After more than 20 years, it’s finally official: the municipal bond market will soon no longer be married to the MOB.
The truth was, their relationship had been crumbling for years.
At the close of trading on March 22, the Chicago Board of Trade plans to de-list its municipal bond futures contract, putting an end to the first hedging tool directly related to the tax-exempt market, which had given rise to the speculative trade known as the MOB in which traders would bet on the spread between the municipal and Treasury bond futures contracts.
In late December, the board posted a notice on the floor of the exchange announcing that after efforts to revive the product had failed to gain traction, and under the pressure of “high product support costs,” it would discontinue the 10-year municipal note index futures contract, which had succeeded an earlier version.
“Most of the market participants felt that our swaps products were more suitable,” said Jennifer Rook, a spokeswoman for CBOT.
Ultimately, the contract was unable to overcome the crisis in confidence that had engulfed the original contract in its latter years and contributed to its dwindling usage. Charges that flaws in the design of the underlying index on which the contract was based left it vulnerable to manipulation and led many traders to turn to other hedging tools, such as BMA swaps, beginning to emerge in the municipal market. Most never looked back.
“There was so much damage done years ago that it never recovered and people lost confidence in the process,” said Tom Doe, president of Municipal Market Advisors in Concord, Mass. “Once a pricing process gets painted with the broad brush of manipulation and there are lawsuits, it’s pretty hard to overcome. It just had too much historical bad baggage.”
| Officials celebrate the launch of the Chicago Board of Trade's municipal futures contract in 1985. |
Seldom used and no longer considered necessary in an age of derivatives markets with liquidity in the billions of dollars, the departure of the contract will hardly make a difference for most. However, its quiet passing belies the important role it played in the evolution of the municipal bond market.Before the municipal futures pit opened on the floor of the exchange on June 11, 1985, participants had no good way to hedge interest rate risk against potential losses in the muni market.
Tax laws governing the accrued interest in securities-lending transactions essentially prevented the short sale of municipal bonds. The BMA swap market, which is based on municipal interest rates, and is commonly used today as a way to offset risk, didn’t yet exist.
“In the late ’70s and early ’80s, the only hedging tool available to municipal traders was the Treasury bond contract,” said Bill Trader, who today is a senior vice president and chief operating officer at Bluebid Brokerage in Chicago. Since Treasury prices do not always move in sync with those in the municipal market, the hedge was not always effective.
The market needed a futures contract of its own, but the task was monumental. The municipal market was highly diverse, with variations based on ratings, maturities, and geographic region. Worse yet, many bonds traded infrequently.
A Public Securities Association committee designed an index consisting of 40 long-term revenue and general obligation bonds rated at least A-minus by major rating agencies, which was intended to mirror the cash market. The PSA was the forerunner to The Bond Market Association. The Bond Buyer was hired to serve as an independent third party to collect bids for the bonds from six brokerage firms and calculate the value of the index.
The contract would utilize a cash settlement system considered advanced at the time, whereby users would pay or receive the difference between a set price and the value of the index at a future date. The index came to be known as The Bond Buyer 40.
Trader, then with former Continental Illinois National Bank & Trust Co. in Chicago, served on the PSA committee.
The product was heralded with great fanfare, and some skepticism, as a tool that could be used by portfolio managers and dealers wishing to hedge their inventories, underwriters bringing deals to market, and issuers looking to lock in rates. Some believed it had the potential to increase the market’s liquidity and efficiency, narrow spreads, and lower issuer borrowing costs.
“The trading of municipal futures contracts is one of the most significant events in the history of municipal trading,” Michael C. Delaney, then manager of trading at Goldman, Sachs & Co., was quoted by The Bond Buyer as saying at a PSA seminar in October 1984. “This is the equivalent of bringing municipal trading out of the dark ages.”
Others at the seminar expressed their reservations. “It’s heavily weighted in revenue bonds,” one banker said. “Does it accurately reflect my holdings if they are in GOs or have an average maturity of seven years?”
From the outset, the market supported the product. By the end of 1985, open interest — which refers to the total number of contracts outstanding — had almost reached 14,000, and daily trading volume had surpassed 7,000.
Much of its liquidity was due to the widespread trading of the MOB spread. Those anticipating a widening spread between the muni and Treasury bond futures contracts would buy the former and sell the latter. If it seemed likely the spread was going to narrow, traders would do the opposite.
“If you were trying to sell some contracts, there was always a MOB bid or a MOB offer that you could kind of lean on,” said Dave Johnson, a managing director of municipal securities at Cabrera Capital Markets Inc. in Chicago.
Despite its name — an acronym for “municipal over bond” — the trade had no connection to organized crime, other than nicknames like “the Widow Maker.”
“It often moved fairly violently in one direction or the other,” Johnson said.
Some important milestones for the fledgling contract occurred early on. In March 1986, then-Sen. Bob Packwood, R-Ore., who was serving as chairman of the Senate Finance Committee, proposed applying a 20% alternative minimum tax to all outstanding and future municipal bonds, which sent shock waves through the market. As trading in cash municipals ground to a halt, the contract continued to provide a source of liquidity.
“If at that time you had been hedging your municipal bonds with Treasury contracts, the risk between the two instruments would have been huge,” said Trader, who had joined Chicago Corp. in May 1985 and worked as a broker on the floor of the exchange. “That really pointed out the need for a municipals-specific hedge.” Chicago Corp. was later purchased by ABN AMRO.
The use of municipal futures soared as the bond market sold off in the summer of 1987 ahead of the stock market crash that was to occur in October of that year on Black Monday, which some took as a lesson on the importance of hedging. Open interest rose above 25,000 contracts at one point during that summer, while daily trading volume neared 19,000 contracts.
| A paperboy passes a copy of The Bond Buyer to a CBOT trader. |
“In the 1980s, it contributed to the evolution of risk management in the muni market,” Doe said. “It helped educate people that munis could be hedged; there was interest rate risk, and guys weren’t just supposed to gun-sling munis.”The science of hedging revolving around the contract that emerged would be the forerunner to today’s risk-management techniques and the array of derivative products that have come to play a highly significant role in the municipal market. The product served as the “training wheels” for many who would go on to become prominent players in the world of municipals and swaps, Doe said.
But that’s not to say the contract was without its problems.
“It always suffered because it didn’t have the volumes that the Treasury contracts had,” Johnson said.
“It was based on a small set of secondary market prices on securities which were thinly traded,” said Philip Fischer, a municipal market strategist at Merrill Lynch & Co. “It was an illiquid futures contract, and as a consequence the basis risk of the futures contract versus the underlying cash portfolio was quite substantial.”
As a result, some said its pricing behavior could be erratic. Others complained it wasn’t volatile enough.
Still, usage of the contract climbed in the early ’90s to a peak open interest of 38,814 in November 1994, as daily trading volume reached a record 20,986.
In an editorial marking the contract’s 10-year anniversary the following summer, The Bond Buyer hailed the contract as a success. But it would never see its usage rise to those levels again.
Market participants began to observe that prices of bonds in the underlying index would be bid up or down during the last minutes on expiration day of the contract, although no transactions would occur at those prices.
Allegations that the contract was being manipulated began to surface — that phony bids were being submitted, or that some traders were executing large trades just before settlement to offset the value of the index.
Then, in May 1997, the Vanguard Group Inc. — which had become a heavy user of the contract — filed a lawsuit on behalf of seven of its mutual funds against six brokers that provided bids for the index and Thomson Publishing Corp., which was then the parent company of The Bond Buyer.
Vanguard claimed the funds lost $3.25 million in December 1995 because the contract had been mispriced, and charged the defendants with breach of contract, negligent misrepresentation, and violation of the Illinois Consumer Fraud and Deceptive Business Practices Act. Thomson, which was eventually dropped from the suit, sold The Bond Buyer in 2004 to Investcorp.
To some, the lawsuit represented a turning point. “It just increased the perspective in the world that this was a manipulated contract,” Trader said.
But the market had already taken notice. By December 1996, open interest had declined as low as 7,407, and daily trading volume to just 103 contracts — a far cry from 1994’s record levels.
While usage levels would recover somewhat in the latter half of the decade, TBMA in 1999 formed a task force to recommend improvements on the contract to CBOT.
The municipal futures contract had at that point survived longer than any other non-Treasury bond-related futures contract. In a series of recommendations published in May 2000, the TBMA task force, which was made up of dozens of market participants, declared the contract “the most important long hedge available in the municipal market.”
But its future was on the line. CBOT officials had expressed concern about its low trading volume, and said the product was not financially self-supporting, according to the TBMA task force.
The Treasury Department’s announcement in October 2001 that it planned to halt issuance of the 30-year bond threatened to further undermine the muni contract’s principal source of liquidity — the MOB trade — by eroding the strong correlation between the two contracts.
On March 20, 2003, the board rolled out the new 10-year municipal note index futures contract. Instead of relying on broker quotes to track just 40 bonds, to prevent manipulation the new contract was based on a much larger index of 250 bonds maintained by CBOT, using prices provided by FT Interactive Data, an independent third party pricing service. Unlike the old contract, the new product was meant to reflect the 10-year sector.
In place of the MOB, the spread to the 10-year Treasury note futures could be traded. The MOB spread did not fall out of use entirely, however, as some continued to trade on the relationship despite the apparent mismatch between the new muni contract and the 30-year Treasury bond contract.
In the meantime, the use of derivatives was growing. One particular product that had become a popular hedging tool was BMA swaps. By entering into an agreement to pay a fixed rate to a counterparty in exchange for a floating rate, BMA swaps can help shield a user’s portfolio from mark-to-market risk because the value of the swap will increase if interest rates rise. Like the muni futures, BMA rates are tied to those in the municipal market, reducing the potential for cross-market risk.
Whereas the muni futures contract mirrored one small maturity range, BMA swaps could target specific points up and down the yield curve. As bid-ask spreads in BMA swaps began to narrow, their liquidity quickly surpassed that of the struggling contract.
“The BMA market is for most people a much better hedge because they can match up the maturity of the bonds they’re buying with the maturity of their hedge,” Jonathan Fiebach, a managing director at Duration Capital in Bala Cynwyd, Pa. “Buy a 12 1/2 year bond, short a 12 1/2 year BMA swap.”
“When mutual funds were accumulating assets, and most were long insured funds, their needs matched up better with the futures contract,” Fiebach said.
| June 11, 1985: Opening day for the municipal futures contract on the floor of the exchange. |
“Over the last few years, what have traditionally been longer buyers have tended to move up and down the curve more often, and the contract probably wasn’t able to pinpoint where they wanted to be hedged,” Johnson said.What’s worse, the newly designed contract had a major flaw.
What some came to see as the death knell occurred on June 19, 2003, when a mechanism built into the settlement procedure in order to reduce its volatility backfired.
On that day, the contract settled down 1.28 points from the reported value from the previous day, although not a single bond in the index moved as much as half a point. The reason was due to a rule requiring any bond with an overnight price change exceeding one standard deviation of the mean index bond change to be eliminated from the final settlement calculation upon expiry of the contract, but not before.
The process was supposed to reduce volatility just prior to settlement. Instead, it increased it almost tenfold.
Bond prices dropped on the last day, requiring more than one-fifth of all the bonds in the index to be excluded from the final calculation. Most of the bonds taken out were those that had been trading at high premiums, knocking the settlement down to 106.19. Contracts are settled at the settlement price times $1,000. Were it not for the last minute deletions, the index would have only moved about 0.14 points from the previous day’s index value of 107.47.
The sudden drop — which traders on the floor at first thought to be typographical error — caused some accounts to incur sizeable losses. Three months later, the phenomenon occurred again, although losses were not as large.
By year-end, the board had eliminated the procedure, and was concurrently taking other steps to try to save the contract. CBOT appointed the New York-based Nassau Street Capital LLC as a primary market maker for floor trades in late 2003, and began making trades available on its electronic platform.
But the damage had been done. It was illiquid, and had lost the trust of traders with large Wall Street firms it needed to survive.
“The contract design never really allowed us to play out a full development of the new futures contract,” Fischer said.
“We saw that the contract behaved in an erratic fashion and people simply lost faith in it,” Fischer added. “The people who either won or lost as a result of the contract malfunction couldn’t afford to risk it again.”
“The loss of confidence perpetuated itself because as volume and open interest went down, it got harder to open and close positions,” Fiebach said. “Once the snowball starts rolling downhill, it’s pretty hard to stop it.”
In January 2005, Alternative Strategy Advisors, a hedge fund firm in Minnetonka, Minn., was appointed electronic market maker.
Shortly thereafter, in March, open interest in the new contract would reach a peak of 4,506. But it could not be sustained. As of Monday, open interest had dwindled to just 142. Not a single contract traded all day.
Whereas the muni futures pit had once drawn crowds of as many as 50 people, as brokers executed client orders, speculators placed bets, and the MOB trade once flourished, today it stands nearly empty. The few traders left in it are mostly watching other markets on screens, according to brokers on the exchange floor.
In the contract’s absence, the market will be left with one less hedging tool.
BMA swaps have become the predominant alternative, as their rates are tied to those in the municipal cash market. Even so, they do not perfectly correspond, especially on the long end. So much like the muni futures contract, they entail a certain amount of risk.
Some will lament its passing, such as municipal hedge funds that take on large amounts of interest rate risk by leveraging their portfolios using tender-option bonds, known as TOBs, and have continued to use the contract.
“For those investors that have a significant amount of BMA/muni exposure, the muni contract offered another alternative to help diversify their hedging risks,” said Randy Jacobus, a managing principal at Alternative Strategy Advisors.
Some smaller market participants lack the capital base necessary to participate in the swaps market, and legal and accounting costs can be prohibitive. Whereas swaps transactions are typically no smaller than $1 million in size, a muni futures contract can be bought or sold for around $100,000.
“The board of trade’s decision to de-list the muni futures contract really hurts the small dealers more than anybody else because they don’t have access to the over-the-counter derivatives market, which forces them to hedge their long muni securities positions with a cross-market product, which is much riskier,” Fiebach said.
For an underwriter that would like a short, two-day hedge for a small municipal deal because they are worried about the release of an upcoming employment report, swap-type products may not be suitable, Trader said. “They’re viable instruments for rocket scientist-type TOB program runners and things like that, but not for the smaller people.”
To many traders at large Wall Street firms, the contract’s de-listing will make little difference. Most stopped using it long ago.
As one banker told a reporter with The Bond Buyer during a break at the PSA seminar to discuss the proposed contract in October 1984: “I think this will flop. But we all applaud the attempt.”
More than two decades later, those words will finally ring true on March 22.
But first, the product would serve for years as an effective hedging instrument for municipal bonds, and usher a new era of risk management into the marketplace.
