A spike in Treasury rates threatens to stomp out the rally in short-term municipal bonds, investors and analysts say.
Participants in the bond market say oversupply, growing risk appetites, and the specter of a rising interest rate environment promise to send Treasury rates higher - and take short-term muni rates with them.
By standard measures, investment-grade municipals with maturities seven years and in are expensive.
The yield on the two-year triple-A muni touched 0.66% last week, according to the Municipal Market Data yield curve, which was the lowest yield since MMD started keeping track in the early 1980s.
The yield on the two-year triple-A yesterday was barely more than half the yield on the two-year Treasury note. On Friday, the two-year set the record for the lowest yield as a percentage of the Treasury, at 51.9%.
At some maturities, tax-exempt muni yields are lower than Treasury yields even after taxes.
The five-year Treasury yielded 2.74% yesterday, which, assuming a 35% tax rate, translates to a 1.78% after-tax yield. The tax-free five-year triple-A yields 1.69%.
It would not make sense for muni yields to remain much lower than Treasury yields because a Treasury yield is a risk-free rate while a muni yield is not.
Some analysts worry that if Treasury rates keep rising, short-term municipal rates would have to follow.
Matt Fabian, managing director at Municipal Market Advisors, wrote in a report yesterday the uptick in Treasury yields lately means the short-term rally is increasingly at risk.
Yields on munis historically have tracked Treasury yields, within a range.
While yields on munis broke out of that range in the last two years, Fabian said they could latch back on if Treasury yields jump much higher.
"Looming losses in the Treasury market cast a pall over aggressive risk-taking in fixed income generally," he wrote. "Expectations that tax-exempts will continue to ignore Treasury losses seem less and less reasonable."
A slew of good news about the economy - most prominently the decline in the unemployment rate to 9.4% from 9.5% reported last week - has chased money out of Treasury bonds.
Treasuries traditionally serve as safe perches for investors, offering impregnable safety and utmost liquidity at a lower yield than riskier or less liquid assets.
The economy's brightening prospects have coaxed cash out of Treasuries and into riskier investments offering superior returns, according to John Derrick, director of research at US Global Investors.
"People are taking money out of very safe assets and putting them into riskier assets," he said.
The unwinding of the so-called flight-to-safety trade can be found in numerous corners of financial markets.
According to EPFR Global, investors have ferried more than $200 billion from money market funds this year, another low-yielding safe haven.
The encouraging news about the economy has also prompted investors to revise the timeline for when the Federal Reserve will mop up all the money it is flooding into the economy, Derrick said.
Fed chairman Ben Bernanke last month responded to criticism his policies would lead to inflation. In testimony to Congress, he said the Fed has ample tools at its disposal to siphon money back out of the economy before inflation gathers steam.
The Fed has pumped more than $900 billion into the economy since the recession began in December 2007, based on the M2 money supply measure, to say nothing of the "quantitative easing" programs designed to liquefy markets.
Derrick said investors had expected the Fed to begin sopping up the excess money supply to stave off inflation, perhaps in the middle of next year or later. Now, some people think the Fed will begin tightening early next year, he said.
A reversal of the Fed's commitment to short-term interest rates near zero would lift the risk-free rate of return higher.
Short-term municipals would have trouble competing with rising risk-free rates, Derrick said.
Fabian also cited oversupply and the threats by foreign governments, particularly China, to begin paring Treasury holdings as forces pushing up U.S. government bond yields.
Mark Pawlak, an analyst with Keefe, Bruyette, & Woods, wrote in a report yesterday that yields on Treasuries have begun breaking past levels he previously considered points of resistance.
The two-year last week breached the support level at 1.25% to finish at 1.31%, Pawlak said. The next resistance point is 1.4%, though he does not suggest "fighting the move up in short rates."