Bloomberg News

False Default Signal With Swaps Most Since January: Muni Credit

October 06, 2011

Oct. 6 (Bloomberg) -- The cost of protecting municipal debt against default is at the highest level since January even as past warning signals from derivative contracts proved unfounded.

Protection on $10 million of securities for 10 years cost as much as $245,000 this week, according to London-based data provider CMA. That’s the most since Jan. 7, three weeks after banking analyst Meredith Whitney predicted “hundreds of billions of dollars” of defaults in the coming year. Instead, failures plunged to $1.1 billion, a quarter of 2010’s rate, according to Bank of America Merrill Lynch.

Prices of privately traded credit-default swap contracts have risen 78 percent since May 31 even after states closed a projected $32 billion in budget deficits, according to the Washington-based National Conference of State Legislatures. States and localities have also recorded seven straight quarters of year-over-year revenue growth, the U.S. Census Bureau said, while enjoying the longest stretch of rising income and falling interest rates since Bill Clinton’s presidency.

While states and cities are balancing budgets and slashing borrowing costs, investors are buying hedges against defaults on concern about a slowing global economy, said Peter Demirali, who manages $350 million of municipal debt at Cumberland Advisors in Mendham Township, New Jersey.

“Revenues are increasing,” Demirali said in a telephone interview. “They’re laying off workers and restructuring health and pension benefits. So the risk isn’t really any higher, it’s just that risk around the globe has moved higher.”

Economies Slow

U.S. gross domestic product growth may slow to 1.6 percent this year from 3 percent in 2010, while Europe’s expansion rate may cool to 1.7 percent from 1.8 percent, according to economists’ forecasts compiled by Bloomberg.

A credit-default insurance contract based on the Markit MCDX credit-default swaps index reached a record of 340 basis points in December 2008, following the collapse of Lehman Brothers Holdings. While CDS prices were rising, yields on municipal bonds had already begun plummeting to the lowest levels in at least six years, according to Bloomberg Fair Value data. A basis point is 0.01 percentage point.

Prices of the privately traded contracts next peaked on June 30, 2010, two weeks after 10-year muni yields began a 29 percent drop lasting through early September. The 2011 high for the CDS index was in January after Whitney’s appearance on CBS’s “60 Minutes” on Dec. 19. By mid-February, municipal debt had started an eight-month rally that pushed interest rates to the lowest levels since 1967, when Lyndon B. Johnson was president.

Default Drop

About 64 percent of municipal bankers, advisers and government officials expect the number of defaults to drop or remain the same this year compared with 2010, according to an RBC Capital Markets survey conducted at a Bond Buyer conference in Carlsbad, California last month.

Credit-default swap costs may not be a precise gauge of risk, said Tom Dresslar, a spokesman for California Treasurer Bill Lockyer. The biggest borrower in the $2.9 trillion municipal market saw the price of protecting its debt for 10 years jump to 286 basis points yesterday from 247 basis points on Sept. 29, according to data from CMA, which is owned by CME Group Inc.

“Anyone who tried to divine the reasons for movement in municipal CDS prices is on a fool’s errand,” Dresslar said in an e-mail. “There is no rhyme or reason. That’s probably because the entire market has no basis in reality.”

Ratio Increase

The rise in credit default swaps has accompanied an increase in the ratio of 10-year municipal yields to similarly maturing U.S. government-bond rates. The yields on tax-exempt debt have been at or above 100 percent of Treasuries for five straight weeks, the longest stretch since May 2009, according to Bloomberg data.

Still, investors in September added $1.9 billion to tax- exempt funds, the biggest monthly inflow since September 2010 when buyers added $2.6 billion, according to Lipper US Fund Flows. States and cities are set to issue $75 billion in the last three months of 2010, up from an earlier projection of $60 million, as issuers take advantage of plunging interest rates, Chris Mauro, a municipal-debt investment strategist for RBC Capital Markets in New York wrote in a report last month.

Yields on top-rated municipal debt maturing in 10 years reached the highest level in almost two months today following the biggest one-day increase since January.

They climbed 1 basis point to about 2.3 percent, the highest since Aug. 10, according to Bloomberg Valuation index data. The yield increased about 10 basis points yesterday, the most since Jan. 13. Before the recent rise, interest rates had fallen from about 3.5 percent on Jan. 18, the highest since Mar. 11, 2009, to 2 percent on Sept. 23.

Following are descriptions of pending sales of municipal debt:

The STATE OF WASHINGTON plans to borrow $1.29 billion in general-obligation bonds as soon as Oct. 10 with $516.7 million of the transaction in new money to help fund the Floating Bridge and Eastside Project. The remainder is to refinance debt. The state is rated AA+ by Standard & Poor’s, second-highest grade. JPMorgan Chase & Co. will lead a syndicate of banks on the deal. (Added Oct. 5)

NEW YORK CITY TRANSITIONAL FINANCE AUTHORITY, which finances capital projects for the most populous U.S. city, will sell $750 million of subordinate revenue debt as soon as Oct. 12 to convert variable-rate bonds into fixed-rate securities and refund debt. The authority’s subordinate debt is rated AAA, S&P’s highest grade. Bank of America Merrill Lynch is senior manager of the sale. (Added Oct. 6)

The STATE OF MICHIGAN is to borrow $138.7 million of general-obligation bonds as soon as Oct. 12. The transaction will help finance school loan programs and refund environmental program debt. The bonds are rated Aa2 by Moody’s Investors Service, its third-lowest ranking. Robert W. Baird & Co. will lead the sale. (Added Oct. 5)

CHICAGO BOARD OF EDUCATION, which finances school construction for the third-largest public-education system in the U.S., will sell as soon as next week $398 million of general-obligation bonds secured with dedicated revenue. Proceeds will renovate school buildings and finance expansion. The deal is rated Aa3, Moody’s fourth-highest grade. Jefferies & Co. will lead a syndicate of banks on the sale. (Added Oct. 6)

--With assistance from Michael B. Marois in Sacramento. Editors: William Glasgall, Stephen Merelman

To contact the reporters on this story: Michelle Kaske in New York at mkaske@bloomberg.net; Andrea Riquier in New York at ariquier@bloomberg.net

To contact the editor responsible for this story: Mark Tannenbaum at mtannen@bloomberg.net


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