Diverging Yield Benchmarks Complicate Pricing
Recent illiquidity in the municipal bond market is making price discovery difficult for traders, a problem that is being complicated by divergences in the indexes they use to track benchmark yields.
In one stark example, on May 30 the Bloomberg Valuation Benchmark Municipal Curve, or BVAL, showed a selloff that drove yields 27 basis points higher. The Municipal Market Data scale and the Municipal Market Advisors scale showed yields flat that day. With a variety of different of indexes to choose from, each with different methods of pricing, investors have to be particularly careful in illiquid markets, traders say.
“Muni scale providers’ differing methodologies can result in a disjointed picture of market sentiment, especially in periods of elevated volatility,” Chip Hughey, a fixed income trader at Caprin Asset Management said in an e-mail. “The idiosyncratic nature of the muni market and its large issuer pools require looking beyond generic AAA scales for guidance, regardless of the source,” he said. “We believe muni benchmarks, while helpful, can only be viewed as a small piece of the puzzle.”
The triple-A 5% coupon MMD curve “represents the MMD analyst team’s opinion of triple-A valuation, based on institution block size market activity in both the primary and secondary municipal bond market,” according to the Municipal Security Rulemaking Board’s website. “In the interest of transparency, MMD publishes extensive yield curve assumptions relating to various structural criteria which are used in filtering market information for the purpose of benchmark yield curve creation.”
MMA yields are taken from evaluations of the seven largest municipal underwriting firms based on primary and secondary transactions. The high and low for each maturity are dropped and the average of the remaining five firms is calculated for the daily yield curve.
Bloomberg’s BVAL scale is constructed from trading activity, and the evaluation team monitors trading activity to construct the curve.
In periods of illiquidity, these benchmarks can tell different stories. Throughout the week of May 27, muni prices were falling and yields rising though the majority of transactions didn’t take place until Thursday, May 30, after the market hit bottom and liquidity returned.
On Tuesday, May 28, the 10-year MMD scale rose nine basis points to 1.99% and the 30-year yield rose seven basis points to 3.15%. On Wednesday, May 29, the MMD 10-year yield rose another eight basis points to 2.07% and the 30-year yield increased five basis points to 3.20%. By Thursday, May 30, a majority of the trades were transacted when the market had found its footing. The 10-year yield ended steady at 2.07% while the 30-year MMD yield increased two basis points to 3.22%.
Similarly, the MMA scale showed the 10-year yield rising eight basis points on Tuesday, May 28 to 2.05% and the 30-year yield increased seven basis points to 3.26%. On Wednesday, May 28, the selloff continued as the 10-year yield rose six basis points to 2.11% and the 30-year yield increased five basis points to 3.31%. The market settled Thursday, May 30 and the 10-year and 30-year MMA yields rose one basis point each to 2.12% and 3.32%, respectively.
BVAL told a more dramatic tale. On May 28 and May 29, the 10-year yield was flat at 1.92%. When liquidity returned on May 30, the 10-year yield jumped 27 basis points to 2.19%. The 30-year yields were similar, though not as illiquid earlier in the week. The 30-year yield rose three basis points Tuesday to 3.17% and eight basis points Wednesday to 3.25%. The 30-year yield increased another five basis points Thursday, May 30 to 3.30%.
“[Bloomberg’s evaluated pricing] models are driven by pricing data and the reason for a selloff that day was a number of new deals that came to market and priced at lower levels,” said Bruce Manson, the head of Bloomberg Valuation Services, referring to the May 30 selloff. “We incorporate new issues because they come to market at certain levels, [which are] reflective of where those sectors of [the] market are currently trading. And if the secondary trade data comes across MSRB, we will incorporate that into the model.”
The different methodologies and prices for these scales makes it more difficult for the MSRB when deciding which, if any, yield curves to provide to retail investors on its Electronic Municipal Market Access website.
“There is no magic formula and no 'right’ curve because they are all using different methods for different reasons,” said Ernesto Lanza, deputy executive director at the MSRB. “There needs to be more discovery and discussion around a right curve. It’s not clear if there is one.”
The rule maker is talking to various providers in the market place and there is appetite to provide additional access to these benchmarks to the retail investor, Lanza said. “First and foremost EMMA serves retail by tracking trades and muni disclosure and we have a plan to over time build up additional data as well tools like yields curves to help investors.”
The illiquidity of the marketplace makes pricing for each scale difficult, according to Matt Posner, legislative coordinator at MMA. “All municipal benchmarks help to tell the tale of the market’s daily moves, but each has certain limitations due to the over-the-counter nature of the marketplace, the variety of credits, outstanding debt all tied together with the inevitable constrained secondary market liquidity.”
In particular, he said May was a tough month for the market liquidity dried up as the month progressed. “When there are fewer transactions to point to, then a transaction-led data-set becomes compromised,” Posner said. The increase in bids-wanted and offerings showed more weakening in the market than actual trades reported by the MSRB, he said.
“This topic becomes especially important when we start to think about retail, or less sophisticated market participants,” Posner said. “An individual looking to buy municipals at the start of the week may not know that the tax-exempt marketplace is undergoing a swift correction if they are looking at a transaction-only benchmark and could perhaps be penalized if they bought on a spread to an overly rich Benchmark that is not adjusting in a timely manner.”
Randy Smolik, an analyst at Municipal Market Data, said the company is “in conversations with people in terms of depth of bidding and actual markets and maybe some quality information in regard to the transactions we are witnessing. We try to evaluate all those factors to determine a more uniform feel on how support is developing in the marketplace.”