How much have tax fears been driving muni prices?

January 22nd, 2013 by

Signature:baed3687aecc9fc02b05e033f52ab04b5ac34144c6f0702c4e0cfe36f9d34041At the end of 2012, there was a great deal of chatter about municipal bond yields rising on  fears that the federal tax treatment of municipal bond interest would be changing. Interest on most municipal bonds is free from federal income tax and excluded from AMT income calculations. In short, there are big tax benefits from owning municipal bonds. Take away those tax benefits, and the value of municipal bonds would be much lower and their yields higher.

In the last minute fiscal cliff deal, there was no change in tax rules for municipal bonds. However, eliminating the special treatment for municipal bond interest would result in about $50 Billion  more a year in revenue for the government. As this is a significant number, its an attractive way for congress to raise revenues without increasing income tax rates. Because of this, the issue will come up again.

 

To see a list of high yielding CDs go here.

 

How much does talk about eliminating or capping the tax benefits of munis impact muni rates?

Conventional wisdom is that all of the increase in yield for munis in December of 2012 was tax fear related.  However, an analysis shows that this was not the driving force behind all of the move.

 

Rise in Muni Yields Attributed To Tax Talk

On December 11th, the Wall Street Journal came out with an article where they stated a rare area of agreement had been reached in the Fiscal Cliff negotiations.  Both Republicans and democrats agreed that limiting tax breaks on municipal bonds was on the table.  As you can see from the chart below municipal bond yields headed substantially higher after that article.

10 year municipal bond yield

In the weeks following the Wall St. Journal article, there were many follow up articles attributing the rise in municipal bond yields to fears over potential changes to municipal bond tax exemption.

 

But, Treasuries Yields Were Rising At The Same Time

During that same time period however, interest rates on US Treasuries also headed higher.  On December 12th, the day after the Wall St. Journal Article, the FOMC came out with an announcement containing major revisions in how it would handle monetary policy going forward.  This caused the market to increase its expectations for inflation, sending treasury yields higher.

10 year treasury yield

As municipal bond yields take into account inflation expectations as well, it seems obvious to me that not all the rise in municipal bond rates was due to tax uncertainty.  In order to dig a little deeper I looked at something which is known as the muni treasury ratio.

 

M/T Ratio Helps Separate The Impact of an Overall Rise in Interest Rates

The muni treasury ratio takes the yield on a municipal bond and divides it by the yield on a US treasury bond with the same maturity.  If the muni treasury ratio is above 1, that means that municipal bonds yield more than treasury bonds.  If it is below 1 that means that munis yield less than treasuries.

So how does this give me insight into how much of the rise in municipal bond rates is due to tax uncertainty?

We can see this by looking at the three possible scenarios for how the muni treasury ratio could have moved after December 11th.

Scenario 1: M/T Ratio stays the same.  This would mean that municipal bond yields and treasury yields rose by the same amount.  In this case most of the movement in municipal bond yields could likely be attributed to increases in inflation expectations.

Scenario 2: M/T ratio falls in value.  This would mean that treasury yields rose more than municipal bond yields, and that tax concerns really did not play a role in the rate movement.

Scenario 3: M/T Ratio rises in value.  This would mean that municipal bond yields rose more than treasury yields, and that at least a portion of the municipal bond yield move could likely be attributed to tax concerns.

So What Happened?

10 year muni treasury ratio

As you can see from a chart above, the 10 year muni treasury ratio rose from around .92 to a little over 1 from December 11th through December 31st before the fiscal cliff deal was announced.  This means that municipal bond yields rose more than their comparable treasuries.  To be exact  in December the yield on the 10 year AAA municipal bond rose by around 30 basis points.  During that same time the yield on the 10 year treasury note rose by around 19 basis points.

As you can also see from the chart, after the deal was announced on the 1st of January, yields on munis started to drop and the Muni Treasury ratio returned to a similar level as before the Wall Street Journal’s article was released.

 

What can investors learn from this?

Two things.

1. The pundits were correct that some of December’s rise in municipal bond yields was due to tax fears relating to the fiscal cliff.  What they left out however is that a significant portion of the rise was also due to increases in inflation expectations.

2. The rise in the muni treasury ratio to back over 1 was a good buying opportunity.  If the municipal bond exemption had been lowered, investors were still left with a very safe bond that paid a higher before tax yield than a treasury with the same maturity.  At the same time they positioned themselves to benefit from the increase in prices that was likely if the municipal bond exemption was left unaffected.  As you can see from the chart above that’s exactly what happened.

We update the muni treasury ratio weekly here at Learn Bonds so you can use this important tool in your investment decisions.  You can find it here.

    Want to learn how to generate more income from your portfolio so you can live better?  Get our free guide to income investing here.  

 

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