Big dump in Muni world of late. As previously noted there are many factors influencing pricing. Declining credit quality and increasing supply are the big issues. But there is more at play in this story than just the traditional fundamentals. The wild card is our old friend CDS.
There are today two ways to play the long side of Munis. The easy and old-fashioned way is to simply buy them. Once you own them you get a semi –annual yield; in return you assume the risk of default of the issuer.
Alternatively one could just buy a Treasury bond and write a CDS contract on the municipality in question. In this transaction you would get (A) the yield on the Treasuries and (B) a stream of income from writing the CDS contract. The risk parameters are similar to actual ownership of the muni bond. If there is a default, the CDS writer assumes the loss.
Now consider the current pricing for Illinois GO bonds. (example from Bond Buyer)
Five year yield on IL Muni=2.85%
Five year yield on Treasuries=1.53%
Five year return on writing IL CDS=2.91%
Do the maths. You could either invest your money at 2.85%, or you could concoct the same economic result through a CDS contract and get a net yield of 4.44%. Not hard to figure out which one make more sense.
Of course it is not so easy to write CDS. You must be a big player to do something like this. Warren Buffet and Goldman can do it. So can a bunch of others. But the list is still pretty short.
Market makers are not investors. They are arbs. When powerful street players see market holes like this they just try to exploit it until it is gone. The question at hand is, “What side of the market is wrong?” Either (I) Muni yields will rise to eliminate the spread, (II) CDS pricing will fall, or (III) both sides of the equation will move toward the centre and a more efficient price will be established.
My bet on the outcome? Muni yields are set to go higher. Demand for Muni CDS protection will remain firm. When a street player writes a CDS contract for a Muni what do they do to lock in a gain and offset the risk? Simple, they just short the underlying Muni bond. The net result of the CDS demand is that bond prices fall and yields rise.
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