Art Carden  

Barriers to Entry in Markets for Options on Municipal Bonds?

Getting a B.A. and Living With... Dobelli on Stadiums: What are ...

I learned from my finance colleagues that there apparently aren't very liquid markets in which I could short-sell or buy put options on municipal bonds. Birmingham has been going around and around about expanding the Convention Center and building a domed football stadium. My oldest and I stayed at the Sheraton downtown last Saturday night (he loves hotels and elevators, so we do stuff like this periodically), and while the Convention Center has a lot of problems it didn't look from our experience like excess demand was among them.

I am therefore bearish on proposals to build a domed stadium and convention center. I lay out the case against it here, but for Public Choice reasons I think we'll get one anyway.

In his new book Convention Center Follies, Heywood Sanders discusses a debacle in Phoenix in which the bonds issued to build a city-owned hotel were downgraded (iirc). If I'm right about the prospects for a dome in Birmingham, a sure-fire way to profit from my superior insight would be to short-sell or buy put options on the bonds that will be used to finance the venture. Then, when the bonds are either downgraded or defaulted upon, I can clean up.

Alas, there apparently aren't markets in which people can do this. That's a shame because, as I argued for recently, financial markets can save the world. Am I missing an obvious trading strategy in which I can profit from my beliefs, which are apparently way out of step with the beliefs of many people in and around Birmingham?

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COMMENTS (2 to date)
Doug writes:

The typical way that speculators short an issuer's creditworthiness is by buying protections with Credit Default Swaps (CDS). CDS derivatives a lot of the underlying inconveniences of short-selling underlying bond instruments, as well as creating a much more liquid market than exists for individual bond series.

By selling protection with a CDS contract it's possible to create synthetic exposure to the underlying bond. For example if the typical GM bond trades at 500 basis points (5%), and the corresponding treasury at 300 basis points, than arbitrageurs will make sure the CDS trades close to 200 basis points. A fixed income investor wanting to add $10 million of GM credit exposure can go out, buy $10 million of treasuries and sell protection on $10 million in GM CDS swaps. He'll have near identical investment results as if he went out and bought $10 million in GM bonds.

CDS contracts create natural counter parties for credit short sellers in a liquid, well-defined and convenient market. However CDS contracts are virtually unknown with munis bonds, because the cash flows from the contracts don't contain the same tax benefits.

If Birmingham has the same creditworthiness as GM, then without the tax advantage it's bonds would trade at 500 basis points. However the marginal investors are high-income US investors, who avoid a 40% marginal income tax on interest income. So in this case the muni bonds will trade at 300 basis points, because that provides the same after-tax income.

However a muni investor trying to replicate exposure with the same CDS strategy as above does not receive the tax benefits. The income stream from the treasury and the CDS cash flows gets taxed as ordinary income. The difference in tax treatment means there's no arbitrage between muni bonds and muni CDS. There are no natural sellers of CDS protection, and hence the market barely exists.

John Becker writes:

What is backing the bond? If it depends on the proceeds from the stadium, then there's a chance-albeit relatively slight-of a default. If it's a general revenue bond, the chances of failure are far less. Even in my home state of Illinois, one of the least creditworthy states in the country, interest rates on munis are very low.

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