Muni investing is popular because it has the potential to offer higher yields than similar taxable bonds. If an investor wants to know if muni bonds are cheap in comparison to taxable bonds or Treasuries, they could find out by comparing them to their historical average. However, this method does have its limitations, and if an investor was to use only this method, he or she would have missed out on a 30-year bull run.
A better alternative is to look at the value of an investment by comparing its yield relative to other similar financial instruments. The Municipal/Treasury Ratio is a popular metric among municipal bond investors and a useful barometer of relative value.
What is the Municipal/Treasury Ratio?
The Municipal/Treasury Ratio, M/T ratio or muni-Treasury ratio, as it is more commonly known, is a comparison of the current yield of municipal bonds to U.S. Treasuries. It aims to ascertain whether or not municipal bonds are an attractive buy in comparison. The ratio uses indices from the Thomson-Reuters Municipal Market Data (MMD) series.
How Do I Calculate It?
The M/T ratio is calculated by comparing the yield on an index of AAA-rated municipal bonds vs. the yield on the equivalent Treasury Note. For example, if AAA 10-year Municipal Bonds were yielding 1.4% and 10-Year Treasuries were yielding 2.2%, then the M/T ratio would be 64% (1.40%/2.20%= 0.64).
If the M/T ratio is below 100%, then municipal bonds are yielding less than U.S. Treasuries and it would not be a good idea to buy. If the ratio is above 100% then municipal bonds are yielding more than treasuries, meaning it’s a good time to buy.
How Do I Use the M/T Ratio?
The main question that investors should ask themselves is, “When is it a good time to buy?” The general rule has been that if the M/T ratio exceeds 80% then municipal bonds are cheap. A ratio that is in excess of 100% has typically suggested a buy signal.
The logic behind this is that municipal bonds are tax-free while treasuries are taxable. Why invest in the taxable instrument when you can invest tax free at a higher yield? For example, in 2008, the ratio shot up to over 180% before settling down near its historical average of 80%. Those who invested at that time made out well.
Essentially, an M/T ratio north of 100% means that investors receive the tax benefit of muni bonds for free, making them even more attractive for high net-worth investors with higher tax rate considerations.
Factors and Considerations
While a ratio over 100% is typically a buy signal, there are still a few factors to consider. One of those factors is that the U.S. Treasury market operates independently from the municipal bond market. As the denominator of the ratio, the U.S. Treasury market can have a major impact on the ratio itself. In times of uncertainty the yields on Treasury bonds drop causing the ratio to skyrocket, as seen between 2007 and 2009.
The second factor is that there are fewer bond insurers in the market that help muni bonds obtain their AAA credit rating, which dramatically improves liquidity. From 1990 to 2006, the M/T ratio averaged 81% and exceeded 95% for only 44 weeks, never topping 100%.
Today, nine out of 10 bond insurers have closed and the change has been drastic. From 2009 to 2013, the ratio was over 100%, even hitting 200% at one point from increasing yields, raising the numerator of the equation. Additionally, during this period Treasuries were being artificially depressed by the Fed’s quantitative easing program, making the denominator decrease; a double-edged sword that drove the ratio upward to record highs.
Other factors to consider are that munis are less liquid than Treasuries, which affects their pricing in relation to the M/T ratio. As well, the Treasury market typically has more short-term traders, whereas the muni market is dominated by longer-term investors. Lastly, the M/T ratio also reacts to expectations for future tax rates, and not necessarily what the rates are right now.
Investors should look at these factors and the macroeconomic environment to see if the ratio is abnormally low or high, and if so, consider whether or not it will return to the historical average before making an investment decision.
Investors should be vigilant and look into what the ratio means in relation to the macro environment and the broader investment picture. The Fed could be driving rates artificially low, there could be a flight to safety as seen during the credit crash and turmoil in Europe, or the economy could be performing well and rates increase.
With that said, a high M/T ratio does not automatically mean that municipal bonds are cheap; it could also mean the Treasuries are expensive. On the flip side, a low M/T ratio does not mean municipal bonds are expensive. Furthermore, it is important to note that municipals can still produce a negative return when the ratio is high, since a downturn in Treasury prices is likely to be followed by a similar downturn in municipals. Bearing all this in mind, investors should look to the M/T ratio to see if municipal bonds offer yields acceptable for their risk horizon compared to Treasuries.
Disclosure: No positions at time of writing