MCDX Municipal CDS index on the rise

MCDX, the benchmark index of credit defaults swaps referencing 50 different municipal entities ranging from general obligation debt to revenue bonds from municipal authorities has been on a particularly strong rise since April of this year. The recent graphs below from eFinancialNews, WSJ and Bloomberg all highlight the increased attention this little-known index has been getting.

The 5-year MCDX increased from 115 bps to 209 bps during the period from April 20 to June 11, 2010 and had nearly doubled 11 days later when it closed at 226.5 bps on June 22. Between September 28, 2009 and April 20, 2010, the index had only increased from 90 bps to 115 bps.

The reason for the rise has been obvious, if not evident in CDS market prices, for quite a while now. Ballooning municipal deficits and lower revenues are creating fiscal problems for many states across America. California and Massachusetts have both announced probes (though mostly inconclusive to date) into municipal CDS trading while Illinois has seen its credit default swaps achieve the status as riskiest state in America.

The municipal crisis is not just limited to the USA either (nor is the reporting of it just limited to American media as this Korean story demonstrates). For a brief period of time in May, The Italian island of Sicily saw swaps tied to its debt claim the title of riskiest municipal CDS before being overtaken by California (and then later Illinois).

The WSJ recently reported that “famed investor Warren Buffett recently warned of a “terrible problem” ahead for municipal bonds. But municipal-bond prices aren’t reflecting much concern. Yields on municipal bonds maturing in 2020 stood at 3.15% Friday, up slightly for the week but down from 3.3% in April. As prices and yields move inversely, this indicates lessening concern among muni investors, even as the cost of insuring against defaults has been rising……223 out of more than 40,000 municipal issuers defaulted on their debt payments in the past year, says Matt Fabian, managing director of consulting firm Municipal Market Advisors. That represented about $6.4 billion, or just .002% of outstanding municipal debt.”

Another issue in the municipal market is the issue of the appropriate standards of financial reporting. with the paper talking about how,

some investors argue that current municipal-bond analyses don’t take into account the liability of citizens in each state for their share of federal debt.

Investors typically look at the amount of debt a state holds compared with its economic output, known as the “gross state product.”

In Illinois, for example, the ratio is about 4%. But federal government debt will be paid by individuals through income taxes and federal taxes levied locally, such as gas and highway taxes. This would make it more difficult to raise taxes to pay all these debts.

“Ultimately, you’re going to support debt at a national level as well,” says Lyle Fitterer, managing director who oversees municipal bonds at Wells Capital Management, a large investment firm. So, in reality, he says, Illinois owes 65% to 70% of its gross state product.

John Sinsheimer, Illinois director of capital markets, says the state isn’t responsible for federal debt and therefore the national deficit doesn’t affect its ability to pay bonds, though citizens are resistant to tax increases in general.

With no quick fix in sight and continued municipal debt issuances despite no concrete plan to close budget gaps, the rise in MCDX and some individual municipal credit default swaps could continue.

Current prices and implied spreads (from July 1, 2010) for the on-the-run MCDX index (MCDX North America Series 14) of varying tenors is given below:

  • MCDX.NA.14.3year $96.44 (243 bps)
  • MCDX.NA.14.5year $94.37 (256 bps)
  • MCDX.NA.14.10year $91.50 (266 bps)

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