Buy Side

Crisis Upends Muni-Treasury Relationship

It used to be that a good stretch for Treasuries probably also meant a good stretch for municipal bonds. No longer.

A scorching-hot two months for Treasuries did munis little good in October and November. As investors seeking shelter have poured money into federal government debt, munis have become unprecedentedly cheap relative to Treasuries.

For most of their history, municipals and Treasuries have maintained a stable correlation reflecting pristine credit quality for Treasuries and tax-exempt interest for munis. Depending on the maturity, yields on munis have historically ranged between 70% and 100% of the yields on Treasuries. The financial crisis has disentangled this relationship.

John Derrick, who manages Treasury-based money market funds and two tax-exempt funds for U.S. Global Investors, said he has traditionally looked for top-quality 10-year munis to yield 80% of a 10-year Treasury and for 30-year munis to yield 90% of a 30-year Treasury.

On Wednesday, a 10-year triple-A rated municipal bond yielded 136.73% of a 10-year Treasury note, the highest ratio ever for that maturity, according to Municipal Market Data.

That ratio remained at less than 100% for all of 2007 and did not breach 120% until October 2008.

The disparity on longer-dated maturities was starker. A 30-year triple-A rated muni on Wednesday yielded 154.6% of a 30-year Treasury, according to MMD.

In 2007, that ratio topped 100% only three times. The ratio spent most of the 1980s and 1990s at less than 95%.

"The traditional relationship between Treasuries and munis is breaking down somewhat," said Guy LeBas, fixed-income strategist at Janney Montgomery Scott. "That relationship will likely remain squirrelly for some time to come."

Many market participants say they expect the ratio eventually to revert or at least retreat; that is, for munis to recoup some of their value relative to Treasuries.

"It's not normal for a tax-free yield to be higher than a taxable yield," said Joseph Mowrer, a portfolio manager at Karpus Investment Management. "I would expect that at some point it would go back closer to its historic average. ... Anyone's guess is as good as mine as to how long it will last."

Derrick, for example, said he expects 10-year and 30-year munis to once again yield 80% and 90% of Treasuries, respectively.

The collapse of several major Wall Street banks, the specter of recession, and what could be the worst year for stocks since the Great Depression have sent investors on a hunt for safe havens this year.

During this hunt, the market has sent a clear signal: Treasuries are safe havens and munis are not. The upshot has been a massive flood of cash into Treasuries and a sell-off in the muni market.

On Monday, the yield on a 10-year Treasury note compressed to as low as 2.65%, down more than a percentage point from six weeks earlier and its lowest rate in half a century.

Meanwhile, at more than 4%, the yield on a 10-year triple-A rated muni yield curve scale was up roughly 50 basis points from six months earlier.

Far from moving in tandem, Treasuries and munis have moved in opposite directions during the financial crisis.

"Historical relationships aren't really significant at this time," said Ron Schwartz, a portfolio manager at StableRiver Capital Management. "At this point in time, it's not a matter of looking at past ratios. It's a matter of looking at the liquidity aspect, and the flight to quality in Treasuries is in its own league. ... When there is liquidity in the market, then the municipal market will trade more in line with Treasuries."

Investors have not flocked to municipals during this crisis for several reasons. The one cited most often is the illiquidity of the muni market.

Many municipal bonds trade only a few times once they are issued. A 2004 Securities and Exchange Commission study examining trading data from 1999 and 2000 found roughly 70% of municipal bonds do not trade during the course of a year.

Trading volume of Treasuries averaged $565 billion a day last year, according to the Treasury Department, or more than 20 times muni trading volume.

A 2005 study commissioned by the Federal Reserve sought to determine why munis traded at such low prices compared with Treasuries.

Even in those placid times, the study concluded investors demanded a yield premium of 14 basis points for top-rated one-year municipals and 65 basis points for 20-year munis to compensate for illiquidity.

Illiquidity is not the only factor. The economic slowdown threatens to weigh on municipal credit quality.

State tax revenues shrank an inflation-adjusted 2.6% in the third quarter, according to the Nelson A. Rockefeller Institute of Government.

However, Derrick believes credit quality's role in the sell-off has been marginal compared with illiquidity.

Prerefunded munis offer a powerful illustration. They theoretically have identical credit quality to U.S. government debt because they are backed by payments from escrowed Treasuries with comparable maturities.

Yet prerefunded five-year munis were yielding more than 138% of five-year Treasuries last week, according to MMD.

"The severity of this particular crisis has just caught people off-guard," Derrick said, citing the implosion of the bond insurance industry as a scare chasing investors from the market. "Now we've seen those spreads just blow way out. It's nothing like we've seen over the last 20 years."

LeBas said heavier buying of municipals by hedge funds and other institutional investors in the last few years helped bind munis and Treasuries within their historical range.

Any time yields drifted from their pattern, hedge funds would arbitrage the price back into line, he said.

With many hedge funds in forced liquidation and institutional investors nursing their balance sheets, the market has suffered an exodus of buyers that had been ensuring efficiency, according to LeBas.

One of the reasons it is impossible to predict when munis and Treasuries will revert to a more normal ratio is those buyers may be out of the market permanently, he said.


Upcoming Events

Already a subscriber? Log in here
Please note you must now log in with your email address and password.