With the Muni-Treasury Ratio Back to 'Normal,' What Comes Next?

The 10-year muni-Treasury ratio is back to normal. Whether it will stay there is debatable.

The standard valuation metric for benchmark 10-year municipal bonds for decades has been the relationship between its yield and the yield on the 10-year Treasury.

The credit crisis that began last year challenged all perceptions about this relationship. Some said the market was in an anomalous period and the ratio would eventually revert to its traditional range. Others said it was forever changed.

Last week, the 10-year triple-A yielded 3.32%, according to the Municipal Market Data scale, while the 10-year Treasury yielded 3.81%.

At 87.1%, this ratio is at a level that, while historically on the high side, is within the bounds of traditional normalcy.

John Derrick, who manages both Treasury and muni funds at U.S. Global Investors, thinks it will stay there.

"I think we're more or less back to normal," Derrick said.

Munis yielding more than Treasuries almost uninterruptedly from Sept. 15 through April 20 reflected panicked markets, Derrick said.

Muni yields used to track Treasury yields because both products thrived or suffered on similar factors: inflation expectations, interest rates, risk appetite, the attractiveness of stocks.

With investors fearing the worst last year and early this year, people seeking safe havens bought Treasuries and sold municipals. Suddenly, there was a new dichotomy in the market: Treasuries were safe and munis were not.

That yanked the yield on the Treasury down to barely more than 2%, forcing the Treasury yield below the 10-year triple-A yield for the first time.

Now that financial markets seem to have settled down a bit, people are selling Treasuries to emerge from their safe havens and munis are no longer suffering from forced selling and other market dislocations, according to Derrick.

"The whole risk trade kind of ran its course," he said. "The selling in a lot of the other areas kind of exhausted itself. ... The idea is that more or less the recession is probably behind us now; if we're not at the end, we're very close."

Until the beginning of 2008, the muni-Treasury ratio followed a faithful pattern. The 10-year triple-A muni never yielded more than 97.9% of the 10-year Treasury, and never less than 65.3%.

The average was 79%, and the standard deviation from the average over that period was roughly 5.5. More than 99 days out of 100, the ratio was between 72% and 91%.

Furthermore, yields on the two assets tended to move in tandem, to such an extent that Treasuries could be used to hedge municipal inventory.

Until last year, yields on 10-year munis and Treasuries on a weekly basis moved with a correlation of 0.64, with 1 being same direction and same magnitude and zero being randomness.

The financial panic that began last year pummeled this relationship. The 10-year triple-A muni at one point yielded 186.1% of the Treasury, which would have been more than 19 standard deviations from the mean prior to 2008. The correlation between shifts in muni yields and Treasury yields in 2008 was 0.26 - closer to random than tandem.

Many people said the ratio did not mean what it used to. Some in the market even argued about whether the relationship was meaningful any longer.

One trader in New Jersey said now that munis yield less than Treasuries, people are starting to pay attention again.

"It's not something we can ignore anymore," the trader said. "Municipal traders might be looking at the Treasury market more lately than they have been."

The trader said that while munis are not moving "tick for tick" with Treasuries, people are starting to become aware of the specter of inflation and higher interest rates, which would hurt both markets.

A trader in Chicago said he has to pay attention to the muni-Treasury relationship now: when the ratio is too low, nobody buys municipal bonds.

The 10-year muni-Treasury ratio returned below 100% in late April. That eliminated the marketing schtick that investors should buy munis because they yielded more than Treasuries.

Then, in May, it briefly ducked below 80%.

"It was pretty tough getting any business done then," the trader said. "We don't have the percentage cushion munis-to-Treasuries that we had a few months ago."

The trader said a muni yield at less than 90% of Treasuries "gets a little more scrutiny."

This all refers to the 10-year muni-Treasury ratio.

For munis with longer maturities, the ratio is still at a historically bloated level. The 30-year triple-A muni on the MMD scale yielded 4.7%, 102.2% of the 30-year Treasury. The record before 2008 was 102.6%.

"Munis are still historically cheap," said Bob MacIntosh, chief economist and a muni portfolio manager at Eaton Vance. "As long as people are paying taxes, I think a top-quality muni bond should have a yield that's less than the Treasury."

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