Municipal Bonds Look Cheap. Here’s Why.

July 13th, 2012 by

(July 2012) Where are municipal bond yields currently? The following snapshot was provided to Learn Bonds by MMA research the leading boutique municipal bond advisory firm. They collect prices from the leading municipal bond dealers. The following prices are an average of AAA rated municipal bonds (assuming a 5.00% coupon rate and that they are callable at 10 Years.)

 

 

 

MMA Research Municipal Bond Yields (as of July 5th, 2012)

Maturity Date Yield Change From Last Week
2014 (2 years) 0.33% none
2017 (5 years) 0.83% none
2020 (8 years) 1.53% none
2022 (10 Years) 1.90% -0.01%
2042 (30 Years) 3.23% -0.01%

 

Where is the sweet spot in the yield curve?

The steepness of the yield curve (the amount of extra yield that you receive each year) keeps increasing every year, up until you reach 8 year maturities. The 2020 maturity AAA rated municipal bond pays about 0.25% more yield per year than the 2019. This difference becomes even more dramatic, if you calculate the taxable equivalent yield. After the 2020 maturity, there is a decline in the amount of extra interest you earn for pushing out maturity dates out by a year.

 

Bonds Are Cheap According to Municipal / Treasury Ratio

According to data provided by Daniel Berger of Thomson Reuters, the M / T ratio for 10 year municipal bond yields compared to treasuries is around 117%. Mr. Berger suggested that looking at the ratio within the context of the previous 3 months was useful. During the last 3 months, the ratio has traded between 93 – 120%. The ratio is near the top of its range.  There is a popular belief that an M / T ratio above 100 indicates that municipal bonds are inexpensive compared to treasuries.

 

If the M/T ratio moves towards 100%, how will it happen?

There are two ways that the M / T ratio can move towards 100%, treasury yields can go up or municipal bond yields can go down. I asked Matt Posner of MMA research, “If the M/T ratio was to move towards 100% would it be from treasury yields rising?” He replied:

To your question about 100% without municipal rates moving, that would mean that the Greece situation would have to be resolved and a suspension of Operation Twist, which I don’t think will happen anytime soon. Instead, I think we will see the ratios decline but as a result of municipal rates going lower. The retail component of our market should undergo a shift in psychology and become more comfortable with current low absolute yield levels with the extension of operation twist and a broader desire to preserve principal.

 

What’s the Bottom Line?

Based on our research with the M/T ratio well over 100% Municipal Bonds look cheap.  The M/T ratio is likely to move back towards 100%, and that is more likely to happen from municipal bond yields falling rather than from Treasury Yields rising.

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