As of last night, the yield spread between a 30Y Treasury versus a 10Y Treasury is 0.07%. For Munis, the yield pick-up for buying a 30Y vs a 10Y is 0.97%; over 10 times the yield pick-up for US Treasuries.
The steepness of the municipal yield curve relative to the US Treasury curve should not come as much of a surprise. Munis are notoriously steep compared to their Treasury cousin. However, the relative comparison to the US Treasury curve is near extreme levels not seen since early 2009.
First, let’s consider why Munis are typically steeper than Treasuries:
Is it Credit Risk? Doubtful. We are looking at AAA-rated Munis (BVAL) which have a cumulative 10Y default rate over the last 50 years of 0.00% (Moody’s). So, if there is a credit component it would likely be insignificant.
Is it Duration Risk? Unlikely. Munis are typically callable. Even for the longest 5% coupon paying bonds, the duration is around 8.0 years given the higher likelihood that they are refinanced. Treasuries, by comparison, are generally not callable and have longer durations, sometimes twice that of Munis with similar maturities.
I believe it is related to Liquidity Risk. The Muni market is dominated by retail investors who are risk averse and typically avoid the perceived duration risk and potential volatility of long-term municipal bonds. This creates a persistent liquidity premium on the long end of the curve.
The difference between the two curves fluctuates over time, is almost always positive, and has averaged approximately 25-30 bps for the last 14 years.
Today, the difference between the Long-term Muni-to-Treasury curve spread is 90 basis points as seen in the chart above. The ratio has hovered between the 95th and 99th percentile for the past four months. While relative cheapness can last longer than expected and by itself is not a trigger to start backing the truck up on 20Y+ Munis, extreme valuations are certainly worth paying attention to.
U.S. Treasury Yield Curve; Electronic Municipal Market Access (EMMA), MSRB
BVAL AAA Municipal Curves, Bloomberg; Electronic Municipal Market Access (EMMA), MSRB
This content has been prepared for informational purposes only and should not be considered as investment advice. This commentary is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice.
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