Municipal bonds are at some of their cheapest levels, relative to Treasuries, in market history. The problem is, most muni buyers don’t care.
Or so it seems. Traders and portfolio managers speak of muni-Treasury relationships daily, but the average retail investor doesn’t seem to pay much attention. Nor is it clear that they should.
Ratios are the muni market’s way of communicating credit spreads. A higher ratio is equivalent to a fat spread; the higher it is, the more value there is in buying tax-exempts, relative to taxable Treasuries.
When ratios are 100%, it means tax-exempts are yielding the same as Treasuries. And year-to-date, 10-year and 30-year spreads have averaged, respectively, 94% and 106% — considerably more than historical averages, according to Municipal Market Data. Last week they both bounced around the 128% mark.
Sell-side players naturally pitch these ratios to investors, but Municipal Market Advisors’ Matt Fabian said the retail market needs to interpret these figures with caution. He said high ratios are advertised as clear buying opportunities, but such relative values are fairly meaningless to anyone buying munis for cash flow when interest rates are hitting record lows.
“When yields suck, they push ratios, and when ratios suck, they push yields,” Fabian said Thursday, speaking of the sell-side. “It’s just different ways to sell bonds.”
The bulk of people buying munis are retail investors seeking tax-free income, Fabian said. Income is produced by absolute yields, not relative valuations. Retail investors who buy munis based on high ratios might find themselves staring at losses if Treasury and municipal rates each rise.
In a rising rate environment, munis tend to be more stable and thus outperform Treasuries, so ratios tighten. But unless the retail investor has shorted Treasuries to play the ratio trade directly — which is rather unlikely — that tightening won’t do any good.
“I don’t see where the opportunity lies with ratios,” Fabian said. “I’ve always thought that ratios were just a cynical way to sell bonds to people who don’t otherwise want to buy them.”
Yet it’s not as though the sell-side doesn’t have a point: muni-Treasury ratios aren’t just attractive right now, they are downright seductive. Consider that an investor in the top marginal tax bracket requires a tax-free bond to deliver at least 65% of the Treasury rate to break even.
Because munis are less liquid than Treasuries and state and local governments don’t have a printing press for money, investors demand a higher valuation to compensate. Thus, the two-decade averages for 10-year and 30-year ratios are 84.2% and 92.8%, according to MMD.
With muni-Treasury ratios for the 10-year and 30-year spots recently approaching 130%, their relative values are nearly double the break-even point.
These are the highest ratios since November 2008 to January 2009, when leveraged buyers unwound their muni trades and frightened investors across the globe flooded the Treasury market. Muni-Treasury ratios hit their all-time highs in December 2008 with the 10-year peaking at 186% and the 30-year hitting 208%.
Peter DeGroot and Josh Rudolph, strategists at JPMorgan, noted last Thursday that the muni curve is now trading 4-sigma cheap to Treasuries throughout the curve — a scenario about as likely as flipping 17 heads in a row. (In a bell curve, events deviate from the mean by more than three standard deviations 1% of the time.)
“It’s a wake-up call,” said Alan Schankel, head of fixed-income research and strategy at Janney Capital Markets.
Schankel published a research note last week saying history has smiled on investors who take advantage of the periods when tax-free yields significantly exceed taxable alternatives.
“Precise timing is tough to nail down, but in this case we believe that what went up will come down in the near future,” he wrote. “Although diversification remains important, today’s cyclical high ratios warrant some switching of fixed-income assets from taxable to tax-free. In coming months AAA-rated municipal bonds will likely significantly outperform Treasury issues, irrespective of interest rate changes.”
Reflecting on the buying opportunity presented in late 2008, billionaire investor Warren Buffett chided himself for not exploiting the “ridiculously cheap” valuations. “When it’s raining gold, reach for a bucket not, a thimble,” he told shareholders in February 2010. “Big opportunities come infrequently.”
Ratios, and yields for munis in general, aren’t near those levels now, and Schankel is in no way suggesting that people grab a bucket. But a cup might do the trick.
“An institutional investor might lock in munis at 125% ratios and then in a month, assuming it falls to 105%, unwind it and go back the other way,” Schankel said. “Retail can’t do that, I acknowledge that. But if you have a portfolio of half munis and half taxables, you should think about maybe going 60% muni and 40% taxables. That will serve you well in the future.”
The JPMorgan strategists added that cash for reinvestment should outweigh new supply in the December through February period. Three months of net negative supply, they said, should result in 20 to 40 basis points of relative outperformance in 10-year tax-exempts versus Treasuries.
“Traditional municipal investors should view the current environment as an opportunity to position municipals at wider spreads than will be available as we move closer to year-end,” they wrote. “Crossover buyers may consider a strategic allocation in tax-exempt municipal bonds as a means of outperforming taxable benchmarks and peers.”