Short-Term Municipal Spreads Hit Historic TightsAugust 16, 2017
Municipal bond yields are extremely tight in comparison to Treasury yields. Historically, the AAA Muni/Treasury ratio can be a good indicator of the relative value in municipals. We typically see relative value in municipals when the ratio is greater than 85%. The spread is particularly tight in short duration (<5 years) municipal bonds. In Chart 1, we plotted the YTD movement in the AAA Muni/Treasury ratio for 1, 2 and 3-year municipals. At the beginning of the year, the 1-year muni yield was 120% of Treasuries; today, we are in the 60% range. This tightening has occurred in both taxable and tax-free munis.
There has been very little supply in the municipal sector for 2017, and year over year, issuance is down approximately 15.5%. Limited supply, combined with the fact that the largest demand has been on the short end of the curve, has been the primary catalyst for short duration municipals becoming so expensive. The overall Barclays Municipal bond Index YTD has returned 4.82%, and the short-term (2-4 year duration) Barclays Muni Bond Index YTD return is 2.57%. That said, performance within the municipal sector has been very strong, which presents investors an opportunity to book gains at high valuations and reposition accordingly.
The benefit of tax-free munis is the tax equivalent yield (TEY) realized due to the tax benefit. However, in Chart 2, we can see that even on a TEY basis (assuming a 35% effective tax rate), the yield is still tight to Treasuries for anything under 5 years. In fact, returns do not exceed Treasuries until 7+ year maturities. Needless to say, the market is paying a high premium for short-term munis. Typically, it does not make sense to pay more for a municipal, which possesses credit risk, then it does for a risk-free Treasury.
Investors who own short-term municipals should analyze the benefit of selling their positions, capturing gains and repositioning out the curve into higher performing sectors with wider spreads. Investing in products when they are a relative value play (wider spread and higher yield) creates future opportunities for potential gains/earnings if spreads were to tighten. Many clients have opted to utilize the gains realized from selling short duration munis to help offset losses in longer-term/underperforming/riskier bonds in their portfolios. This risk reduction trade enables investors to adopt a more defensive position within the portfolio by eliminating lower yields/extension risk and reinvesting into the belly of the curve to increase earnings now.