Citi's exit raises concerns about liquidity in high-yield market

With the high-yield municipal bond market riding a tide of inflows and new deals in 2024, investors say Citigroup's December exit from the space appears manageable so far, but that the true test will come when flows reverse and the market has to fare without its longtime, go-to liquidity provider.

For a thinly traded market where finding secondary buyers is a frequent concern, the exit of any player would cause worries. But the loss of Citi's large and active high-yield team that underwrote deals, kept the market liquid through its trading desk and provided investors with color and "story bond" analysis could carry an outsized impact on an often-opaque market that's buffeted about by headline risk and interest rates.

"Their team was supportive of buyside players like us, and they made a market in things that they underwrote," said Gilbert Southwell, a senior credit analyst at Allspring Global Investments.

"They were more in tune with the market," he said. "It decreases market makers to the extent that they exist in the high-yield space and that certainly hurts."

Citi's exit capped a year of Wall Street belt-tightening that saw layoffs across public finance. UBS' decision in October , though the firm has maintained its competitive underwriting and secondary market-making business, including high yield.

Belle Haven Investments

"While Citi had ramped down its new issuance activity well before its official exit from the space, just having one less market player is not a good direction for the market to going in," said Dora Lee, director of research and partner at Belle Haven Investments. "The loss of any player in the market is definitely going to hurt liquidity."

Buy-side firms also lost access to credit analysts and traders who are intimately familiar with issuers, many of which are so-called story bonds that require extensive analysis.

"It creates more of a need for buyside firms to do more credit work because Citi's desks are not there to support it," said Tyler Wynn, founder and CIO at Birch Creek.

Citi's ability to bolster the market during times of stress was illustrated during the dislocation during the height of COVID-19 in 2020. Between February and October 2020, the firm traded "up to 25% of the secondary market volume ... providing pricing support and market liquidity," according to an October 2020 presentation. During COVID, the firm was "one of few broker-dealers consistently making a market for high-yield investors," the firm said. In total, from 2017 through 2020, the firm made between 10% and 20% of high-yield market trades, according to the presentation.

Citi provided liquidity across the full muni market, said a banker.

"So when you would run into certain scenarios, like noise in the market, or when the [Silicon Valley Bank] bid lists hit the street, they would quietly come in and provide liquidity," the banker said.

"They were the biggest liquidity provider across the market in investment grade and high yield," they said of Citi. "When the next liquidity crisis happens, who's going to step in?"

So far this year, high-yield investors haven't had to worry. Like investment-grade munis, junk bonds have suffered from two years of outflows and anemic new issuance. But starting late last year the market mounted a recovery, and in 2024 high-yield muni mutual funds have enjoyed 10 straight weeks of inflows per the most recent period, according to LSEG Lipper. High-yield continues to outperform at +1.01% in March and 1.33% in 2024.

Issuance is expected to pick up as well, which will help generate more interest and liquidity, participants said.

The healthy appetite for unrated paper was demonstrated Tuesday with Keybank's pricing of the Suffolk Regional Off-Track Better Corp.'s $349 million, where the long end was 14 times oversubscribed in early pricing. Final pricing showed yields of 5.865% for the 2044 bonds, +250bps over the AAA BVAL yield, and 6.1% on the 2053 bonds, a spread of +249bps.

But during times of selloffs, consolidation and lower capital levels tend to create a more volatile environment, noted Greg Gizzi, Macquarie Asset Management's head of U.S. fixed income and head of municipal bonds. Gizzi added that so far, there has been a "positive response" from remaining players who have stepped up to help fill Citi's void.

Wynn said the loss of a sell-side balance sheet "is at the top of our minds, especially during times of stress, when the dealer community is relied upon to provide liquidity." It remains to be seen how other sell-side firms will absorb the loss of Citi's balance sheet, he said, adding that the buy-side will also need to step in

"The downsizing of all the balance sheets of the broker-dealer community makes the loss of Citi that much more impactful," said Belle Haven's Lee. "You have smaller balance sheets, so the broker-dealer community can't take on as much risk during times of market stress, and then also you have fewer players, so the players who are still around, they have that much less flexibility to act as shock absorbers for those times."

On the bright side, Wynn said Citi's exit creates opportunities by allowing other sell-side firms to provide liquidity and giving buy-side firms the room to "capture" more trading volume and source bonds they wouldn't be able to otherwise source.

Firms like UBS, RBC, Goldman, Jefferies, Morgan Stanley and Oppenheimer remain active in the space and in some cases are bulking up their teams. HJ Sims and Ziegler remain known for healthcare and continuing care retirement home deals and Piper and D.A. Davidson for dirt deals. Meanwhile, Citi's high-yield veterans are emigrating to other shops as public finance firms are eager to scoop up the firm's employees.

Last week, Stifel announced it had hired Joseph Narens, who was Citi's head of High Yield Municipal Trading & Credit Analytics, to oversee its institutional high-yield trading. Another firm is set to announce this week the hire of a former Citi employee to co-head high-yield trading on its fixed income team, sources said.

Before Citi's exit, Jefferies hired around 10 healthcare bankers from the firm. 

Former Citi employees have also been hired a slew of other firms, including Morgan Stanley, J.P. Morgan, Raymond James, Barclays, BofA Securities, 16Rock Asset Management, Truist Financial Corp., Ramirez, Assured Guaranty, Loop Capital Markets and Huntington National Bank.

"The loss of Citi really highlights the over-the-counter nature and the importance of relationships within the muni market," Lee said. "I do expect to see that gap being filled, it's just going to take some time."