MCDX: Once munis start down the dark path...

From the people who brought you the ABX, now comes the MCDX, a basket of municipal credit default swaps (CDS). The index will begin trading on May 6 with three, five, and ten year tenors. Markit set the coupon for the MCDX last Thursday night at 35, 35, and 40bps respectively. It started trading today, and traded wider, closing at 42bps for the 5yr tenor and 48bps for the 10-year.

This is a potential game changer in the municipal market. First, we'll go over what the MCDX is, and then how it might change municipals forever.

The MCDX is going to be very similar to the CDX or ABX indices currently trading. It will represent a basket of 50 equally weighted municipal CDS. You can see the list of credits here. These will be recognized by municipal traders as more or less the 50 largest regular issuers of bonds. There are a few AAA credits in there, but mostly AA and A-rated credits. If rated on Moody's Global Scale, the one where Moody's attempts to match muni ratings with corporate ratings, almost all of these issues would be AAA.

There are 26 "general obligation" issuers. These issuers have the legal authority to levy taxes and have pledged their full taxing power to bond holders. 21 of these are states, the other 5 are local municipalities: New York, Los Angeles, Los Angeles School District, Phoenix, and Clark County Nevada.

There are also 24 "revenue" issuers, who don't have any taxing power. The items in the MCDX are of the "essential service" variety, including water and sewer systems, public power, and transportation. The term "essential service" implies that while the issuer does not have taxing power, the local government would have a strong incentive to ensure continued operation. Tobacco and health care issuers are explicitly excluded from the index.

Here is how the index works. A buyer of protection on the MCDX has essentially bought equal amounts of protection on the 50 names in the index. So a $10 million notional trade in the MCDX is de facto $200,000 in protection on each of the 50 names. Should any of the names default, the buyer of protection would deliver an eligible obligation of the issuer to the seller of protection at par. Markit has provided a list of CUSIPs as examples of eligible obligations. Any bond which is pari passu with the listed CUSIP would be eligible.

So why should you care? To date, trading in municipal CDS has been very light, and with good reason. Default rates of general obligation and essential service municipals are almost non-existent. There is a limited number of large and frequent issuers outside of these two categories. So demand from hedgers for specific names is light. There might be demand from speculators who want to bet on the contagion hitting munis. But such a buyer would prefer to make a generalized bet on municipal credit as opposed to picking out individual credits.

The MCDX solves both these problems. Trading desks who want to hedge against municipal credit spreads generally widening can use the basket as a on-going hedge. It wouldn't really matter if the particular names in the index don't match the names the desk owns, since the hedge is really a macro/contagion position. If California runs into major budget problems, odds are that New York CDS would widen at the same time. Obviously this is a better product for a speculator who wants to bet on a broad municipal contagion. So the MCDX is bound to be a hell of a lot more liquid than the single name market ever was.

The implications for the muni market are huge. First of all, it would seem the MCDX will more or less dictate the price of muni bond insurance. It will also heavily influence the spread between insured and uninsured munis. I've heard some talk that such a product would be another nail in the muni insurance coffin, but not so fast. The muni market will remain retail driven, and mom-and-pop investors don't buy CDS. They will still demand insurance.

The MCDX will also heavily influence how munis trade on a given day, especially in institutional size. If dealer desks start using the MCDX to hedge their books, then the daily movement in the index will become part of their P&L. In other sectors, when traders hedges are up, they are a little more willing to cut the price on their long position. The same will happen in munis. If the MCDX is 3bps wider on the day, traders will be willing to sell their bonds 3bps wider too. Well, maybe 2bps anyway. Traders aren't generous people.

It could also start to chip away at some of the old habits of muni buyers. Today municipals are traded mostly on yield. Even if the Treasury bond market is mildly up on the day, muni traders usually don't mark their positions higher. If the MCDX becomes heavily used as a hedging vehicle, traders will want to quote their offerings in terms of their hedges. Thus you are likely to see offering levels altered more often, and possibly even starting to be quoted on spread.

Right off the bat, it almost has to widen. There are going to be more natural buyers of protection (anyone who has a large muni portfolio) than sellers (speculators). So I wouldn't read too much into the movement of the first month of trading. Given that the natural sellers of the MCDX are probably mostly hedge funds and prop desks, I expect municipals to be permanently more correlated with corporate bonds.

All participants in the muni market should become familiar with the MCDX, even if you have no intention of actually trading it. Like the CDX and the ABX before, it has strong potential to alter the market substantially.