Adventures at the long end of the muni yield curve | FT Alphaville

Adventures at the long end of the muni yield curve

The Bond Buyer has a story on Thursday highlighting strong demand for tax-exempt municipal bonds, which despite recent tightening are still trading at above 100 per cent of comparable US Treasuries at the long end of the yield curve.

The “magic” 5% tax-free yield is ­sustaining strong demand from retail investors.

Experts agree that municipals offer high yields relative to Treasury bonds even though interest rates in general have been falling amid a paltry supply of new tax-exempt debt.

In a note published on Tuesday Citi analysts write that this ahistorical pattern has persisted through QE2 and despite a decline in the ratio of 10-yr MMD/Tsy yields.

AAA MMD rates are generally lower than TSY rates, owing mainly to their tax-exempt status. 10-YR MMD rates have traded lower than 10-YR TSY 97% of the time, and 30-YR MMD rates have traded lower than 30-YR TSY 89% of time (since 1990 in each case). Thus, a yield ratio of less than 100% can be viewed as the “normal case”.

This chart from Barclays Capital shows how the yield curve for AAA has steepened into 2011:

At pixel time on Thursday the 10-yr MMD/Tsy yield ratio was at 85.4 per cent while the 30-yr MMD/Tsy yield ratio was at 102.8 per cent, according to data from Thomson Reuters.

Why has this relative underperformance occurred?

Broadly, for two reasons: (1) credit concerns and (2) more fundamental supply and demand factors.

Supply and demand imbalances are less well understood and we recommend this post from Bond Girl as a starting point to understanding how these have conflated well-documented credit concerns. Here’s a quick excerpt but we encourage you to read the post in full.

The second narrative (let’s call it the “structure narrative”) suggests that for decades municipals on the long-end of the curve have been supported by a patchwork of transitory market influences (such as the popularity of variable rate debt instruments and leveraged muni arbitrage funds), and most recently, the Build America Bond (BAB) program, which was established by the American Recovery and Reinvestment Act (i.e., federal fiscal stimulus legislation) in early 2009 and expired at the end of 2010.

Fear not, Citi says. It reckons that the AAA MMD curve will flatten as QE2 comes to an end — at least if QE1 was anything to go by:

QE1 of course came after an epic dislocation of the municipal bond market from US Treasuries because of the financial crisis, so there is only so much one can read into these few data points. And there are non-technical reasons why the curve could remain steep, such as persisting worries over public pension liabilities.

However, Citi does make an interesting implication (which we noted a while back) that we’re seeing a dislocation within the tax-exempt municipal market itself: between AAA MMD, which has recently reasserted its traditional correlation with US Treasuries, and medium-quality and near-junk paper. The latter is certainly in a credit space whereas the former can’t be described as such.

The end of QE2 should provide more of an idea, perhaps.

Related links:
Buyers Flocking to Tax-Exempts, Thanks to ‘Magic’ Yield – The Bond Buyer
Munis coverage – FT Alphaville
What is retail trading – Muniland