Volatility in the former BMA Muni Swap Index has been a comfortable, somewhat predictable reality for short-term investors.
These days, though, buyers say they’re seeing increasing instability at the turn of each month and feeling a measure of discomfort creeping in: Many investors say it feels as if they’re being shortchanged by other players in the market.
Compounding the volatility is the increased presence of price-sensitive institutional clients in the portfolios of short-term money funds that use the index for many transactions. Additionally, portfolio managers are feeling the consequences, as their new client base is much more willing to move cash quickly in and out of tax-exempts, a nuance for money managers accustomed to less-sensitive retail investors.
In the last year, the drops of the Securities Industry and Financial Markets Association Municipal Swap Index, as the BMA is now known, have become more dramatic at the beginning of each month.
The SIFMA swap index dropped 17 basis points in its Nov. 1 weekly reset landing at 3.39%, only to jump 24 basis points in the following reset. The Nov. 29 reset, the closest date to the turn of the month for the schedule of the seven-day rate, dropped 15 basis points from the week earlier, settling at 3.48%.
This volatility in the seven-day reset at the beginning of this month is not a random occurrence. In fact, since the start of 2005, this calculation used in most derivative operations in the marketplace drops an average of 20.5 basis points when looking at the last rate of the month compared to the start of the next.
Two or three years ago, these buyers would see a swing of six or seven basis points between the change–of-month resets.
VIEWS ON VOLATILITY
“In the last year, the index has been much more volatile,” said Colleen Meehan, senior municipal portfolio manager at Dreyfus Corp. in New York. “The dealers who are setting the weekly rates, which in turn goes to the [SIFMA] index, are just throwing a dart and setting the rates based on what their anticipated cash flow projects are. So they know that coupon payments are due at the beginning of the month and that us, the investors, have more cash to invest. They want to push our yields down.”
Some managers claim the dealer community is intentionally bottoming out prices at the start of the month when these managers have a fresh supply of cash to put to work as a result of coupon payments and other start-of-the-month factors that creates an influx of money into the market.
Members of the dealer community contacted for this article disagreed with the accusations, saying new players in the municipal market, and the attendant market dynamics, explain the increased spread between the crests and troughs of the SIFMA municipal bond swap index.
“All money market funds reinvest their coupon at the beginning of the month,” one dealer said. “They accrue for the coupon during the month and then they pay it out, so there is a lot of cash in the market at the beginning of each month. So the dealers anticipate this amount of cash coming in and lower their rate.”
Another dealer expressed similar thoughts.
“Remember, we are all in competition here, and these are simply market dynamics playing a hand in where these rates fall,” he said, comparing the VRD market to the stock market in this regard. “People are anticipating the market — as you do in any market. You bet when stocks go up and when stocks go down.”
While index adjustment occurs as the supply of cash rises at the beginning of the month, some investors argue the process is a result of mispricing the rates lower than they should be, and not a mere result of supply and demand.
A New York-based tax-exempt portfolio manager said while market dynamics are at play, what is actually going on is a mispricing for dealers to “get more bang for their buck.”
Portfolio managers point to a comparison between the single-day reset to the seven-day reset to buttress their argument.
One manager said in many cases, when the seven-day index comes out, the daily variable rate will also go down, but immediately afterward will begin to jump right up. For example, comparing SIFMA weekly swap index to a triple-A, non-alternative minimum tax, all region, daily VRD index provided by MMD, in the last two months of this year alone, the daily has jumped between 10 and 14 basis points after the first reset of October and November within two days after the weekly was set.
“If you go back three years or so, and watch the weekly and the daily rates, you will see the more liquid daily resets quickly get back up to the level it was before and sometimes even higher,” the portfolio manager said. “In my mind, if you see that happen at any time between the Wednesday to Wednesday reset, it means that you set the weekly wrong. It means that where the market is, where dailies are showing you where the liquidity and demand is, it ain’t where you set that weekly rate and that you set it too low.”
One dealer did say that while mispricing does occur on occasion, characterizing it that way is a misnomer.
“First of all, comparing the daily rate and the weekly rate is artificial because they represent a completely different time schedule,” the dealer said. “Granted, this is going to happen from time to time, but guess what? I will have bonds left over by the end of the day, and the next day I’ll adjust as a result to get rid of those bonds. You have to be careful, though, when comparing daily and weekly resets because the daily is much more liquid, and as a result will jump around a lot more.”
It is this volatility that has some money managers afraid that possible regulatory involvement could ensue if nothing is changed.
“What really scares me is that if you look at what is going on with what I think is some intentional mispricing, the [Securities and Exchange Commission] could just come in, and upon announcing that they are looking into this, the whole market could crumble,” one mutual fund manager said. “Just ask yourself: Is there room for manipulation? Yes. Is there a potential conflict of interest? Yes. That is all it takes.”
While various investors noted that such an outcome would be detrimental to this sector of the municipal market, dealers do not see the potential for anything as serious as the SEC, or any other enforcement agency, becoming involved.
“There is no way that there is anything going on that could possibly incur the interest of any agency like that,” a dealer in New York said. “We are constantly in check by our clients that the dealers aren’t allowed any funny business even if we wanted to.”
While there is disagreement on the forces behind the wider spreads, dealers and investors agree that the pattern is likely to hold for the foreseeable future.
THE INDEX
THE SWAP INDEX WAS CREATED IN 1991 “AS A JOINT VENTURE BETWEEN THE [THE BOND MARKET ASSOCIATION] AND THOMSON FINANCIAL MUNICIPAL MARKET DATA IN RESPONSE TO INDUSTRY PARTICIPANTS’ DEMAND FOR A SHORT-TERM INDEX WHICH ACCURATELY REFLECTS ACTIVITY IN THE VARIABLE-RATE DEMAND OBLIGATION MARKET,” ACCORDING TO A SIFMA STATEMENT.
Thomson’s municipal group does most of the legwork in compiling the index, according to Greg Belanger, director of short-term rates at Thomson. He said these days, his group pulls weekly rates from more than 25,000 high-grade active VRDs from a little more than 80 remarketing agents throughout the country.
Of the total, about 15,000 are deemed eligible to be included in the index each week, which then get tallied through a formula to create the index. Notes are removed afterward for credit reasons, size reasons, or because they are more than one standard deviation away from the mean, among the many different criteria.
Belanger stressed that the process is somewhat of a “double blind” endeavor, as the remarketing agents for all the major dealers, which set rates internally for their banks, do not know what other dealers are sending Thomson, and the statisticians who receive the data don’t keep track of which firms are sending what numbers for the current index being calculated. However, Thomson does not allow one dealer to make up more than 15% of the notes going into the index, a key factor that limits the sway one bank has on the final index figure.
“Our entire goal is to be an independent benchmarking process,” Belanger said. “The more we have the ability to have our fingers in the pie, or tweak it, the more questions are raised about the validity of that index. That is why much of that part of the process is part of a bigger formula that our computers handle.”
The index “has been extremely successful and is used for the basis of the vast majority of interest rate swaps in tax-exempt space … I think the market puts a lot of faith in it,” said Michael Decker, senior vice president of policy and research analysis for SIFMA.
One money manager, however, took issue with the principle behind the index.
“The problems with [SIFMA] is that it is a subjectively set index, so the actual formula that goes into coming up with the number is completely irrelevant,” the manager said. “Every one of the underlying floating rates that go into the index are subjectively set by the dealers. That is the crux of the problem: It doesn’t float on any actual market index itself, it floats on where these guys want the market to go.”
A DOMINANT FEW
Consolidation in the short-term muni market over the years has placed greater control in the hands of fewer large firms. Since 1980, the 10 firms leading the top 500 remarketing agents have held 11.3% of the VRDs that eventually make their way into the SIFMA index, accounting for more than $607 billion of variable-rate bonds. Citigroup Investment Banking, Lehman Brothers, and Goldman, Sachs & Co. rank first through third in that market, respectively, according to Thomson.
Some market participants are concerned that the small cadre of firms commanding such a large volume of the market are able to sway prices.
As the percentages of each firm’s influence in each weekly reset is not publicly available, another window to this information is looking at other variable-rate indices that use fewer remarketing agents, but tend to include these large firms. Since March of this year, four highly used seven-day indexes — from SIFMA, Ponder’s VariFact, Moody’s Investors Service, and Bloomberg LP — average three or four basis points difference for each reset, with one week, Sept. 20, having a nine basis-point spread.
Belanger said while it is possible that a few firms are moving the index, he thinks such a scenario is unlikely.
“The index is very public,” Belanger said. “Swap and derivative products in general have grown recently and make up a large percentage of tax-exempt holdings right now, and I think that it would be hard to have such a pull in a large market.”
Of the top six remarketing agents Citigroup, Lehman Brothers, Goldman Sachs, Merrill Lynch & Co., and JPMorgan declined to comment for this article. UBS Securities LLC did not return calls.
“Listen,” one manager said, “you have a small group of banks that dominate this market in tax-exempt space. It is all in their interest to plummet this index at the beginning of the month, so while it is not a planned action, they all act separately in the same function to squeeze all they can out of us.”
NEW PLAYERS IN MUNILAND
The tax-exempt landscape has shifted dramatically over the last few years, which has exacerbated the volatility, according to both investors and dealers. Notably, the increase in price-sensitive institutional clients in municipal funds has made the portfolio managers especially conscious of volatility.
“The volatility of the index is something that has been there for some time, but now tax-exempts are no longer dominated by retail investors, who were, frankly, a lot of glacial money in that they would just sit there and ride things out,” said Peter Crane, president and chief executive officer of Crane Data LLC, a company that provides analysis of the money market industry. “But now this market is getting dominated by institutions that will kill you for a basis point and will move money around at the drop of a hat if they see the types of changes you see now in municipals.”
Nick Rabiecki, senior municipal portfolio manager at JPMorgan, said: “The average mom-and-pop retail person who used to be our main client would either not notice or say that 20 out of 30 days of looking good is OK. But the paid professional at a major corporation will be making the switch out of tax-exempts, and it has stunted many money funds’ asset growth as a result.”
Another factor that has increased volatility of late is the emergence of nontraditional investors in the municipal bond market.
Reid Smith, a senior portfolio manager at Pennsylvania-based Vanguard Group, highlighted the entrance of new players in muniland.
“There is a nontraditional type of focused buyer now, these would be the hedge funds, the arbitrage accounts, the cross-over buyers — basically anyone who is coming into the tax-exempt market on a tax-insensitive basis,” Smith said. “These guys are looking to take advantage of various idiosyncrasies that have historically been in place, because individual buyers don’t necessarily act in a purely efficient manor.”
Smith, along with other investors and various members of dealer community, describes this new buyer as focused on various ratios of munis to taxables and munis to Treasuries, among others.
“These guys are driving off a very different set of calculations than the traditional buyers, and these two forces are banging against each other, in terms of relative value,” he said. “So it is this push and pull between the two forces here that creates a very volatile and dynamic market.”
