richcano
By Ryan D’Souza
The recent rise in swapping activity has quietly clouded market transparency, creating significant opportunities for active managers to add value.
Transparency and competition in the municipal market have largely improved with advances in regulation, electronic platforms and algorithms. Additionally, liquidity conditions have remained stable since the Federal Reserve introduced the Municipal Liquidity Facility following the pandemic-induced selloff in March 2020. Although bid-ask spreads have widened amid heightened volatility in 2022, elevated selling pressure has been absorbed in a more orderly manner this time around. The surge in trading volume year-to-date, however, also reflects a pronounced rise in swapping activity, which has distorted typical market signals and rewarded those who have remained vigilant.
Compounding this issue is investors’ reliance on comparable trade data to support bond valuations. While trades are published promptly upon execution, swap trades appear indistinguishable from cash trades within this data. And with swap trades inherently arranged on a relative-value rather than an absolute-yield basis, investors are likely to misattribute these trade levels, resulting in illusions of cash demand throughout the market. Tax-loss swaps, which have become especially prevalent, are furthermore typically executed in large block sizes, producing trade prints that appear to establish a particular trading level. Subsequent investors may naively perceive liquidity to exist at the established level, looking to execute and continuing the cycle until a larger cash trade reprices the market. In addition to tax-loss swaps, volatility has prompted dealers to more frequently swap out of stale inventory items to bring in seemingly fresh offerings. Amid these dynamics, passive and non-traditional investors may see value where there is none.
We believe a diligent approach to analyzing market liquidity helps us discern these mispricings perpetuated by swap trades, which we have observed deviate from fair value by as much as 20 – 30 basis points, in our view. Foundational to this approach is monitoring new issue pricing levels and subscriptions, as well as bid-wanted trade prints, which we believe provide the clearest signals of cash demand. Moreover, we believe accurately tracking the flow of secondary activity requires a deep awareness of current secondary offers and markets, as well as thorough market color gleaned from strong dealer relationships. Utilizing this knowledge, we refrain from what we believe to be mispriced bonds, while continuously pursuing value throughout the rest of the market. By positioning ourselves to capitalize on corrections and executing at more optimal levels, we believe we can substantially enhance performance for our clients.
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