Before the financial crisis of 2008-09, it would have been significant news if yields on municipal bonds had exceeded those on Treasury securities at any maturity, and that occurrence likely would have attracted a variety of investors seeking to take advantage of the relative-value opportunity.
Following the financial crisis, however, the ratio of 10-year municipal bond yields to comparable 10-year Treasury yields has frequently hovered above 100% and even moved more than 200% during the most strained moments.
After the crisis, the ratio attempted to revert to its historical relationship as the ratio on 10-year munis fell to about 82% as of May 2011. But even then, the upward slope of the trend remained intact and the ratio again reached more than 100% of Treasuries in late April 2013.
This recent increase also has taken the ratio back above its post-credit crisis average of 93.7% since 2009, according to the Municipal Market Monitor. Previously, the 10-year municipal-Treasury ratio was typically in the 80-85% range.
Many investors have become accustomed to higher muni-Treasury ratios, so the historical yield ratios may have less influence on their investment decisions. However, in an environment where investors’ search for income has compressed the yields in most asset classes below their historical spread levels, bond buyers should consider the rarity of a credit-spread relationship that remains above its long-term average.
Investors seeking relative-value opportunities might also want to consider what needs to occur for the yield ratio between municipal and Treasury yields to revert to its historical average. In that scenario, municipals will need to outperform Treasuries.
For this to happen, either Treasury yields would need to rise — which is one of the prominent concerns for fixed-income investors — while muni yields would need to remain stable or rise to a much lesser extent. Another way the ratio could revert to its historical average is that Treasury yields could remain stable, while municipal yields decline.
When taking a broader look at the current yield environment, the higher yields on munis compared to Treasury securities reflect two major considerations. The first one has been investors’ flight to the perceived safety of Treasuries given the recent bout of weaker than expected economic reports. The second one has been the Federal Reserve’s monthly purchases of $85 billion in securities, including Treasuries, under its open-ended quantitative easing initiative.
The combination of these factors have pushed Treasury yields lower, while municipal bond yields have been held back by the presence of some incremental credit risk, despite being regarded as an asset class with traditionally strong credit quality, and the uncertainty regarding federal budget initiatives.
In addition, municipal securities have encountered some seasonal selling pressure from investors who tend to sell bonds for tax-related reasons.
With muni-Treasury yield ratios remaining above their historical levels, the Fed’s pervasive influence on the Treasury market may have convinced some investors that higher municipal yields may not necessarily reflect relative-value opportunities. Instead, these investors may believe that the yields represent a new paradigm that persists even when the Fed starts to adjust monetary policy.
These investors should also consider that the financial advantages provided by municipal securities have not only remained in place but also have potentially improved. Therefore, investors should question whether such a new paradigm outweighs municipal bonds’ exemption from federal income taxes and, in some cases, state and local income taxes.
This characteristic may be of particular interest, considering the recent increase in the top marginal income tax bracket to 39.6% and the implementation of the 3.8% Medicare surcharge.
For those in the top marginal income-tax bracket, the recent tax changes indicate that municipal securities with 'A’ credit ratings provided a tax-equivalent yield of 4.61% as of March 31, 2013, compared to 2.46% from corporate bonds with similar credit ratings.
Although munis generally have longer maturities than corporate bonds, the difference of 215 basis points may reflect much more than the impact of slightly longer maturities.
These tax-equivalent yields reflect the value that investors may obtain from the tax benefit on municipal securities. Prior to 2008, this benefit typically would cost investors a notable amount of yield relative to taxable securities. However, that cost has steadily declined in recent years, to the point where investors could receive the tax benefit without giving up yield when compared to buying Treasury bonds.
And in an environment where investors have scoured the fixed-income markets for every incremental income opportunity, and yields continue to compress toward Treasury rates, the minimal cost of the tax benefit on municipal securities may be an opportunity that remains available to many investors. It also may allow municipal bonds to outperform other fixed-income markets as the interest-rate environment continues to evolve.