Buy Side

Muni-Treasury Yield Ratio Returns to 100%

Almost a year after barreling past a previously unprecedented milestone, municipal bonds have returned to that milestone - coming from the opposite direction.

Last year, the 10-year yield for a triple-A muni matched the yield on the 10-year Treasury for the first time. Munis for decades yielded less than their counterpart Treasuries.

At that time, the muni yield reaching the Treasury yield was an alarming signal of illiquidity in the municipal market and a flight to safety in the broader credit markets.

Yesterday the two rates returned to parity.

This time around, municipals yielding 100% of Treasuries prompted a sigh of relief.

From the turn of the 21st Century to the beginning of last year, the 10-year yield for a triple-A rated muni ranged from 78% to 98% of the yield on the 10-year Treasury, according to Municipal Market Data.

The average ratio for that time frame was roughly 85%.

The relationship expressed the relative merits of munis and Treasuries. Treasuries boast top-notch credit quality and unassailable liquidity; munis have generally stellar credit and are tax-free but also often illiquid.

The 10-year yield for a triple-A municipal eclipsed the yield on the Treasury for the first time on Feb. 27.

The municipal market was bedeviled by stressed bond markets and the collapse of the bond insurance industry. This pushed muni yields up just as Treasury rates were slipping.

The yield at more than 100% persisted for two months before subsiding. The ratio hovered in the 90% range for most of the spring and summer.

Then, in mid-September, Lehman Brothers Holdings Inc. filed for bankruptcy protection, the biggest insolvency in the history of American business.

That sparked a wholesale flight to quality. Cash drained out of virtually every instrument and into Treasuries, which are known as the safest place to keep money.

The flight to safety had a profound influence on the relationship between Treasuries and munis.

First, the yield on Treasuries plunged as buyers snapped up U.S. government debt. The Federal Reserve's campaign to slash its interest rate target to stimulate the economy helped yank Treasury yields down even further.

The 10-year Treasury yielded 3.73% the day before the Lehman bankruptcy. By the end of the year, the Treasury yield tumbled to 2.23%.

Meantime, munis suffered along with corporate bonds, stocks, commodities, real estate, art, and just about everything else.

The financial crisis compounded or contributed to worsening fiscal outlooks at state and local governments, the exit from the market of several major underwriters, and the forced liquidation of many hedge funds that invested in long-term munis.

The 10-year yield for a triple-A rated muni spiked from 3.48% before the Lehman bankruptcy to as high as 4.86% in mid-October, according to data from MMD.

The result was the distention of a ratio investors had for decades used to gauge the attractiveness of municipals. The yield on a 10-year triple-A muni skyrocketed to as much as 186.1% of the yield on the 10-year Treasury.

The muni yield at the peak that day - Dec. 18 - could have halved and it would still have represented a distressed price based on the historical relationship to Treasury yields.

"You went to extremes on both sides," said John Derrick, who manages municipal and Treasury funds at U.S. Global Investors. "Treasuries went to one extreme; municipals went to the other."

The distortion was more pronounced for longer-term and lower-credit munis. The yield on a 30-year triple-A that day more than doubled its counterpart Treasury, based on MMD's yield curve. The yield on a single-A rated 10-year muni touched an implausible 249.5% of the 10-year Treasury.

While municipals with longer maturities or weaker credit continue to carry higher yields than their counterpart Treasuries, ratios for 10-year munis have returned to something approaching normalcy.

The yield on a 10-year triple-A was 99.9% of the yield on the 10-year Treasury at the close of the market yesterday, according to MMD.

That was the first time since Sept. 12 the ratio was under 100%. Less than two months ago, the yields were 184 basis points apart.

The convergence reflects two factors: a sell-off in Treasuries and a screaming rally in high-grade munis.

With talk of a bubble in the Treasury market, the yield on the 10-year Treasury has rocketed from a low of 2.08% on Dec. 18 to 2.9% yesterday.

Aside from a recognition that the rally in Treasuries was overblown, Derrick attributed the run-up in Treasury yields in part to a glut of new supply and the potential inflationary pressure from the $885 billion stimulus package working its way through Congress.

High-grade municipals, meanwhile, are on a tear.

The yield on triple-A 10-year munis has squeezed from 4.21% on Dec. 15 to 2.9% yesterday.

Jeffery Timlin, a muni portfolio manager at Sage Financial Advisors Inc., said compelling rates on munis relative to Treasuries lured yield-hungry retail investors into the market.

According to AMG Data Services, muni mutual funds have attracted $1.7 billion in deposits since the beginning of the year. Funds reported withdrawals of almost $10.2 billion in the last 15 weeks of the year.

Timlin and Derrick both said investors hoping to pick up bargains on high-grade 10-year munis relative to the Treasury probably missed most of the rally.

Timlin sees a real danger of muni yields leaping back above 100% of Treasury yields, while Derrick believes that, barring further crisis, the yields are resuming a more normal relationship.


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