Municipal Credit Hedging: Even In Detroit, A Whole Lot Of Nothing Going On

by: Donald van Deventer

The bankruptcy of Detroit brings new pressure on municipal bond investors and related exchange-traded funds [such as (NYSEARCA:HYD)(NYSE:NUV)(NYSE:PML)(NYSEARCA:PZA)(NYSE:IIM)(NIO) (NYSE:VMO)] specializing in municipal bonds to heighten risk management and to hedge where appropriate. One key tool in that regard is the single name credit default swap market, which has been a key source of profitability for firms like Bank of America (NYSE:BAC), Barclays Bank PLC (NYSE:BCS), BNP Paribas (OTCPK:BNPZY), Citigroup (NYSE:C), Credit Suisse, Deutsche Bank (NYSE:DB), Goldman Sachs (NYSE:GS), HSBC Holdings (HBC), JPMorgan Chase (NYSE:JPM), Morgan Stanley (NYSE:MS), The Royal Bank of Scotland Group PLC (NYSE:RBS), and UBS AG (NYSE:UBS). Municipal credit default swaps have also been central in conversations those bond underwriters have with bond issuers among the USA's states and municipalities. On January 15, 2013, Kamakura Corporation reported on weekly credit default swap trading volume for sub-sovereigns and municipals among 1,130 reference names that had traded in the 129 weeks ended December 30, 2012. The study found, unfortunately, that (in the words of Gertrude Stein) "there is no there there." In this note, we update the Kamakura CDS volume analysis for sub-sovereigns and municipals among the 1,144 reference names traded in the 155 weeks ended June 28, 2013. Alas, our conclusion is unchanged.

The data used in this study consists of CDS trades reported by Depository Trust & Clearing Corporation ("DTCC") during the 155 week period ending June 28, 2013. The weekly trade information is from the Section IV reports from DTCC. The data is described this way in the DTCC document "Explanation of Trade Information Warehouse Data" (May, 2011):

"Section IV (Weekly Transaction Activity) provides weekly activity where market participants were engaging in market risk transfer activity. The transaction types include new trades between two parties, a termination of an existing transaction, or the assignment of an existing transaction to a third party. Section IV excludes transactions which did not result in a change in the market risk position of the market participants, and are not market activity. For example, central counterparty clearing, and portfolio compression both terminate existing transactions and re-book new transactions or amend existing transactions. These transactions still maintain the same risk profile and consequently are not included as 'market risk transfer activity.'"

As always, our emphasis is not on gross trading volume. As of July 5, 2013, dealer-dealer volume was 75.16% of the single name credit default swap market and it would be nearly costless for dealers to inflate gross trading volume by trading among themselves. Instead, we focus on "end user" trading where at least one of the parties to a trade is not a dealer. Accordingly, we make the following adjustments to the weekly number of trades reported by DTCC for each municipal and sub-sovereign reference name:

  1. We divide each weekly number of trades by 5 to convert weekly trading volume to an average daily volume for that week.
  1. From that gross daily average number of trades, we classify 75.16% of trades as "dealer-dealer" trades, using the average "dealer-dealer" share of trades in the DTCC trade warehouse as of July 05, 2013.
  1. The remaining 24.84% is classified as daily average "non-dealer" volume, the focus of the reporting below.

Daily Non-Dealer Trading Volume for Municipal and Sub-Sovereign Reference Names

Of the 1,144 reference names for which DTCC reported credit default swap trades in the 155 week period, only 10 were sub-sovereigns of any type:

  1. Hong Kong Special Administrative Region
  2. State of California
  3. State of Florida
  4. State of Illinois
  5. State of Michigan
  6. State of New Jersey
  7. State of New York
  8. State of Texas
  9. The City of New York
  10. The Commonwealth of Massachusetts

Between December 30, 2012 and June 28, 2013, one name (State of Michigan) was added to this list. Nine of the 10 reference names were in the United States and 8 of the 10 reference names were U.S. states. The only cities on which credit default swaps had any trades in the 155 weeks ended June 28, 2013 were the City of New York and Hong Kong. We can summarize the trading volume in these 10 reference names as follows:

  1. There were 10 x 155 = 1,550 weekly observations, but there were no trades for 1,035 of the weekly observations. That means in 67% of the 155 weeks, on average, there would be no trades on these 10 reference names.
  2. The average number of non-dealer trades per day on all 10 reference names over the 155 week period was 0.21 trades per day.
  3. The median number of non-dealer trades per day over the 155 week period among the 10 reference names was 0.17 trades per day.
  4. The highest number of gross trades in one week was 173, which is the equivalent of 34.6 gross trades per day and 8.6 non-dealer trades per day. This data is for the State of California in the week ended September 21, 2012.

The following chart summarizes trading volume by the ten reference names:

Week by week gross trading volume for the State of California over the full 155 week period ending June 28, 2013 is given in this chart:

Among the 1,144 reference names traded during the 155 week period, the muni market volume leader, the State of California, ranked only 702th of the 1,144 reference names.

Detailed Information on CDS Trading Volume by Individual Reference Name

Detailed information on trading volume is available to those analysts who agree to the DTCC terms of use agreement.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Kamakura Corporation has business relationships with a number of firms mentioned in this article.