Summer Muni Market Snoozes away Market Efficiency
The relationship between municipal bond yields and U.S. Treasury bond yields have reached an extreme worth capitalizing on.
Municipal bonds are not taxed by the federal government and most states - including California and New York - do not tax muni bonds issued within their borders. U.S. Treasury Yields are not subject to state income tax, but are subject to federal income tax.
Because of this, taxable bond investors have often looked at muni yields as a percentage of treasury ratios to judge whether the tax savings of investing in munis are worth the higher risk and lower liquidity for a given tax payer.
For example, a muni bond at 3% next to a treasury at 4% results in a 75% muni-to-treasury ratio. In this case, investors with a tax rate above 25% would receive a higher after-tax yield by buying the municipal bond instead of the treasury.
Over the last week, the highest rated (AAA) muni-to-treasury ratio for short term bonds has been measured as low as 51%. In this case, the after-tax return is only higher for someone that has a federal tax rate of 49%. Under current law the highest possible tax rate is 41.8%.
When the Tax Cut and Jobs Act expires in 2025 the top rate will be 44.4%, still 4.6 points too low to justify a AAA muni.
As muni’s go down in credit quality, the muni-to-treasury ratio increases to compensate for the poorer credit quality. The 2 year AA-/A+ California State General Obligation bond currently offers 60.6% of a corresponding treasury. If the market is pricing credit accurately then a Cal GO is a similar credit to the U.S. Treasury.
Or maybe nobody is paying attention to this sleepy, low stakes corner of financial markets as Wall St wraps up summer vacations.
To play devil’s advocate, the potential for a divided government playing chicken with the debt ceiling does not increase confidence in U.S. Treasuries. But the federal government’s control of the currency, taxes, bond buying, and guns, has made them widely regarded as the best credit around, if not completely risk-free.
On the other hand, the State of California is cash flush -- just as it was in 2000 and 2007 on the eve of recessions that led the state to pay obligations with IOUs. Prop 13, high income tax rates, and lots of in-state IPOs make CA tax revenues notoriously volatile. Most states get a larger share of tax revenues from more stable sources, especially property taxes.
California is representative of the wider short term municipal bond market. Even when ratios can make for a slightly higher after-tax yield, lower quality credits today fail to justify taking more risk.