Reading the muni CDS tea leaves

December 2, 2011

I saw a strange tweet this morning that said “State CDS blew out yesterday per Bloomberg. Not sure what I missed here.” The anonymous tweeter attached the image above of graphs of credit-default swaps for 9 big states. Notice the very sharp one-day spike for every state except Ohio. Those spikes mean that those who trade muni CDS suddenly thought U.S. states were riskier, by anywhere from 2.09 percent to 17.02 percent, in one day. That is a big gap up.

Municipal CDS reference the equivalent cash bonds of the obligor. So a NY10Yr CDS references New York State general obligation bonds that mature in 10 years. CDS and cash bonds use different units of measurement but generally move proportionally to each other. So if investors no longer want New York State general obligation bonds and their price declines, one would usually see the CDS sell off too.

But municipal cash bond markets didn’t sell off yesterday. You can see in the Thomson Reuters Municipal Market Data chart below that New York State general obligations have been trading pretty steady recently. There certainly wasn’t a 17 percent drop yesterday like there was in the NY10Yr muni CDS. What’s going here?

Well-known blogger ZeroHedge published a Muni CDS Market Primer last January that provides good background on the product:

Theoretically, MCDS [municipal CDS] is equivalent to a financed purchase of a muni bond with an interest rate hedge and, therefore, the MCDS spread should track the muni bond spread. However, like in the corporate market, there could be a basis between the two spreads based on demand/supply and transaction cost considerations.

You might wonder what “there could be a basis between the two spreads based on demand/supply” means. It means that one of the products could sell off for some reason that’s exclusive to that market, and the relationship between the two products would break down.

A plausible scenario of what happened to muni CDS is that some big seller had to suddenly dump their positions to raise cash — a panic sale, in other words. Bond and derivative traders get big salaries because they know how to exit positions quietly without causing spreads to blow out. Since these moves happened across 8 states, it wasn’t just an error by some newbie on the trading desk.

Of course, there could be other explanations, but it made me wonder who could be dumping assets. Maybe it was a municipal bond fund that got run over by holding 8 percent of their assets in the muni debt of American Airlines? They are certainly a group who needed fast cash.


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Markit US and Municipal CDS Report: Politics in the New Usual – December 2, 2011

This week saw uncharacteristic volatility in the municipal CDS market, both in single names and the MCDX, widening out dramatically on Tuesday, by 18bp, only to tighten back on Wednesday by the same amount. The tightening Wednesday was easily explained based on the prior day’s move and central bank interventions to provide dollar liquidity to the European financial system helped risky assets rally broadly. However, the widening on Tuesday caught some market participants a bit by surprise. The move appears largely technical and could be due to large trade unwinds hitting the market. More than $1.3bln traded in the Markit MCDX in the prior week according to figures from DTCC, which is significant. Movements in the municipal cash bond market were not nearly as pronounced in comparison lending further credence to the idea that the spike was related to unwinds.

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