Even as Build America Bonds continue to transform municipal finance, one thing stays constant: hedging a portfolio of muni securities remains very difficult.
The BAB program has opened the market to new types of investors and traders, and potentially to greater liquidity and transparency.
That’s small solace so far to dealers, traders, and brokers of state and local government debt, who have found that hedging the credit risk in taxable municipal securities is just as elusive as it is in the tax-exempt space.
“For the most part, neither tax-exempts or Build America Bonds are that easy to hedge,” said a capital markets veteran. “It’s a long-only market, and it’s not super-liquid, with a limited ability to hedge spread risk.”
Whether in the taxable or tax-free municipal debt markets, the impracticability of hedging comes down to one thing: fully shielding an inventory of municipal bonds requires shorting municipal credit, and nobody has figured out a good way to do that yet.
In a sense, any decline in the value of a muni bond is attributable to one of two things: either the benchmark interest rate rises, or the spread of the bond’s yield over that benchmark interest rate widens.
Many market participants agree that hedging the former risk — which is known as duration — is not so tough.
Because U.S. Treasury debt provides the benchmark rate for just about all bonds denominated in dollars, and because Treasuries are among the most liquid and continuously traded instruments in the world, a trader stuck with a municipal position can hedge duration risk by shorting a Treasury.
Market participants say duration risk has also been hedged using Treasury futures or options, or short positions on the London Interbank Offered Rate.
That way, if prevailing interest rates spike and clobber the value of a dealer’s municipal bonds, he will recoup his losses with gains on his short position on Treasuries or Libor.
The risk of a widening in a bond’s spread over the Treasury rate is a different story altogether. A reliable method for positioning oneself to benefit from a municipal bond’s spread swelling out has yet to emerge.
Take the story of Fred Yosca, who trades both tax-exempt and taxable municipal bonds at Bank of New York Mellon. Yosca began trading BABs at the beginning of this year, and like many traders hedged his exposure by shorting Treasuries.
“My model was to hedge them fully based on duration, with the appropriate cash Treasury,” Yosca said. “That worked like a charm until May.”
From January through April, the nominal spread of the average BAB yield indicated by a Wells Fargo index tracking the sector over the 30-year Treasury rate compressed 40 basis points.
The long-BABs short-Treasuries model worked fine as BABs outperformed Treasuries during that period.
Then, in May, public sector workers in Greece rioted. The markets fretted over sovereign debt defaults and fat-fingered traders and double-dip recessions. People worried about the swelling supply of taxable municipal bonds in the primary market, or about federal subsidy withholdings — or whatever else you want to attribute the widening of BABs spreads to.
The BAB spread over the 30-year Treasury jumped 17 basis points in May.
Yosca was slammed with a short position on Treasuries, which strengthened 30 basis points in May, and a long position on BABs, which strengthened fewer than 15 basis points.
“I got killed,” he said.
Yosca’s lament: hedging duration risk does not address a shift in spreads.
The long-BAB short-Treasury hedge has since completely fallen apart, as the nominal spread has distended an additional 40 basis points since the end of May to about 200 basis points.
“There’s duration to hedge, and then there’s spread,” said one public finance banker. By shorting Treasuries, this banker said, “you’d really only be hedging duration — you haven’t hedged that spread risk.”
This is not so foreboding a problem in the investment-grade corporate bond market, where traders have long had access to futures on a number of credit indexes that would decline should corporate spreads bleed out. That offers corporate traders a way to hedge duration using Treasuries, and hedge spread risk using indexes.
Municipal traders have no such index.
“It is very difficult to short state or local government credit in the U.S.,” JPMorgan municipal analysts Chris Holmes and Alex Roever wrote in a report last month. “In both the cash and derivative markets, shorting U.S. state and local government credits ranges in difficulty from 'challenging’ to 'outright impossible,’ depending on the target.”
It has been tried before.
In the mid-1980s, the Chicago Board of Trade launched a municipal bond index future based on The Bond Buyer 40 Index. In a paper written for CBOT in 1988, Richard Bookstaber, then a principal at Morgan Stanley, called hedging municipal inventory by taking opposite positions on Treasuries “largely ineffective.”
While shorting Treasuries does address duration risk, “it does not address the major sources of risk in the municipal bond market,” he said. Credit default threats and changes in the tax law are idiosyncratic risks posed by municipals and unanswered by a short Treasury position, he said. The only way to truly hedge a municipal position, Bookstaber argued, was with an instrument that responded directly to municipal bond prices.
Maybe so in theory, but the muni-bond index product in practice was bedeviled by a number of setbacks, most notably reports of index manipulation, culminating in CBOT dumping the product from its exchange in 2002.
By that time, the market had begun the process of forgetting about spread risk, anyway.
Roughly 46% of the $2.7 trillion of new municipal bonds sold from 2001 to 2007 were insured, according to Thomson Reuters. Tender-option bond programs had devised ways to arbitrage the municipal yield curve, keeping distortions in the relationship between tax-exempt and taxable rates to a minimum.
The market’s acceptance of the value of bond insurance, the stable interest rate patterns ensured by the TOB programs, and a widespread appetite for risk rendered municipals essentially a duration product — changes in municipal bond values were a function principally of changes in Treasury rates.
Spreads rarely played much of a role.
From the beginning of 2004 to the end of 2006, the ratio of the triple-A 10-year municipal to the 10-year Treasury averaged 83.6%, according to the Municipal Market Data scale. In those three years the ratio never dipped below 78% or ascended past 92%. That meant hedging munis with opposite positioning on taxable rates was eminently sensible. The average 30-day correlation between changes in the rates over that period was 0.88. At no point in those three years was it lower than 0.77.
In 2008, that all changed. The ratio climbed to a once-unthinkable peak of 186.1% as Treasury yields collapsed and municipal yields jumped. The 30-day correlation between changes in the two at times in the second half of the year approached zero. Changes in Treasury yields no longer explained changes in muni values — not exactly the ingredients for a stable hedge.
Phil Condon, head of municipal portfolio management at DWS Investments, said far from recouping losses on munis with short Treasury positions, many people in the financial crisis lost money both on their long municipal positions and on the short Treasury positions they had hoped would serve as a hedge.
The behavior of tax-exempt rates relative to Treasuries during the crisis challenged people’s assumptions about just how stable the relationship was, according to Condon.
People had long assumed the triple-A 10-year municipal rate could not persist above the 10-year Treasury rate for any appreciable length of time, he said. Yet it did for 73 straight trading days to close out 2008, and 22 days to open 2009.
“In ’08, they showed they can do almost anything they want to do,” Condon said.
Since then, munis have become more of a credit-spread product, tending to move in tandem with Treasuries but clearly exhibiting spread-shifting at times.
The difficulty of capturing this spread through a derivative or some other mechanism is perhaps best illustrated by the fact that municipal spreads often vary for the same issuer between the taxable and tax-exempt markets.
The tax-exempt market has strengthened in July, based on the ratio of the Municipal Market Advisors 30-year triple-A yield to the 30-year Treasury, while the taxable municipal market has weakened, based on the BABs spread.
Since the beginning of May, the taxable municipal market has weakened far more than the tax-exempt market, based on their respective relations to Treasuries.
The trailing 30-day correlation between the changes in BABs yields and tax-exempt yields has been under 0.2 at certain points this year. It has averaged 0.5.
While it would be an exaggeration to say spreads in the two markets are uncorrelated, they have not moved in lockstep.
How can an index or derivative offer a position on municipal spreads if different parts of the cash muni bond market do not even agree on what the spread is?
“While the credit may be the same, that doesn’t mean they’ll trade the same” in the taxable and tax-exempt markets, Condon said. “The buyers are different buyers. That’s the bottom line.”
Holmes’ and Roever’s report explored a number of short-selling mechanisms that exist in the taxable market that do not work so well for munis.
One of these is municipal credit-default swaps, which are essentially insurance contracts that gain in value when a municipality edges toward default.
These presumably provide a good way to short municipals, thus hedging the credit spread exposure of a bond inventory.
Just as the tax-exempt and taxable markets argue over the appropriate spread for an issuer, CDS contracts do not always agree with the bond market on spreads.
When the Wells Fargo index on BABs launched in August, the nominal spread over the 30-year Treasury was 179.6. The average spread on municipal CDS contracts compiled by Bloomberg LP was 174.
The two spreads have since walked divergent paths, at one point differing by 86 basis points — in November 2009, when the BAB spread remained elevated and municipal CDS spreads had contracted significantly.
Holmes and Roever explain that municipal CDS are thinly traded and “largely unused by the most experienced institutional investors.” They also point out that muni spreads are illogically high compared with corporate spreads. That suggests to them that most of the users of these contracts are people shorting municipals.
Directly selling a municipal bond short by borrowing it, selling it, and buying it back later is usually impractical because the lender of the security collects tax-free interest from the municipality but owes taxable interest to the short-seller.
Selling a taxable municipal security short is theoretically more plausible, but is hampered by the fractured maturity structure of the BAB market.
It would be dangerous to sell short a bond unless you thought you would be able to buy it back at some future date.
The roughly $120 billion of BABs state and local governments have floated since the program’s inception are split into nearly 15,000 Cusip numbers, according to Bloomberg. The peril with short-selling BABs is, who knows whether the particular Cusip you borrowed will be available for purchase later?
“For many issues, a short-seller could find it hard to locate specific bonds to cover his position,” Holmes and Roever said.
For those hoping that the development of the taxable municipal market will one day facilitate short-selling, Holmes and Roever warn that many issuers and some institutional investors have “strong incentives” to make sure selling municipal debt short stays as hard as possible.
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