The muni-Treasury ratio (M/T ratio) compares the rates of municipal bonds with those of U.S. Treasury bonds. It's a helpful tool for deciding which is a better purchase at any given time. But it's only a rough guide. It's not one that will provide hard rules or point you toward a firm move.
What Is the Muni-Treasury Ratio (M/T Ratio)?
The M/T ratio is a formula that's used to compare the rates of municipal bonds with U.S. Treasurys. It can help you decide which is a better investment. It uses indexes from the Thomson-Reuters Municipal Market Data to compare the bonds' performance.
How to Find the Muni-Treasury Ratio
The math behind the ratio is very basic. Simply divide the yield on AAA-rated municipal bonds (munis) by the yield on a U.S. Treasury bonds of the same maturity.
"X" is the maturity years for the bonds you're comparing. You would always compare 10-year munis to 10-year Treasurys. The ratio is 0.75 if the yield on 10-year AAA munis is 1.5% and the yield on the 10-year Treasury is 2.0%.
The higher the M/T ratio, the more attractive munis become. The ratio has averaged about 0.8 throughout history.
Yields on municipal bonds are often lower than those of Treasury bonds because the interest earned by munis is tax-exempt. The interest on Treasury bonds is taxable. Investors tend to require higher yields to invest in Treasurys.
How the Muni-Treasury Ratio Works
A number of factors impact what the M/T ratio is at any given time. The first is the base level. This is the average of the tax rates for municipal investors.
Assume the M/T ratio is 0.75. An investor in the 25% tax bracket receives the same after-tax yield on municipal bonds and Treasury bonds at that level.
Now assume that munis yield 3%. Treasury bonds yield 4%. The Treasurys investor would receive an after-tax yield of 3% (4% x 0.75), so the yield on the two bonds is the same.
The two markets should reach an equilibrium based on the average tax rate of the investor base over time. Investors make buy-and-sell choices based on their after-tax yields.
Other Factors to Keep in Mind
Other factors go into determining the actual ratio, such as liquidity. Munis are less liquid. They're less easily traded than Treasury bonds. This affects pricing.
The two markets have distinct supply and demand dynamics. Municipal bonds were supported by the combination of higher than normal demand and below normal new supply in past years. This helped boost their prices compared to Treasury bonds.
The investor base in the two markets is also quite different. The Treasury market tends to attract more short-term traders. The municipal bond market is dominated by longer-term investors. Municipal bonds often move more slowly than Treasury bonds as a result. This affects the ratio.
The M/T ratio also reacts to expectations for future tax rates, not always what the rates are at the time.
An M/T ratio above 0.8 is often a signal that municipal bonds are a good buy.
The M/T Ratio in 2021
The M/T ratio ran well above average in the years after the 2007–2008 financial crisis. This was due to the aggressive policies of the Federal Reserve (the Fed), designed to fuel economic recovery. They included ultra-low interest rates and quantitative easing.
The ratio has moved up and down a great deal since 2020 as a result of COVID-19. But it has still trended in favor of municipal bonds. The yield on munis is trending high to attract investors who are wary of the potential for municipal default in light of the economic crisis that's facing many cities.
The M/T ratio was 0.765 as of August 4, 2021.
The Bottom Line
The M/T ratio is just one tool you can use to assess the value of municipal bonds. But many factors can affect the ratio, so you should always take the broader picture into account.
Keep in mind that municipal bonds can still produce a negative return when the ratio is high. A downturn in Treasury prices is often accompanied by the same downturn in municipals. Bond prices and yields move in opposite directions.
One good rule of thumb is that it's better to choose your investments based on your own goals rather than on market conditions.
- The M/T ratio compares the yields on municipal bonds and U.S. Treasury bonds.
- An M/T ratio above 0.8 can mean that municipal bonds are a better investment, but this isn't always the case.
- Investors who are looking at bonds should always check the M/T ratio and weigh it with other factors and their own goals.