Historically, when compared with comparable maturity Treasury bonds, municipal bond yields have been lower due to their federal tax exemption. Over the very long term, this yield “discount” has averaged about 25-30 percent. An interesting change, though, has occurred from about the start of the financial crisis to today.
Municipal yields have generally been about the same or higher than Treasury yields even before adjusting for tax exemption. The chart below is a plot of the ratio of the five-year Treasury yield relative to the five-year Aaa municipal bond yield. A ratio of higher than 100 percent means the Treasury yield is higher than the municipal bond yield, and vice versa.
Ratio of Treasury Yield to Municipal Yield
The graph shows that after 2007 municipal yields have generally been higher than Treasury yields, while they were almost always lower prior to 2008. So, what explains this apparent change in pricing of municipal bonds relative to Treasuries, and why has it been so persistent in recent times?
The first caveat is that of course this could still prove to be a temporary change, meaning municipal yields will eventually revert to form and be below Treasury yields. Nevertheless, there are at least four explanations that come to mind.
First, broker-dealers have generally contracted their balance sheets since the financial crisis, which could mean they are simply holding less municipal bond inventory, consequently making the market a bit less liquid. If true, this would push municipal yields up relative to Treasury yields.
Second (and this is a bit of speculation on my part), Federal Reserve actions seem to more directly impact taxable bond markets than tax-exempt bond markets. Part of this may be due to the fact that the tax-exempt bond market is much more of a retail investor market than the taxable bond market, and therefore taxable bond investors are generally hesitant to buy tax-exempt municipal bonds even though their yields are higher than other comparable risk alternatives. Also, to this point the Federal Reserve hasn’t purchased any tax-exempt municipal bonds (at least that I’m aware of), but has purchased a significant amount of Treasuries and mortgage-backed securities.
Third, I think the municipal market has incorporated the possibility that municipal bond federal tax exemption could change. While this story has died down a bit, I don’t think it’s completely dead. If municipal bond investors know there is some chance that municipal bonds could become partially federally taxable, they will naturally demand more yield to hold them.
Fourth, for all the discussion about the credit worthiness of the U.S. government, U.S. Treasuries are still the go-to “safe haven” option. This has no doubt reduced Treasury yields relative to other alternatives.
Random Links and Commentary of the Week
If you like the NBA (or basketball in general), I think you’ll love this blog. Also, Kirk does a good bit of writing for Grantland as well, but I’m not sure how much of that overlaps with his blog.