If you wanted to tell if municipal bonds were cheap or expensive one method would be to compare municipal bond yields today, to their historical average. Had you done this over the last 30 years as interest rates have headed lower and lower however, you would have missed the biggest bond bull market ever. A better option to assess the relative value of an investment is to compare its yield relative to other, similar types of investments. This is where the Municipal Treasury Ratio comes into play.
The Municipal/Treasury Ratio or M/T Ratio for short, is a comparison of the current yield of municipal bonds to US Treasuries.
To make the comparison most analysts look at the yield on an index of AAA rated municipal bonds vs. the yield of the 10 year Treasury Note. If AAA Municipal Bonds were currently yielding 1.60% and 10 Year Treasuries were yielding 2%, then the M/T ratio would be 80% (1.60%/2.00% = .80).
As you can see from the above calculation, if the M/T Ratio is below 100% then municipal bonds are yielding less than US Treasuries. If the M/T Ratio is above 100% then municipal bonds are yielding more than treasuries.
The closest comparable investment to AAA Municipal Bonds are US Treasuries. Unlike US Treasuries, AAA municipal bonds are not considered 100% free from risk of default. However, they are considered by most to be very, very safe, and here has never been a municipal bond default on a AAA rated municipal bond in my lifetime.
Treasuries are considered risk-free as they are backed by US government. Thus, many analysts look at bond yields having two components:
When treasury rates make large moves, typically all other rates move in concert. By comparing municipal bonds to treasuries, you are getting a reading cheapness / expensiveness of municipal bonds compared to overall interest rates.
Prior to 2007, the safest municipal bond yielded around 80% of treasuries. The difference is that municipal bonds are federally tax free, while the interest on treasury bonds is taxable. If you compare the after tax yield on municipal bonds to the after-tax yield on AAA municipal bonds at the highest personal income tax rate however, the yield on the municipal bonds was slightly higher than the treasury yield. As triple AAA munis have never had a default in my lifetime, an after-tax yield that is only slightly higher than treasuries makes sense.
The last few years have been a rollercoaster for M/T ratio. At one point during the 2008 financial crisis, the M/T ratio went to 200%. Since that time it has fluctuated from around 90% to 120%, which would indicate that Municipal Bonds are “cheap” by historical standards.
Should you be buying munis because they are “cheap” by historical standards?
I will let Matt Posner of Municipal Market Advisors (MMA), the leading boutique research firm on municipal bonds, answer this question:
I am always wary of ratios when a bond salesman tells me munis are cheap because they are yielding over 90% of Govies. It is better to put it into context. Since the Fed announced ‘Operation Twist’ in late 2011, the ratios have moved into a higher than usual range (~90% to 120%) with the exception of mid-March when the municipal market backed up for a variety of reasons but supply played a big role there. So, basically, the ratios are high because Treasuries are incredibly rich right now due to an artificial depression of rates and a global flight to safety with Europe in mind.
Matt makes a number of excellent points. However, I want emphasize his central point,a high M/T ratio does not mean automatically mean that municipal bonds are cheap. It can also mean the treasuries are expensive. What the M/T ratio really tells you is do municipal bonds offer attractive yields compared to treasuries for individual investors.