08/01/07
The Bond Buyer
Lehman Brothers launched two indexes today aiming to provide a more efficient hedging vehicle for municipal bond investors than what is currently available in the market.
The Lehman Municipal Index Swap products, first announced last week, will be comprised of an underlying basket of general obligation bonds, one with five-year maturities and one with 10-year maturities.
They will be used primarily as the basis for rate-lock instruments, where an investor buys or sells a rate-locked futures contract that typically lasts from three months to up to a year. The indexes will compete with Thomson Financial’s Municipal Market Data yield curves. These are the industry benchmarks that are currently used for the vast majority of rate-lock contracts.
“Our goal here is to put out a superior rate-lock product than what is currently out there,” said James Vergara, a vice president at Lehman. “It should provide a better mouse trap for our cash-hedging customers.”
Lehman is targeting different types of funds that want to hedge their portfolio using a rate lock. In these agreements, a fund will sign a contract with another party — typically an established bank — that agrees to a future yield level on a certain maturity in a given amount of time. Once the time has elapsed, the contract must be settled, with one party paying the difference of actual yields at that time and what the agreed upon rate lock was. Lehman hopes that funds and dealers will use this index to determine yield levels.
Typically, rate-lock users now use the MMD curve as a benchmark. For example, an arbitrage account has a large amount of 10-year bonds that it wants to hedge the risk on for the next six months. Yesterday, the MMD triple-A yield scale for bonds maturing in 10 years was 3.97%. The arb account will contact a bank, and based on a calculation method similar to how typical futures contracts are agreed upon, will come up with a rate lock for where the MMD 10-year yield will be at in six months, say 4.05%.
After six months, the transaction must be settled. If in this time the 10-year has risen to 4.10%, the hedge has worked in the arb account’s favor and the bank will have to pay the fund five basis points. This works as a hedge because the bonds that the fund owns have depreciated in value —from 3.97% — but now the bank will have to pay it that amount. If the opposite happens, the fund will owe the bank, but in turn the funds’ bonds have appreciated in value.
The Lehman indexes will not have it easy.
“They are going to have an uphill climb on this one,” said one manager for an arb account based in New York. “MMD is not perfect by any means, but to get people off of MMD, which is so ingrained with how people do business, is a tall order.”
Lehman will try to garner interest in these products by allowing all other dealers to use their index free of charge.
Also, it already maintains several municipal indexes and is using this as a starting point for these new products. The criteria for the two new indexes will be all GO bonds with credit ratings no lower than AA-minus or Aa3. The underlying basket of bonds must also come from deals that are $75 million or larger and have maturities no smaller than $7 million.
The main difference between the new indexes and the established ones, is that the maturities will be restricted to five and 10 years each. But by already having the infrastructure for the products, Lehman officials say they can create a more seamless match up with municipal yield changes.
MMD uses a different methodology for its triple-A yield curves. According to Bob Nelson of Thomson’s municipal group, MMD is fully dependent upon the amount of paper being priced in the primary and trading in the secondary on a day-to-day basis. He explained that the group looks at primary market pricings compared to the triple-A curve and how these bonds then trade in the secondary taking into account block trades.
MMD only uses 5% coupons and bonds with a 10-year call option. While this process takes into account a larger universe, some market participants dislike the lack of transparency in the process and claim it is too slow in taking into account market moves.
“The problems with MMD rate locks is the lack of transparency and the idea that it’s a bunch of guys in a room setting the price for your hedge,” said another fund manager in New York. In response to this, Nelson said that MMD is the only independent source of benchmarks in the muni market.
“We are the only party in this business that does not offer broker-dealer or money management services,” he said. “We tell you where the market is at and have no vested interest other than providing accurate data.”
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