relief [if they use a CDS]. Banks may get better capital treatment as a result of using a CDS.”
While dealers had a hard time pinning down when the first trades took place, they said interest started to emerge during the California fiscal crisis in 2003. That year, California was downgraded several notches to the BBB level to become the lowest-rated state in the country. It had $47.13 billion in debt outstanding as of April 1, according to the state treasurer’s office.
Although California’s fiscal situation has improved since and its ratings returned into the A category, the state remains one of the key names quoted in the municipal CDS market. Besides California, one can buy protection against a credit event, such as a downgrade or a default, by Puerto Rico, New York State, New York City, New Jersey, Massachusetts, Texas, Illinois, Florida, the California Department of Water Resources, and New York’s Metropolitan Transportation Authority. Dealers are also quoting protection on high-grade states, such as Maryland, or states with a split rating, such as Florida.
The contracts are usually for five or 10 years and payments, which are typically quarterly, are calculated by multiplying the notional amount stipulated in the contract by the number of basis points agreed by counterparties. For example, a dealer would buy five-year protection on a high-grade name for three basis points and would sell it for seven basis points, according to indicative quotes provided last week by Merrill. The market for five-year protection against a credit event by Puerto Rico was 27 to 35 basis points last week. Puerto Rico is rated BBB by Standard & Poor’s and Baa2 by Moody’s Investors Service.
Issuers with a significant amount of outstanding debt tend to become active names in the credit default swap market, according to Lary Stromfeld, head of the municipal capital markets group at Cadwalader, Wickersham & Taft LLP. The name can also become active if a guarantor’s ability for taking risk on that issuer is close to capacity and availability of secondary market insurance is limited.
Dealers said CDS’s could eventually present competition to monoline insurers, who wrap bonds in the secondary market, but at this stage secondary market insurance tends to be cheaper. Insurance runs for the life of the bond, while CDS’s typically offer protection for five or 10 years, but some see that also as an advantage because the length of a CDS can be customized.
Cadwalader was retained by the ISDA to develop standard documentation for trading municipal credits using credit default swaps. The ISDA published the documentation in September 2004. This is one step for making the municipal CDS market more liquid. Other factors that would lead to growth are familiarity with the product and widening of credit spreads, Stromfeld said.
In fact, narrow spreads, low volatility and a very low municipal default rate — the very quality that makes these securities so attractive to investors — impedes the development of the CDS market on single state and local names.
“The credits in general in the muni market are too strong and there is not the same kind of concern about credit exposure,” said Nat Singer, a senior managing director at Bear, Stearns & Co. “Even last year when there seemed to be more activity starting up, trades were pretty much by appointment. There wasn’t much volume. Generally, there are plenty of sellers of protection, but few buyers. As a result you are better off buying a bond as opposed to trying to sell protection.”
To sell protection is equivalent to owning or being long a bond because the seller is being paid for taking on credit risk. Since munis rarely default, there are more participants interested in selling protection than those interested in buying it.
“People want to sell protection, but I don’t think the buyers are really there,” said a managing director in a structured product group at one of the dealers. “The core buyers [retail investors and mutual funds] are not naturally inclined to do so. Insurance companies are in the business of taking risk. It really leaves a very small sliver of people who actually have any reason to want to cover any municipal CDS. The demand is limited and the guys who want to sell protection and take the risk could just as likely do it by owning the bonds and avail themselves of the tax-exempt nature of the debt.”
Income received from trading municipal credits using credit default swaps is taxable, but that factor is irrelevant for some investors who view selling protection as a way to “go synthetically long” the credit risk of the reference municipal issuer.
“One big impetus for growth has been the entrance and the desire to get exposure to the municipal market by some of the non-traditional muni investors,” Lehman’s Rein. “That’s foreign banks, life insurance companies — investors who don’t have a lot of appetite for tax-exempt income per se because they are either taxed at very low income tax rates or they are not U.S. taxpayers at all. For people who are indifferent between taxable and tax-exempt income, it’s a very efficient way to get exposure to this asset class.”
Foreign banks made a foray into the municipal market in 2003, when Illinois sold $10 billion of taxable pension bonds. Although Standard & Poor’s and Fitch Ratings rated the state AA and Moody’s assigned a Aa3 at the time of the sale, the deal was given the corporate equivalent rating of triple-A by Moody’s, opening the eyes of foreign investors to the high credit quality of municipal bonds.
While participants are interested in adding muni credit risk, supply seems to outweigh demand because “a natural buyer of protection on municipal credits hasn’t emerged yet,” while on the corporate side development was demand-driven, Rein said.
Robert Pickel, executive director and chief executive officer of the ISDA, said volume exploded on the corporate side with the introduction of various indexes, but the muni market is still far from that point.
To generate activity, Lehman is beginning to quote “yieldier” names — for example, health care credits. Dealers also said a significant credit event, such as further deterioration of Gulf state credits following last year’s wave of post-hurricane downgrades, could also generate activity. More people would be interested in buying protection, which is equivalent to “shorting” a bond or betting the price will decline, when there is more volatility.
Dealers also expect growth in “second generation” credit products, seeing potential in structured credit solutions, when participants want to buy protection on a basket of names such as airport credits. This can be done in first-to-default baskets.
