Second of a 2-Part Series on Credit Default Swaps in the Muni Market Today: Who’s in the Market & Why
Yesterday: When It Began & How It WorksMunicipal issuers have been borrowing techniques from the corporate and international markets for years. Now their investor counterparts are taking similar cues. A global credit and liquidity crisis, among other things, has brought a new wave of hedge funds, European banks, insurance companies, and arms of investment banks into a municipal credit default swap market. The CDS also provides investors a way to offset their credit concentration in a market where selling out of a position quickly can be challenging.Until this year, the muni CDS market struggled to find buyers. It took these new investors — many of whom had never tried their hand in the municipal cash market — to spur growth.“The fledgling municipal credit derivative swap market has experienced a significant increase in volumes, and a marked widening of spreads,” said Ross Berger, vice president in Wells Fargo’s Proprietary Portfolio Group. “The key thing is that it is the first time that people have been able to go and do this because there is now a market for it.”Hedge funds have been one of the big drivers of CDS growth, sources said. “Hedge funds came in and bought protection, something no one did before because of the low default rates in the market,” said Mark DeMitry, portfolio manager at OppenheimerFunds Inc.The market for municipal CDS, which allow people to buy and sell protection against reductions in state and local government credit quality, lets hedge fund managers take a position on where they see the perception of risk is headed. In late July, the municipal market as a whole began to reassess risk and bond prices cheapened. Lower-rated credits were hit harder and spreads between yields on low-rated bonds and those on high-rated debt widened.Some fund managers saw the muni CDS market as natural choice to manage or benefit from that credit risk. Liquidity in that market already was growing.Some bought protection through muni CDS contracts earlier in the year after seeing their other assets get squeezed by the credit crunch.They bet that the widening trend would spill into munis — and their bet has paid off as the prices of CDS have increased in the past few weeks, sources said.“Spreads have blown out in the past couple of weeks and CDS is a way to take advantage of that,” DeMitry said.The bid and offer prices for 10-year CDS contracts on California general obligation bonds were five and eight basis points on Jan. 17, according to a Lehman Brothers presentation. CDS prices are quoted as percentages of the total par being protected in the contract.The bid-offer quote for California increased to 12-17 by July 31, said a report Lehman published this month. The 10-year quotes for triple-A-rated Virginia went from 2-5 on Jan. 17 to 6-10 on July 31, the Lehman data showed.The hedge funds interested in muni CDS are not just the ones lining up to buy long-dated muni bonds in the primary market, either.“For the most part, the people who have been participating in the muni CDS are guys who don’t buy cash bonds,” said one banker at a New York broker-dealer that has been a mainstay in the muni CDS market. “That’s not the case for everybody, but many of the newer participants have been people who never owned a muni bond. It would be hard to say that they are siphoning off any cash demand.”Other nontraditional investors, such as European banks, also have jumped in. Foreign buyers have shown increasing interest in the municipal bond market during recent years.Foreign demand for structured notes linked to municipal swap rates played a large role in the drops in municipal swap rates last fall, and some have said the demand helped push long-term yields down near historic lows. In the spring of this year, there were about $15 billion in notional par outstanding of structured notes linked to municipal swap rates.
Foreign buyers also phoned in to buy large blocks of Illinois’ $10 billion taxable pension bond deal in 2003. Moody’s Investors Service has helped make sense of the muni market for overseas investors by giving extra ratings for some kinds of municipal bonds based on Moody’s global ratings scale — the one it uses to rate all other asset classes.“Europeans are buying more structured notes, and all foreign buyers want more exposure the municipal credits,” said Brad Winges, head of fixed-income sales and trading at Piper Jaffray & Co. “These investors are going to want more esoteric forms to participate in, and the CDS market allows them to take on muni credit exposure in a well-established way.”But foreign investors do not invest seeking the tax-exempt returns that lure traditional and domestic buyers. In the case of muni CDS, however, the income stream is taxable.Instead, their goal of investing in a municipal-related credit is exposure to a different asset class. As muni assets experienced credit problems, muni CDS contracts were a logical next step. Many of the investors entering the market for muni CDS are familiar with the instruments on the corporate side.For example, life insurance companies, have not been major players in the municipal market — until recently.The property and casualty sides of insurance companies have been municipal investors for years. Through the first quarter of 2007, they were the fourth largest category of investor in the market and owned more than $338 billion of the total outstanding municipal debt, according to Federal Reserve data.“What we’ve seen is much more of a pick-up in insurance companies that have both [property and casualty] and life parts are starting to put CDS in their life business because they understand muni credit risk,” the New York-based banker said. “Here is a way they can be paid to take that credit risk where they don’t have to worry about the tax-exempt nature of the cash flows.”A spokeswoman for the Hartford Financial Services Group said the insurance company now buys municipal CDS.Allstate Insurance Co., Nationwide Insurance, State Farm Insurance Cos., and American International Group Inc. declined to comment or did not return calls. While these four companies are large buyers of municipal bonds through their property and casualty lines of business, their life insurance lines have not been as active in the muni market.Municipal mutual funds, which represent the third largest holder of debt with $359 billion through the first quarter of 2007, do not sell in the muni CDS market. They, unlike the international investors, are tax-sensitive. There have been some accounts of these funds acting as protection buyers.“If you are going to sell CDS, which given our bent that we like to take on more credit risk than other people, the payments that you get are taxable and we are a tax-exempt fund,” DeMitry said.Although creating a structure that would allow municipal CDS to generate tax-exempt income would certainly be a boon for the market, several market sources said they would be dubious of anyone who says they’ve figured out a way.Muni CDS buyers cite several reasons for their interest in the products. Some said it helps them balance their books.The amount of equity that a portfolio holds must be balanced against its liabilities, in the event that it can make payments if a liability fails. CDS contracts manage regulatory capital requirements because a portfolio can swap out its credit exposure, thus limiting its liabilities. “If you want to reduce your exposure you can use a CDS as a [way] to get capital relief, and this allows a portfolio greater freedom in its investments,” Berger said. This allows mutual funds, proprietary desks, and other accounts to get around limits on how much exposure they can carry to a single issuer.CDS can also help investors get through tough markets. With the lack of bids in the current market due to volatility, some of these accounts could be using muni CDS to maintain a “holding pattern,” allowing them to keep buying certain credits without selling down their current holdings from the same issuer, said Matt Fabian, senior municipal analyst at Municipal Market Advisors.“If you’re at your limit for Puerto Rico, and yet there is another Puerto Rico deal coming that’s going to look really cheap, your choices are that either you sell your old Puerto Rico or you buy protection against it.”Buying protection against current holdings leaves the investor with exposure to the CDS counterparty, rather than the bond issuer.This can be important in a muni market that is still on pace to set a record for annual volume by year-end.The muni CDS market has grown to $75 billion this year from about $20 billion at the close of 2006. But it is still far too small to sway the muni cash market from day to day. During the past 24 months, issuers have sold an average of $34 billion of debt each month, according to Thomson Financial. By these figures, the muni CDS market is just slightly larger than two months of municipal bond sales.
