Stable muni market gains new fans

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My colleagues and I spend too much time being appalled at the risks to the financial system from excess liquidity, overleveraged balance sheets, and poorly thought out derivative structures.

We fail to appreciate how much money you can make if you just ignore the downside. Pluses and minuses? Why not just look at the pluses? It pays better.

For example, there was a time when the municipal bond market in the US was an entirely domestic affair, with issuers of tax-exempt bonds to pay for sewer systems and roads on one side, and older, conservative investors on the other side.

Since a rash of defaults in the 1840s, and some in the 1930s, US state and municipal governments have been very careful issuers. They are not bailed out by the Federal Reserve or the Federal government and, with a few exceptions, they tend to act responsibly.

One could ask whether anyone in the muni market knew what potential returns are required to attract good traders in this era?

Now they do know. Over the past few years, the US municipal market has been populated increasingly by “non-traditional” buyers (not investors), including German banks and nests of hedge funds. They may or, in the case of non-US banks, may not be interested in the tax exemption for interest income.

What does interest the non-traditional buyers is the interesting scope for arbitrage possibilities offered in the US muni market. All those retirees in Florida are slow to shift their portfolios, since they want to collect their coupons rather than trade their assets.

In September of last year, AAA municipal bonds had a yield that was 110 per cent that of US Treasury bonds.

That was overpaying for default risk, so the bonds were a buy for the risk-averse investors even if, as foreign institutions, they were indifferent to the tax advantage. I noticed this at the time and thought the non-US, “non-traditional” participation in the market was a passing phenomenon that would disappear as soon as muni yields returned to their normal discount to Treasuries.

That did not happen. On the industry standard measurement of AAA yields – the MMD scale – 30-year muni bond yields are now about 85 per cent of Treasuries, and the 12-month average has been 89 per cent. Yet non-traditional buyers are more important than ever, thanks to arbitrage opportunities.

In particular, the US muni bond market, unlike the Treasury market, offers a normal, rather than an inverted, yield curve, and low volatility.

This means that, by using swap contracts with dealers or by taking the short side of the Chicago Board of Trade’s municipal bond contract future, you can pay a low short-term municipal rate on one side and buy long-term munis on the other side, and collect a margin of about 60 basis points. That’s down from the 138 basis point carry you would have earned a year ago, thanks in part to all the non-traditionals jumping on the trade.

Sixty basis points doesn’t sound like a lot of cash flow. However, thanks to the miracle of leverage, you can multiply that by 10 or even 15 times to get a good return. Also, thanks to those retirees and insurance companies, there is still not that much volatility, relatively speaking, in the muni market.

Sure, there are occasional marks-to-market that have to be taken. That’s why you’re paying for investment management expertise.

I would strongly suggest that, if you choose to buy into a strategy such as this, you go to managers who have been in the muni business for more than a few months or a year. There are thousands of issuers out there. Given the sort of leverage being put on in this trade, it takes a detailed knowledge of the underlying securities to avoid the small number of blow-ups that could flush away a fund.

Event risk

You may have read in the FT about the increasing “event risk” to credit default swap (CDS) holders. In particular, a buy-out by one corporate issuer of another can result in CDSs on the acquired company becoming worthless. That’s because the bonds issued by an operating company may be repaid with the proceeds from new issuance by a holding company that is the acquisition vehicle. An acquirer might want to do that to do away with restrictive covenants in the acquired company’s bonds.

The problem is that the CDS contracts will remain outstanding, with no corresponding bonds from the “reference entity”. This came up a couple of weeks ago, though not for the first time, when it was announced that Phelps Dodge would be taken over by Freeport McMoran.

According to a published Bank of America analysis done at the time by Glen Taksler, if all existing Phelps Dodge debt were to be tendered and Phelps Dodge was to issue no new debt, “In standard CDS contracts written on North American Reference entities, holding company debt is not deliverable into operating company protection . . . As such, under this scenario, there would be no Deliverable Obligations into CDS contracts. We would look for Phelps Dodge CDS to become near worthless.”

I thought about the possibilities here. If you were a corporate treasurer of an acquirer, looking to lower your costs, why not make sure that such an outcome was explicitly threatened at the time of the takeover announcement?

Then you could wait for the CDS-holding hedge funds to approach you, beseeching you to consider their interests. You could offer to issue new bonds (without restrictive covenants) at the (acquired) operating company level. At below-market interest rates. The hedge funds would be obliged to buy them to avoid a write-off of their entire CDS position.

Blackmail? I prefer to call it “a gentlemen’s agreement”.

johndizard@hotmail.com

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